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The Market System and Circular Flow
Lesson 2

 

Economic Systems

Economic system - legal structure
  • Institutional arrangement - who owns property, makes products, who consumes products, etc.
  • Economic systems can be plotted on a continuum

Capitalism vs. Socialism scale

1. Command System (i.e. Communism / socialism) - public ownership of property and economic decisions are determined through a central committee.

  • "Collective decision making"
  • Government owns the machines, buildings, and land.
  • Examples
    • China
    • North Korea
    • Cuba
  • Government maintains private property, but uses taxes, subsidies, and regulations to control economy

2. Market System (Pure capitalism or laissez faire)

  • Allow competitive markets to determine the price and quantity of products
  • Laissez faire - French term, which means leave it be; a reference to government
  • Government establishes legal framework
    • “rules of the game”
    • Defines property rights - the right to use, control, and obtain benefits from a good, service, or resource.
    • Resolve conflicts - have people interact harmoniously
    • Coin money
    • Support a military for national defense

3. Islamic Economics - behavioral norms and moral foundations derived from the Quran and Sunna

  • To reduce the gap between the rich and the poor
    • Islam
      • encourages trade
      • discourages the hoarding of wealth
      • outlaws usury (or riba in Arabic)
        • Usury is making money by loaning out money
        • Interest
      • Wealth is taxed through Zakat, but trade is not taxed.
    • Profit sharing and venture capital where the lender is also exposed to risk are acceptable.
    • Hoarding of food for speculation is also discouraged
    • Grabbing other people's land is also prohibited.

4. Index of Economic Freedom

  • Economic Freedom
    • Freedom of enterprise - entrepreneurs and businesses are free to purchase resources to produce products and services
    • Freedom of choice - gives businesses, consumers, and laborers the freedom to make economic choices
      • Freedom to choose occupations, products and services, etc.
    • Economic freedom is not the same as political freedom
      • Examples - Singapore, Kazakhstan, etc. have market economies; it would not be wise to publicly criticize the government
  • Index of Economic Freedom
    • A broad measure of a legal structure
    • Economists assigned "judgment" values
Index of Economic Freedom
Country Heritage Foundation
2010
Heritage Foundation
2000
Gwartney & Lawson
1998-1999
Hong Kong 1 1 1
Ireland 5 10 8
U.S.A. 8 8 3
Mexico 37 76 66
Russia 128 113 119
Bosnia 98 133 -
Venezuela 143 89 100

4. Two methods people can use to influence the market and government

  • Voice - communicating complaints, desires, and suggestions directly to decision makers.
  • Exit - the ability to withdraw from an economic relationship with another person or organization.
  • Examples:
    • If you received bad service from an auto shop, then next time your car needs fixing you will find an alternative auto shop.
    • Exit is easier to exercise in a market economy.
    • Exit is not effective when:
      • Market has one brand.
      • One supplier like an electric power company.
    • Voice and exit are more effective together.

Characteristics of a Market System (i.e. Capitalistic System)

1. Private property rights - the right to use, control, and obtain benefits from a good, service, or resource.

  • Land, capital, or intangibles like patents, trademarks, and copyrights
  • Goes with market system
  • Property rights entail:
    • The right to exclusive use
    • Legal protection against invaders
    • The right to transfer property to another
  • Private property rights create incentives.
    1. Property owners gain by employing their resources that are beneficial to others.
      • Example: Whether to use land to construct houses, apartments, or a mall.
    2. Have a strong incentive to care their property.
      • Example: In the USSR, the government owned all property. Stealing was rampant. Thieves even stole park benches to recycle metal.

2. Economic Freedom

  • Freedom of enterprise - entrepreneurs and businesses are free to purchase resources to produce products and services
  • Freedom of choice - gives businesses, consumers, and laborers the freedom to make economic choices
    • Freedom to choose occupations, products and services, etc.
  • Economic freedom is not the same as political freedom
    • Examples - Singapore, Kazakhstan, etc. have market economies; it would not be wise to publicly criticize the government

3. Self Interest - people and businesses pursue their own self interests

  • Consumers - want cheap prices and high quality
  • Businesses / Entrepreneurs - maximize profits
  • Workers -want high wages, fringe benefits and do the least work
  • Property owners - want high value for their land

4. Market - an institution that brings buyers and sellers together

  • Competitive market - prefer a large number of buyers and sellers in market
    • Ensures market price is the lowest given opportunity costs
  • Competitive firms - have an incentive to use new technology or create new products
  • If market has one buyer or seller, he has market power and swings price in his favor
  • Non-competitive markets - one reason why government may regulate a market

5. Specialization - increases the amount produced and occurs at four levels

  1. "Law of Comparative Advantage" - countries specialize in production of goods where they have a low relative opportunity costs and engage in international trade
    • David Ricardo
    • Countries specialize in products that they are good at
    • Examples - Asian countries - computers and cars
      • United States - corn and soybeans
      • Columbia - coffee
      • Saudi Arabia - petroleum
  2. Regions within a country can specialize
    • Houston, Texas - energy companies and products
    • Wisconsin - milk and cheese
  3. Companies can specialize
    • Microsoft - computer software
    • Honda - vehicles
  4. Division of labor - breaks down the production of a good into specific tasks each performed by a different worker.
  • Specialization allows workers to choose occupations that they are good at
  • Workers become more skilled with time
  • Allows mass-production technology
  • More goods are produced
  • Example: Assembling lines in factories

6. Voluntary exchange - selling goods among people who put the most value on them

  • Creates value
  • Foundation of trade
  • Goes hand in hand with specializing; more products and services
  • Example: 1968 Ford Mustang
    • Buyer $5,000; seller $4,500
    • Both benefit by trading, seller gains $500
  • Transactions costs - the time, effort, and other resources needed to search and negotiate an exchange
    • Transactions costs reduce gains from potential trades
  • Middleman - a person who buys, sells, or arranges trades
    • A middleman reduces transactions costs
      • Car dealerships (car manufacturers - customers)
      • Grocery stores (farmers - customers)
      • Stockbrokers (investors selling - investors buying)
      • Ebay and Craig's List ( internet)

7. Use of Money

  • Medium of Exchange - money allows people to pay for products and services using money
    • Allows people, countries, regions, and businesses to specialize
    • Facilitates voluntary exchange
  • Barter - a system that does not use money
    • Double of coincidence of wants - if a person makes shoes and wants to buy bread, he has to find a person who makes bread and wants shoes
    • Extremely inefficient form of trade
    • Barter is making a come back
      • Internet allows people to find each other
      • Why
        • Businesses may have cash flow problems
        • Use barter to get products and services they need to sell products
        • Help avoid taxes (No money is traded so no value)

Invisible Hand Principle - Adam Smith

  1. Invisible Hand - market prices direct individuals pursuing their own self-interest into productive activities that also promote the economic well-being of society
    • Example: A medical doctor pursuing self-interest to become rich
      • He cures people
      • The people remain productive
      • Society is better off!
  2. Prices communicate information
    • "Brings buyers and sellers into harmony"
    • Example: Surplus of apples in the market. Sellers will lower price until all surplus apples are sold (firms' profits may decrease)
    • Example: Shortage of apples in the market. Sellers will raise the price until shortage disappears (firms' profits may increase)
  3. Market prices direct economic activity
    • If a firm is earning perpetual losses
      • Consumers are placing a low value on those products or services
      • Firm has to restructure or goes out of business
      • Frees resources so they can be used for other more profitable industries
    • If firm is earning profits
      • Other firms enter the market and compete
      • Market prices will fall
    • Competitive markets - markets are consumer oriented
      • Consumer sovereignty
      • "dollar votes"
  4. Market prices directs millions of consumers and producers around the world.
    • Impossible for government to set prices correctly
    • Shortages occur in Socialist countries
  5. Social Welfare is highest
    • Efficiency - resources are directed into the most profitable industries
    • Market efficiency depends on competitive markets and well defined private property rights
    • Firms adopt new technologies and develops new products
    • Incentives - hard work, accumulating assets, and innovation

Circular Flow

Circular flow - shows how resources, goods, services, and money flow in an economy. Firms use resources to produce goods and services for households.

  • Resource markets - factors of production
    • Nonhuman resources
      • Physical capital
        • Tools
        • Machines
        • Buildings
      • Land
      • Natural resources
    • Human capital
      • Skills
      • Knowledge
      • More human capital increases productivity
      • Workers produce more with same level of resources
    • Differences:
      • Worker can quit and work for another firm
  • Households buy goods and services from firms
    • Red Arrow - flow of goods, services, and resources
    • Green Arrow - flow of money
  • Firms produce goods and services from resources
    • Firms hire labor and pay them wages
    • Firms pay higher wages for workers with more skills
    • Firms pay rent to lease land
    • Firms pay interest to rent machines, equipment, and tools
    • Note - firms can own land, machines, and equipment; their opportunity cost is to rent them out.
  • Red Arrow - use labor services to produce goods & services
  • Green Arrow - wages to workers. Income for workers to buy goods & services
Flow of money and resources Resources Market
Market demand and supply for resources
Flow of money and resources
Businesses
Businesses

Households
Households
Flow of money and resources Goods and Services Market
Marlet demand and supply for goods and services
Flow of money and resources

Note: When firms uses capital, land, and natural resources, the payments eventually go to households in the form of income: Wages and interest

  • Firm extracts oil
    • Firm hires workers to drill & extract
    • Firms buy machines which were made by workers

Terminology

  • economic system
  • command system / Communism / socialism
  • market system / pure capitalism / laissez faire
  • property rights
  • freedom of enterprise
  • freedom of choice
  • voice
  • exit
  • self-interest
  • competitive markets
  • market
  • specialization
  • division of labor
  • medium of exchange
  • barter
  • voluntary exchange
  • transaction costs
  • middleman
  • “invisible hand”
  • consumer sovereignty
  • dollar votes
  • circular flow diagram
  • resource market
  • product market
  • nonhuman resources
  • human capital
 

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