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Chapter 2 Market System and Circular Flow

How does a market system cope with economic scarcity?
A market system allows for the private ownership of resources and coordinates economic activity through market prices. Participants act in their own self interest and seek to maximize satisfaction or profit through their own decisions regarding consumption or production. Goods and services are produced and resources are supplied by whoever is willing to do so. The result is competition and widely dispersed economic power.
How does a Command System cope with economic scarcity?
The command economy is characterized by public ownership of nearly all property resources and economic decisions are made through central planning. The planning board, appointed by the government determines production goals for each enterprise. The division of output between capital and consumer goods is centrally decided based on the board’s long-term priorities
In what way are entrepreneurs and businesses at the helm of the economy, but commanded by consumers?
Although producers are free to choose what products they will produce, if the producers are to maximize profits, these good and services must be what consumers desire. Entrepreneurs can drive the economic ship where they want (at least for a while), but the ship will run aground (businesses will fail) if entrepreneurs at the helm don’t listen to the consumers that command them.
Why is there such a wide variety of desired goods and services in a market system?
Each individual consumer will choose a variety of goods and services that in combination will maximize his/her satisfaction (utility). There is a wide variety because individual wants are diverse. To maximize profits, producers must respond to the desires of the individual consumer.
. How does self-interest help achieve society’s economic goals?
The motive of self interest gives direction and consistency to the economy. The primary driving force of the market system is self interest. Entrepreneurs try to maximize their profits; property owners want the highest price for their resources; workers choose the job with the best wages, fringe benefits and working conditions.
Why is private property, and the protection of property rights, so critical to the success of the market system?
The ownership of private property and the protection of property rights encourages investment, innovation, and, therefore, economic growth. Property rights encourage the maintaining of the property and they facilitate the exchange of the property.
How do property rights encourage cooperation?
they encourage people to cooperate by helping to ensure that only mutually agreeable economic transactions take place.
What are the advantages of using capital in the production process
Capital goods enable producers to operate more efficiently and to produce more output.
What is meant by the term “division of labor”?
“Division of labor” means that workers perform those tasks that are best suited to their individual abilities and skills.
What are the advantages of specialization in the use of human and material resources?
The advantages of specialization for workers are that they can choose work according to their natural aptitudes, have the opportunity to perfect those skills, and save time in not having to shift continually from one task to another. Material resources will be developed and adapted for a specific use. On a regional basis, each region will produce those products for which it is best suited. By specializing in its comparative advantage, each region or set of human and material resources is being used to maximize efficiency
Explain why exchange is the necessary consequence of specialization.
When resources are specialized, they are no longer self-sufficient. To obtain the goods and services one needs, exchange is necessary. Also, specialization will result in a surplus of a specific good being produced. The surplus of one good will be exchanged for the surplus production of other goods.
What problem does barter entail?
Barter requires the “double coincidence of wants.” If someone wants something, he/she will have to find someone who wishes to part with that good and at the same time wishes to exchange the good for something that the first party wishes to part with.
Indicate the economic significance of money as a medium of exchange.
Money is a very convenient common denominator, a common measure of value that is also used as a medium of exchange. Money also encourages specialization.
Evaluate and explain The market system is a profit-and-loss system.
In a market system, producer decisions are motivated by the attempt to earn profits. Those products that enable a firm to earn at least a normal profit (minimum compensation for the entrepreneur for his/her time and talents) will be produced. If the product cannot be produced for a profit—in other words, if losses are involved in production—the capitalist firm will respond by seeking lower cost production methods Because profits and/or losses are the motivation behind the fundamental decisions made in a market system, it could be called a “profit and loss economy.”
Explain Competition is the disciplinarian of the market economy.
Competition provides discipline in two ways. First, it forces firms to seek the least-cost production methods or face being driven out of business by their rivals. Second, it prevents successful producers from charging whatever the market will bear. Competition keeps prices at a level where total revenue will just cover the total cost of production including a normal profit, but no more in the long run.
Explain the use of product combinations, why they are used, what determines them, and what decides if they’re no longer produced.
Producers looked for and found the least-cost combination of resources in producing their output. Resource suppliers, seeking income, made these resources available. Consumers, through their dollar votes, ultimately decide on what will continue to be produced.
What is meant by the term “creative destruction”?
Creative destruction refers to the process by which the creation of new products and production techniques destroys the market positions of firms committed to producing only existing products or using outdated methods
In a sentence, describe the meaning of the phrase “invisible hand.”
Market prices act as an “invisible hand,” coordinating an economy by rationing what is scarce and providing incentives to produce the most desired goods and services.
Why is input availability a constant concern in a Command Economy?
In command economies the availability of inputs depends on what was specified in the plan, and how well the plan was executed. There is no opportunity (at least not legally) to offer greater payments to get those resources provided.
Explain why In market economies, firms rarely worry about the availability of inputs to produce their products
In market economies, buyers of inputs know that sellers want to make resources available for sale because that is how they earn their profits. If there aren’t enough resources available, prices will rise until suppliers come forth with the desired amounts.
Distinguish between the resource market and the product market in the circular flow model.
The resource markets are where the owners of the resources (the households) sell their resources to the buyers of the resources (businesses). In the product markets, businesses sell the goods and services they have produced to the buyers of the goods and services, the households.
In what way are households sellers and buyers in this model?
These households are willing to sell their resources to businesses because attractive prices draw them into specific resource markets. Businesses buy resources because they are necessary for producing goods and services. The interaction of the buyers and sellers establishes the price of each resource.
In what way are businesses sellers and buyers in this model?
In the product market, businesses are the sellers and householders are the buyers; their role in the market has been reversed. Each group of economic units both buys and sells.
How does shielding employees and suppliers from business risk help to improve economic outcomes?
This process allows the owners of a business to attract employees and suppliers. If some of the business risk was put on these groups, most of them would stay away.
Who is responsible for managing business risks in the market system?
all the business risk is put on the owners, due to the fact that they are the ones who will enjoy the profits, or suffer the losses, of the business. This gives them an incentive to manage the business wisely
What explains why millions of economic resources tend to get arranged logically and productively rather than haphazardly and unproductively
The institution of private property is a primary reason why resources are arranged logically and productively. Private property eliminates randomness to the allocation of resources, as property owners act in deliberate ways to protect and maximize the benefits from their property. Owners pursue the greatest possible returns from their property, drawing resources to their most valued uses
What are the five fundamental questions of what to produce
what goods and services will be produced?
How will the goods and services be produced?
Who will get the goods and services?
How will the system accommodate change?
How will the system promote progress?
Which curve do the five questions of what to produce relate to?
Production possibilities curve (reality of scarce resources in a world of unlimited wants)
What is consumer sovereignty and why is it crucial?
Costumer sovereignty means that consumers are in command. It is crucial because it determines and quantifies what goods are produced based on the dollar votes of the consumer.
Explain the question of “How will goods and services be produced?”
In combinations and ways that minimize the cost per unit of output. Inefficiency drives up cost and lowers profits. Right mix of labor and capital.
Explain the question of “Who will get the output?”
Those who get the output are the consumers that have the means and ability to afford the output, as well as those who have the want or preference for the output
What determines the amount of income for a consumer?
The quantities of the property and human resources they supply, the prices of those resources (wages, interest, rent, profit). These resources determine how much of the economy’s output they can obtain.
Explain the question, “How will the system accommodate change?”
Change occurs in reponse to changes in consumer preferences/tastes. As tastes change to a new industry, resources, technology, capital are expanded in that industry with the profit generated. Competing industries lower the investment and production.
What is the core element of the market system?
The directing or guiding function of prices and profits.
What are the two factors that play into how the system promotes progress?
Technological Advances, Capital Accumulation.
What are the key drivers of the “invisible hand”
Self Interest/Competition
What are the three major virtues of the market system?
Efficiency, Incentives, Freedom
What is the 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
What is freedom of choice?
Enables owners to employ or dispose of their property and money as they see fit.
Why did command systems fail?
Coordination problem, Incentive problem. Coordination relied on a chain that if any link was broken there would be devastating consequences to the whole system
What is a circular flow model?
A model based on a simplified economy without government involvement. The model’s decision makers are grouped into households and businesses. The markets are resource markets and product markets.
What role do the households play in the circular flow model?
Households buy the goods and services that businesses make available in the product market. Households obtain the income needed to buy those products by selling resources in the resource market. All resources are ultimately owned or provided by households. All income in the economy flows to households.
Describe the role of the businesses in the Circular flow model
Commercial establishments that attempt to earn profits for their owners. (Sole P, Partner, Corp) Businesses sell goods and services in the product market for revenue, they incur costs in the resource market (labor, land, entrepreneurs)
What is the role of the product market in the circular flow model?
The product market is the place where the good and services are produced by businesses are bought and sold. Households use the income received from the sale of resources to buy these goods and services.
What is the role of the resource market in the circular flow model?
The resource market is where households sell resources to businesses, business buy resources to produce goods and services.

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