MarketsChapter 2

In this chapter you will learn:

• The difference between a command system and a market system.

• The main characteristics of the market system.

• How the market system decides what to produce, how to produce it, and who obtains it.

• How the market system adjusts to change and promotes progress.

• The mechanics of the circular flow model.

Economic Systems• Each social system must address:

1. the issue of deciding how to use scarce resources to produce goods and services

2. determine how to distribute these goods and services among the members of their society

3. discern how to maintain enough flexibility in the system to accommodate change and encourage increasing efficiency over time.

• What is your most scarce or precious resource? – Many of you will consider money as your most scarce resource. Although this may run a

seemingly close second to your most precious expendable commodity, it won't ever be your most critical resource.

• Time is your most critical resource constraint in that you can only spend it and you have a fixed supply over your lifetime. Therefore, it is important to use your time most wisely of all.

Free MostlyFree

MostlyUnfree

Repressed

1- Hong Kong3- Ireland9- United States

22- Belgium33- Spain44- France

81- Brazil111- China122- Russia

150- Cuba152- Venezuela157- North Korea

Source: Heritage Foundation (www.heritagefoundation.com) and The Wall Street Journal

Global Perspective

2 Economic Systems

Two general types of economic systems exist today:

• command systems and market systems

• Historically, command systems have been associated with socialist or communist political systems.

• Alternatively, a market-based approach typically referred to as capitalism has historically been most commonly associated with democratic political systems.

Command Economic System• In command economic systems the government owns most

of the property and controls decision making when seeking to answer the economic questions of what to produce, what to use to produce it, and who gets it, etc.

• Central economic plan and are performed by a centrally planning board appointed by the government

• These plans address what will be produced, what resources will be used in production, how to distribute the output, how to accommodate change, and how to integrate change in the process.

Are Command Systems Efficient?

• Command systems are generally inefficient.

• Central planners historically choose for the system to produce too much of certain goods, not enough of others, and have no incentives built into the process for change.

• Accurately predicting future needs for groups of people is difficult because we can't anticipate needs in the future and how those needs may change over time.

• In addition to the prediction dilemma, a change would require not only convening a planning committee, but also gaining consensus among its members.

• When we consider having to go to such extremes in order to accommodate changes, one can understand why this system does not function very efficiently.

The Market System• In contrast, the market system allows private ownership of

resources and defers production and distribution issues to the self-sustaining process of prices in the market.

• The core motivator within the market system is self-interested behavior. All parties in the system are free to make choices perceived to be in their own best interest.

– Why is this so? Let’s take a look at John StosselWhy do people take better care of things they own?

How does a Market system differ from a Command system?

1. Market systems and command systems differ in both the way resources are allocated

2. And also how decisions are made regarding distribution of the goods.

– The market process allows communication in the market place to cue producers and consumers to behave in their respective ways. Secondarily, their behaviors communicate how resources are to be allocated in the future

– So is it magic? How do buyers and sellers communicate?

Does the U.S. have a pure Market Economy?Does the U.S. have a pure Market Economy?• No. We were once a pure market system, but we discovered

that pure capitalism had some inherent weaknesses at the extreme, too. – Such as?

• In pure capitalism, the role of government is diminished to that of protecting private property, maintaining a market environment, and providing national defense.

• The greatest amount of change in this regard in our own economic system coincided with the Great Depression.

Important Characteristics in a Market Economy

1. Technology

• Market economies are quick to integrate technology because gains in this area equate to increases in productivity. A simple definition of productivity is an increase in outputs while employing no more inputs.

2. Capital Goods

• Imagine how inefficient digging a hole with your hands would be when compared to using a ditch digging machine. From this analogy you get an idea of how crucial the development of capital goods is to an economic system.

• Incidentally, gains in technology lead to improvements in capital goods and that is the source of the majority of our productivity gains therefore technology and capital goods naturally accompany one another.

SpecializationSpecialization• Specialization is also a crucial component of a market system in

that resources are often better suited to producing a single good or a small range of goods rather than producing everything.

• Therefore, specialization brings about substantial gains in productivity.

*Cast Away Clip

Division of Labor

• Division of labor is an additional strategy employed in market systems.

• We can actually think of division of labor as a subset of specialization in general.

– Division of labor affords us the luxury of using people with skills best suited for certain activities in the way they will be most productive.

– In addition, there are usually related gains in productivity because practice makes perfect. Stated differently, we continue to improve at the things we do the most.

– Finally, division of labor enables us to use another resource more efficiently. As labor improves productivity, additional time becomes available for alternative uses.

Geographical SpecializationGeographical Specialization• Consider the example of the locations available for the production of wheat, potatoes, and

oranges from your text. – Nebraska has land and climate making it much better suited for producing wheat, whereas Idaho has

land and climate better suited to producing potatoes, and Florida has land and climate better suited to producing oranges.

– Although each state could seek to produce all three commodities independently, we can rest assured Nebraska and Idaho will have a near impossible time producing citrus fruit and the cost of doing so would be exorbitant.

• Specialization allows us to use resources best suited for each use in production and we encounter considerable gains in output as a result.

– Nebraska can specialize in producing wheat, Idaho can specialize in producing potatoes, and Florida can specialize in producing oranges and each can trade with the other.

• The net effect of all this specialization and trade is not only more productivity and total output, but also a higher standard of living for all involved.

• Specialization keeps costs lower and allows our budget to have more buying power in the market.

Use of Money & Active, but limited Government

• An additional critical component enabling efficiency in market systems is the presence and use of money to facilitate trade.

• A primary function of money is that it serves as a medium of exchange. – The use of money as a medium of exchange contributes to efficiency in a very

important way because it allows an economy to evolve beyond the need to barter, or trade one good for another. The process of barter is inefficient because two persons each having what the other wants must encounter one another simultaneously for barter to occur and the sheer probability of this occurring is unlikely.

• The final critical component of a market system we examine is the existence of an active, but limited, government. In market systems, governments protect the right to own property and maintain national defense. Both are essential to assure market systems function at efficient levels. In addition, the government must also compensate for a certain amount of market failure. Although market systems are highly efficient, they are not perfect and thus prompt a certain amount of inherent failure.

Key Market Characteristic #1

• The first of these involves the ownership of private property. Most property in market systems is owned by individuals and firms.

– The government also facilitates trade and business activity by supporting and encouraging the establishment of contracts among individuals and entities. And finally, the government also established and maintains court systems in which disputes to contract law may be resolved.

• A second dimension of private property ownership market systems protect is the domain of intellectual property. Market systems allow the exclusive ownership of intellectual property through legal documents such as patents, copyrights, and trademarks. In the event such protective measures were not in place, much of the motivation to create and invent would diminish.

Key Market Characteristic #2

• Freedom of enterprise and freedom of choice.

• Freedom of enterprise allows businesses and entrepreneurs to obtain and employ resources in any creative manner necessary to satisfy market demand so long as doing so is legal.

• Freedom of choice allows business owners the latitude to purchase or dispose of any personal property as they see fit.

– This capacity provides business owners with the flexibility to grow and shrink quickly and represents another important efficiency mechanism embedded within capitalism. Freedom to choose and quickly change on the production level equates to even more freedom of choice for consumers.

*Moscow on the Hudson Clip

Key Market Characteristic #3

• Self-interested behavior results in increasing efficiency in a market system.

– Producers behave in self-interested ways. They make the choices they believe will lead to the greatest profit.

– Consumers also behave in self-interested ways. We make choices seeking to maximize our satisfaction.

Key Market Characteristic #4

• Competition• In the event competition were absent

from our system, we would be held hostage not only to the prices producers wanted to charge, but also restricted in our choices among available alternatives, too.

Key Market Characteristic #5

• Our final key characteristic of market systems is the capacity of prices in the market to automatically coordinate markets and their activities.

• We have no need for planning committees or establishing other processes to assure our markets provide a wide range of goods available for our choices.

• Prices in the market system coordinate production, distribution, and consumption

5 Questions5 Questions1.1. What goods and services will be produced?What goods and services will be produced?

2.2. How will the goods and services be produced (or what How will the goods and services be produced (or what combination of resources will be used)?combination of resources will be used)?

3.3. Who will get the goods and services once they are Who will get the goods and services once they are produced?produced?

4.4. How will the system accommodate change?How will the system accommodate change?

5.5. How will the system promote progress?How will the system promote progress?

What Goods will be Produced?What Goods will be Produced?• Market systems address this question automatically since Market systems address this question automatically since

producers in the market will provide the goods consumers wish producers in the market will provide the goods consumers wish to purchase. to purchase.

• Consumers approach their purchasing decisions with sovereignty Consumers approach their purchasing decisions with sovereignty (independence of action and thought) and vote with their dollars. (independence of action and thought) and vote with their dollars.

• These dollar votes result in the mix of goods and services that These dollar votes result in the mix of goods and services that will be made available. In the event there are more dollars will be made available. In the event there are more dollars chasing some goods than others, producers recognize that chasing some goods than others, producers recognize that consumers desire to own more of the most popular good and consumers desire to own more of the most popular good and increase production accordingly. increase production accordingly.

What resources will we use to produce our What resources will we use to produce our goods?goods?

• Producers recognize that controlling cost of production is their Producers recognize that controlling cost of production is their primary line of defense in maximizing profits. primary line of defense in maximizing profits.

• Producers choose the mix of resources resulting in the least-cost Producers choose the mix of resources resulting in the least-cost combination of producing the goods while continuing to combination of producing the goods while continuing to maintain a concern for quality of the finished product. maintain a concern for quality of the finished product.

• Prices of relevant resources used in production helps answer this Prices of relevant resources used in production helps answer this question. In conclusion, it is important to accentuate the question. In conclusion, it is important to accentuate the importance of the function of price in the market system. Price importance of the function of price in the market system. Price drives almost every critical production and consumption drives almost every critical production and consumption decision. decision.

Who will receive the goods once they are Who will receive the goods once they are produced?produced?

• You and I can answer this question easily because we You and I can answer this question easily because we completely understand that we can have the goods and services completely understand that we can have the goods and services if we can afford them within our budget. if we can afford them within our budget.

• The market system is at work in the bigger picture here, too. The market system is at work in the bigger picture here, too. Price in the market rations goods and services to those who can Price in the market rations goods and services to those who can afford them.afford them.

How will the system accomodate change?How will the system accomodate change?

• When prices for certain goods become comparatively too expensive, When prices for certain goods become comparatively too expensive, consumers will choose alternatives (substitutes). consumers will choose alternatives (substitutes).

• These choices send signals back to producers that change is needed. It These choices send signals back to producers that change is needed. It is important to keep in mind that some of this change can eventually is important to keep in mind that some of this change can eventually be relatively radical. be relatively radical.

• Domestic producers, for example, may eventually respond to Domestic producers, for example, may eventually respond to consumer choices by deciding they can no longer compete with consumer choices by deciding they can no longer compete with foreign competitors. Therefore the resources they were using become foreign competitors. Therefore the resources they were using become available for alternative uses domestically. available for alternative uses domestically.

• In summary, the market process is very efficient at communicating the In summary, the market process is very efficient at communicating the need for change automatically and once again, prices send the signals.need for change automatically and once again, prices send the signals.

How do we promote technological progress?How do we promote technological progress?

• Technological advances usually result in productivity gains Technological advances usually result in productivity gains among producers. among producers.

• To state this differently, gains in technological knowledge To state this differently, gains in technological knowledge enable producers to use improved technological advances to gain enable producers to use improved technological advances to gain production advantages because they can produce more output production advantages because they can produce more output with no more input. with no more input.

– For example, they may either gain time efficiency or be able to substitute For example, they may either gain time efficiency or be able to substitute technology for labor and save money in the process. Therefore, we are technology for labor and save money in the process. Therefore, we are able to address integration of technological progress into the market able to address integration of technological progress into the market system automatically because we will employ whatever makes us more system automatically because we will employ whatever makes us more efficient and yields lower production costs. efficient and yields lower production costs.

Virtues of the Market System

• Efficiency– The system promotes an efficient use of

resources

• Incentives– The system encourages skill acquisition, hard

work, and innovation

• Freedom– The market emphasizes personal freedom

The Demise of the Command Economic The Demise of the Command Economic SystemSystem

1.1. Coordination ProblemCoordination Problem– The coordination problem in command systems comes from the fact that The coordination problem in command systems comes from the fact that

people are responsible for making coordination decisions. Anticipating people are responsible for making coordination decisions. Anticipating all the future needs of a social system would be impossible for a group of all the future needs of a social system would be impossible for a group of individuals even in the event they were quite experienced in the command individuals even in the event they were quite experienced in the command system planning process. system planning process.

– There are literally millions of resources available to be combined in There are literally millions of resources available to be combined in numerous different ways to provide finished goods and services. numerous different ways to provide finished goods and services. Invariably, planning participants will underestimate the need for some Invariably, planning participants will underestimate the need for some goods and services, and over-estimate the need for others. goods and services, and over-estimate the need for others.

USSR Yugoslavia East Germany

Incentive ProblemIncentive Problem

2. Command systems lack incentives for changes to 2. Command systems lack incentives for changes to occur. Production managers are rewarded for occur. Production managers are rewarded for meeting quotas, meeting quotas, notnot satisfying needs and wants. satisfying needs and wants. We know of several problems command systems We know of several problems command systems encountered from the experiences of citizens in encountered from the experiences of citizens in the former Soviet Union. Their system was the former Soviet Union. Their system was notorious for having surpluses of certain goods notorious for having surpluses of certain goods available and shortages in the production of other available and shortages in the production of other goods.goods.

The Circular Flow Model

ResourceMarket

ProductMarket

Businesses Households

Key Terms Page• economic system• command system• market system• private property• freedom of enterprise• freedom of choice• self-interest• competition• market• specialization• division of labor

• medium of exchange• barter• money• consumer sovereignty• dollar votes• creative destruction• “invisible hand”

• Adam Smith• circular flow diagram• resource market• product market