The Market System and Circular Flow
Lesson 2

Economic Systems

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

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

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

	Resources Market
Businesses		Households
	Goods and Services Market

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