Chap.

The Market System & Circular Flow Model

COMPARATIVE ECONOMIC SYSTEMS
Government
Involvement

Property Rights

Economic Decisions
(output mix, input mix)

determined by individuals
P URE C APITALISM limited except
private ownership of the based on market price
(Laissez -Faire,
to protect
factors of production mechanisms and dependent
Free Market System) property rights
on individual costs/benefits
C OMMAND E CONOMY
major
(Communism)

public ownership of the

determined by government via
factors of production
central economic planning
excluding labor

GOVERNMENT INVOLVEMENT - not just gov. taxation & spending, but also regulation
PROPERTY RIGHTS -

Ownership of Wealth or Land, Labor, and Capital (the factors of production

or resources), inputs and outputs, this includes intellectual property rights
such as patents and copyrights

ECONOMIC DECISIONS (Output Mix, Input Mix)

Command Economy - best output and input mixes by gov. only a guess, no incentives for
production and allocative inefficiency resulting in wasted resources, lower economic growth and
reduced standards of living
Pure Capitalism - decisions made by Invisible Hand, competition, with market incentives more
likely tying costs and benefits resulting in a higher degree of production and allocative efficiency,
higher economic growth and a rising standard of living
MIXED SYSTEM - most countries lay between the two polar extremes
E.g. US is a Mixed System with government controlling 18% of GDP with publically owned
roads, universities, etc., and with redistributions of property rights (generally income) this rises
to 33% of GDP. Under Pure Capitalism, all schools and roads would be privately owned and
charge tolls (instead of funded by taxes).
Most countries while still mixed systems have a larger public sector, e. g with public ownership
of utilities, airlines, and railroads, such more often privately owned in the US.
BLACK MARKET OR UNDERGROUND ECONOMY - considered purest form of capitalism
HISTORY - Twentieth Century after the Great Depression (1930s) - general world wide movement among
countries towards larger government crowding out the private sector. Last Two Decades - partial movement
away from large government towards free markets by those countries which had more of such, e.g. China
and Eastern Europe: privatization of state owned industries and legalization of private ownership of
business enterprise resulting in higher economic growth and living standards in those countries.

Market System
TENETS: 1.) Private Property
2.)
3.)
4.)
5.)
6.)

Freedom of Enterprise and Choice

Self-Interest Provides Incentives
Competition
"Invisible Hand"
Limited Governmental Role

PRIVATE PROPERTY
C
C
C

Individual (not Government) Private Ownership of outputs and resources (land, labor, capital)
includes intellectual property rights (patents, copyrights)
Freedom to Use and Exchange Private Property
Private Property Rights Provide Incentives - encourages exchange, innovation, investment,
efficiency, and economic growth (i.e. creating new property rights or wealth)
Why? - Owners get benefits and costs from economic decisions.

ECONOMIC FREEDOM
Freedom of Enterprise:
C
freedom to start (or exit) business
C
firms free to decide on organizing operations, outputs produced, input combination used
Freedom of Choice:
C
firms & consumers free to exchange private property
C
individuals can chose where to sell labor, and what products to purchase with their income

SELF-INTEREST PROVIDES MOTIVES & INCENTIVES

C

Decisions based on private individual costs and benefits

(man is homoeconomicus) e.g. maximize utility, profits, minimize costs
But is everyone greedy???
Behavior in self-interest is not inconsistent with gift giving/bequests/charity.
Gift givers really receive utility from increasing anothers happiness.

COMPETITION
C
C
C

Large number of buyers & sellers acting independently in self-interest

Easy entry and exit
An individual seller or buyers impact on the market price is insignificant

INVISIBLE HAND - Adam Smith, Wealth of Nations (1776)

Decisions made by producers and consumers pursuing their own individual self-interests through markets
and trade unintentionally promote the public interest or help others as if led by an Invisible Hand.
C
C
C
>

Prices serve as incentives for sellers and consumers

Resources efficiently transformed into various outputs valued most by consumers
Quick adaptions (resources redirected) with changes in tastes, technology, and available resources
(Supply and Demand shifting in individual markets)
Government decision making (what or how to produce) is not needed

LIMITED ROLE FOR GOVERNMENT

!
!
!

Individual choices for the exchange of private property unfettered by government.

Market economy is self-adjusting with generally efficient results.
Little need for government intervention (except to protect property rights, enforce contracts).

OTHER CHARACTERISTICS:
SPECIALIZATION <

more efficient to do what a person does best rather than to be a jack of all trades

when people to specialize, then trade with others, more output can be produced
Division of Labor ...

people have differing skills and abilities, thus more productive if each specialize

e.g. assembly line to build cars

Geographical Specialization ...

similarly, areas have natural resources more suited for certain production

e.g. French wine/American wheat

DETERMINATION OF WHAT TO PRODUCE & RESOURCE ALLOCATION

!

Driving Force: Profit Incentive

Conventional calculation $ :
Accounting Money Profits (loss)
!
!
!

Revenue
(output sales)

Production Costs
(input costs)

Money profits (above) are really a payment to entrepreneurs for organizing and taking risks.
Payments to entrepreneurs are an economic cost.
Normal profits are expected by entrepreneurs.

Total Economic Costs = normal profits

+
(entrepreneur's skills,
opportunity cost of time)

other costs of production

(land, labor, capital)

Economic Profits = Accounting or Money Profits - Normal Profits

Expanding Industries:
Money acct. profits > normal profits,
(or economic profits > 0)
- new entrants attracted,
- more resources flow to industry
- production rises
e.g. cell phones, computers

!
!

Declining Industries:
Money acct. profits < normal profits,
(or economic profits < 0)
- incumbent producers exit,
- less resources flow to industry
- production falls
e.g. buggy whips, fur coats

Changing consumer tastes shift demand Y market price up (down) Y more (less) profits Y
incentives for firms to produce more (less)
Changing economic profits are an incentive to produce more (or less)
Y resources flow to the sectors and firms producing the outputs most valued by consumers

Circular Flow Model

Resource Market S where resources (inputs) are bought and sold
Product Market S where final goods and services (outputs) are bought and sold
Business Owners

S transform resources (inputs or factors of production) into final goods & services
S buy resources, sell products

Households

S transform final goods & services into utility

S buy products, sell resources for income (wages, interest, rents, profits)

Below circular flow diagram shows exchange and money flows (outside) and resource and output flows
(inside).