Chapter 2:

The Market
System and the
Circular Flow

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
 OBJECTIVES
• Differentiate between a command system
and a market system.
• Explain the main characteristics of the
market system.
• Discuss how the market system answers
four fundamental questions.
• Describe how the market system adjusts
to change and promotes progress.
• Explain the mechanics of the circular flow
model.
 Review:
• What is the economic problem?
• Consumers
• Producers
• society
 An Economic Problem
• Both individuals and society face an
economic problem.

An economic problem is the need to make

choices because wants exceed means.

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An Individual’s
Economic Problem
• Limited income (from • Unlimited wants
wages, interest, rent, means individuals have
profit) forces people to to evaluate their
choose what to buy and marginal benefits and
what to forgo. marginal costs to make
• Can be represented choices that maximize
by a budget line their satisfaction
• Two types of wants:
A Budget line shows
• Necessities (food,
various combinations of shelter, clothing, health
two products a care)
consumer can purchase • Luxuries (jewelry,
electronics, private art
with a specific money collections)
income, given the
products’
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 Society’s
Economic Problem
• Scarce economic • Many ways to use
resources (also called limited resources:
factors of production, • Goods
or inputs):
• Services
• Land • Private services
• Labor • Government services

• Capital
• Entrepreneurial
ability
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How do societies solve the
economic problem?
Economic System
• Societies develop economic systems to
solve their economic problem.
• There are four general types of economic
systems
• Traditional economy
• Command system
• Market system
• Mixed economy
Economic system is a particular set of
institutional arrangements and a coordinating
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mechanism for producing goods and services.
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 Traditional Economy
• an original economic system in which
traditions, customs, and beliefs shape the
goods and the products the society
creates.
• Countries that use this type of economic
system are often rural and farm-based.
• Also known as a subsistence economy, a
traditional economy is defined
by bartering and trading
The Command System
• Economic systems differ in two main aspects:
• Who owns the factors of production;
• The method used to motivate, direct, coordinate
economic activity.
• In a command system (a.k.a. socialism or
communism):
• Government owns most factors of production;
• Economic decisions are made by a central governing
body.

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 The Market System
• In a market system (a.k.a. capitalism):
• Factors of production are privately owned;
• Markets and prices are used to direct and
coordinate economic activities.
• Participants act in their own self-interest resulting
in competition among independent buyers and
sellers of each product and resource.
In the capitalism practiced in the United States and most
other countries, government plays a substantial role in
the economy, but it is not the dominant economic force.

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MARKET ECONOMY
Key Features of the
Market System
Private property
Freedom of enterprise and choice
Self-interest
Competition
Markets and prices
Technology and capital goods
Specialization
Use of money
Active but limited government
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 Key Features of the
Market System
• Private Property is the right of persons and firms
to obtain, own, control, employ, dispose of, and
bequeath land, capital, and other property.
• Freedom of enterprise is the freedom of firms to
obtain economic resources, to use those resources
to produce products of the firms’ own choosing,
and to sell their products in markets of their choice.
• Freedom of choice is the freedom of owners of
resources to employ or dispose of them as they
see fit, and the freedom of consumers to spend
their incomes in a manner they think is appropriate.
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 Key Features of the
Market System
• Self-interest is the most advantageous outcome
as viewed by each firm, property owner, worker, or
consumer.
• Competition is the presence in a market or
independent buyers and sellers vying with one
another, and the freedom of buyers and sellers to
have a market.
• A market is an institution or mechanism that brings
buyers and sellers together.
• Technology and capital goods promote efficiency
and the ability to produce more goods and
services.
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 Key Features of the
Market System
• Specialization is the use of resources of an
individual, region, or nation to produce one or a
few goods and services rather than the entire
range of products.
• The use of money where money is any item that
is generally acceptable to sellers in exchange for
goods and services.
• Active, but Limited, Government where
government can sometimes increase the overall
effectiveness of the economic system.

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videos
• Market economy
• Command economy
 Four Fundamental
Questions
• The key features of the market system
allow market economies to answer four
fundamental questions:
• What goods and services will be produced?
• How will the goods and services be
produced?
• Who will get the goods and services?
• How will the system promote progress?
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What Will be Produced?
• The goods and services produced at a
continuing profit will be produced. Those
producing at a continuing loss will not.
• In a market system, consumers are sovereign
(in command) – they “vote” with their dollars.
Consumer sovereignty is the determination by
consumers of the types and quantities of goods
and services that will be produced with the
economy’s scarce resources.
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How Will Goods and Services
Be Produced?
• The combination of resources and
technologies that minimizes the cost per unit
of output will be used to produce goods and
services.
• In a competitive market economy, high-cost
producers lose business to low-cost
producers of equal-quality products.

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 Who Will Get the Output?
• Distribution of goods and services is determined
by:
• Prices of these goods and services;
• Consumers’ preferences for these goods and
services;
• Consumers’ ability and willingness to pay for
these good in services. This in turn depends on
income which is determined by:
• Quantity of property and human resources they
supply,
• Prices those resources command on the resource
market.

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How Will the System
Promote Progress?
• Technological advance in encouraged by the
market system
• Market rewards invention of new products
• New production technologies may help lower cost
of production
• Capital accumulation
• Entrepreneurs and business owners “vote” with
their dollars for capital goods.
• By paying interest or selling shares firms attract
households’ income to pay for capital goods.
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The Circular Flow
Model
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The Circular Flow Model
• Resource Market
• Households sell resources
• Firms buy resources
• Product Market
• Households buy products
• Firms sell products
• Real flow of resources and products
corresponds to the money flow in the
opposite direction.
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 QUIZ
• What is an economic system?
• Differentiate the four types of economic
systems
• What are the four fundamental problems
in the economy
• Describe how each problem is answered
by a command economy and a market
economy
 Assignment
• What is the law of demand?
• What is the law of supply?
• Define when equilibrium happens. What
happens when there is no equilibrium?
• What are the determinants of demand
aside from price?
• What are the determinants of supply aside
from price?