Chapter 2:

The market system and the circular flow

Role players in the economy who make the decisions in the circular flow diagram
 Households
o Consists of a single person, a family or a group of people who live
together, depend on a common income and within that income he/her
or they exercise their choices with a view to meeting their economic
objectives
o They function in the economy is primarily to supply primary
production factors (labour, land, capital and entrepreneurship) to
private business enterprises as well as to government institutions.
 Business enterprise
o Is an economic decision taker whose purpose is to earn income, or to
make profit, by supplying goods and services for which there exists a
demand in the economy
o General function is the production of goods and services
 Government
o Government sector consists of all organisations from the level of local
authorities to central government that process legislative, judicial and
executive powers and have been established by means of a political
process
o Governments are there to create the environment in which the
economy can operate freely and fairly
 Foreign sector
o It consists of large number of individual states, each with its own
government, consumers and business enterprises.
o Countries extensively involved in international trade are classified as
an open economy

The economic system

The role players in the economy decisions and actions are fulfilled in the three
imaginary markets in the economy. They are:
 Resource market
o The place where resources or the services of resource suppliers are
bought and sold.
o Here households sell resources and businesses buy them
o Funds that businesses pay for resources are costs to them, but flows of
wage, rent, interest and profit income to households
 o Productive resources therefore flow from households to businesses,
and money flows from business to households
 Productive market
o The where goods and services produced by businesses are bought
and sold.
o Households use the (limited) income they have received from the sale
of resources to buy goods and services
o The monetary flow of consumer spending on goods and services yields
sales revenues for businesses
 Financial market
o Takes care of the flow of surplus funds in the economy.
o Savings in all forms are pooled together to create a source if funds for
investment purposes
It is important to realise that the behaviour of one of the participants in the
economy can affect the whole system
The economic flow of resources: goods, services and money
The basic concepts of the circular flow
 The production factors flow from households to firms through the resource
market
 Goods and services flow from firms to households through the product market
 Opposite these real flows are monetary flows
o Households receive income from firms (their costs) through the
resource market, and
o Firms receive revenue from households (their expenditure) through the
product market
Draw the different circular flow diagrams that are on page 32 and 33 and looks at the descriptions

Economic systems
Is a particular set of institutional arrangements and coordinating mechanism – to
respond to the economising problem.
It has to determine what goods are produced, how they are produced, who gets
them, how to accommodate change and how to promote technological
advances/progress
 Economic systems differ as to
o Who owns the factors of production
o The method used to motivate, coordinate and direct economic activity.
 Economic systems have two polar extremes:
o The command system
o The market system
  The Command System
o Also, known as socialism or communism
o Government owns most property resources, and economic decision
making occurs through a central economic plan
o A central economic planning board appointed by the government
makes nearly all the major decisions concerning the use of resources,
the composition and distribution of output, and the organisation of
production
 The Market system
o Also, known as pure capitalism
o Characterised by private ownership of resources (capital) and the use
of markets and prices to coordinate and direct economic activity
o Participants act in their own self-interest - individuals and businesses
seek to achieve their economic goals through their own decisions
regarding work, consumption or production
o In pure capitalism or laissez-faire capitalism – governments role would
be limited to protecting private property and establishing an
environment appropriate to the operation of the market system
 laissez-faire – means let it be = to keep government from
interfering with the economy
read mixed system (page 36)

characteristics of the market system

 private property
o the right of private property, coupled with the freedom to negotiate
binding legal contracts, enables individuals and businesses to obtain,
use and dispose of property resources as they see fit
o encourage investment, innovation, exchange, maintenance of property
and economic growth
 freedom of enterprise and choice
o freedom of enterprise – ensures that entrepreneurs and private
businesses are free to obtain and use economic resources to produce
their choice of goods and services and to sell them in their chosen
markets
o freedom of choice – enables owners to employ or dispose of their
property and money as they see fit. It also allows workers to try enter any
line of work for which they are qualified. Finally it ensures that customers
are free to buy the goods and services that best satisfy their wants and
that their budgets allow
 self-interest
o the motivating force of various economic units as they express their
free choice
  competition
o the market system depends on competition among economic units.
The basis of this competition I freedom of choice exercised in pursuit of
a monetary return. Very broadly competition requires:
 two or more buyers/sellers acting independently in a particular
product or resource market
 freedom of sellers and buyers to enter or leave markets, on the
basis of their economic self-interest
 markets and prices
o market – an institution or mechanism that brings buyers (demanders)
and sellers (suppliers) into contact
o the decisions made on each side of the market determines a set of
product and resource prices that guide resource owners, entrepreneurs
and consumers as they make and revise their choices and pursue their
self-interest
 technology and capital goods
 specialisation
o the use of resources an individual, firm, region or nation to produce one
or a few goods or services rather than the entire range of goods and
services
 division of labour – human specialisation
o specialisation makes use of differences in ability
o specialisation fosters learning by doing
o specialisation saves time
 geographic specialisation
 use of money
o barter – swapping goods for goods
 active, but limited government
o an active, but limited government is the final characteristic of market
systems in modern advanced industrial economies
the five fundamental questions
1. what goods and services will be produced?
2. How will the goods and services be produced?
3. Who will get the goods and services?
4. How will the system accommodate change?
5. How will the system promote progress?
Market system criteria The Command System Pure market system
Private property Government owned Mostly private owned
Freedom of enterprise and Government makes choices Freedom to make choices
choice of what, how and for whom and start enterprise
Self-interest No incentive to work or Completely self-interest
choose for own interest driven
Competition No competition Full market competition
between buyers and sellers
Markets and prices Determined by government Choices are freely driven by
the price-mechanism
Technology and capital Central government decides Constant drive by
goods on what is used and how individuals and firms to
improve technology and
obtain more capital goods
Specialisation Government decides on Specialisation is determined
where to specialise and in by the price mechanisms
what
Division of labour Government controlled Labour market driven based
on individual choices
Government intervention in Full government control Very limited government
market control
Five fundamental questions Solved by central Solved by individuals and
government decisions firms driven by the price
mechanism

The demise of the command system

 Coordination problem
o Failure in any single industry to achieve its output target caused a
chain reaction of repercussions
o Managers and workers often sacrificed product quality and variety
because they were being rewarded bonuses for meeting quantitative
not qualitative targets.
 Incentive problem
o Go read