McConnell_Brue_Chapter02 - Chapter 2: The Market System and...

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Unformatted text preview: Chapter 2: The Market System and The Circular Flow Slide 1 In this chapter we examine distinguishing features of a capitalistic economic system. This system is more commonly referred to as a market system. In addition, we will be making some comparisons of the market system with another system that was once deeply engrained in the former Soviet Union. This alternative economic system is referred to as a command economy and still exists in a few places, such as Cuba, even today. The final major general concept we will examine in this chapter the circular flow model. Economics 17th Edition Campbell McConnell and Stan Brue Chapter #2 The Market System and The Circular Flow Chapter 2 As we move through the chapter content, please keep in mind just how amazingly efficient the market system tends to be. Although a market system, or capitalistic economy, is not naturally perfect, it is impressively efficient and most of the efficiency occurs naturally. 1 That leads me to another point I would like for you to ponder as we progress through this presentation. The pure capitalistic market system has no governmental checks and balances in place and functions much like nature. The system rewards the most efficient resource users and the process becomes economic survival of the fittest. It is the concept of economic survival of the fittest that brings much of the natural efficiency to the capitalistic economic system. Slide 2 Chapter Learning Objectives In this chapter you will learn: 1. The difference between a command system and a market system. 2. The main characteristics of the market system. 3. How the market system decides what to produce, how to produce it, and who obtains it. 4. How the market system adjusts to change and promotes progress. 5. The mechanics of the circular flow model. Chapter 2 2 1 Chapter 2: The Market System and The Circular Flow Slide 3 Each social system must address the issue of deciding how to use scarce resources to produce goods and services, determine how to distribute these goods and services among the members of their society, and discern how to maintain enough flexibility in the system to accommodate change and encourage increasing efficiency over time. Economic Systems Each economy must develop a system, or particular set of institutional arrangements and a coordinating mechanism in response to the economizing problem. This economics system must address what goods are produced, how they will be produced, who gets them once they are produced, how to accommodate change, and how to promote technological progress. Chapter 2 3 Learning Objective 2-1 Take a moment and imagine how challenging the task of making these choices in a large nation would be for a group of individuals. The numerous possible resource combinations available to produce goods and services are substantially beyond our capacity to comprehend. One can grasp a much better understanding of the complexity and sheer magnitude of the mathematical challenge a social system faces by reading Last Word: Shuffling the Deck, in the latter portion of this chapter. The possible combinations do not number in the billions or trillions, they are truly in a numerical range beyond our capacity to comprehend and yet market systems function quite efficiently through a natural process, making such decisions automatically. Market systems are truly amazing entities. 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. Studying this natural market process and economics are quite worthy choices when considering how to spend your most scarce resource. Slide 4 Economic systems differ depending upon the ownership of the factors of production on the one hand, and the methods used to coordinate, motivate, and direct economic activity on the other. What determines how economic systems will differ from one another? Economic systems differ as to: Ponder this question for a moment. Who owns the factors of production in our system and how is economic activity orchestrated therein? Once we can clarify these points, we will also be able to see how amazing a market system truly is. • Who owns the factors of production. • The method used to motivate, coordinate, and direct economic activity. Chapter 2 4 Learning Objective 2-1 2 Chapter 2: The Market System and The Circular Flow Slide 5 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. What types of economic systems exist? Command economic systems known as socialism or communism. Market systems known as capitalism. Chapter 2 5 Learning Objective 2-1 Slide 6 Command Economic Systems 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. These decisions occur through a central economic plan and are performed by a central planning board appointed by the government. Chapter 2 6 It would benefit us at this point to learn a bit more about command systems. • In these systems, the government traditionally owns most of the property and controls decisions regarding the use of scarce resources. • Production and distribution decisions in command systems are performed by central planning committees. These committees are appointed by the government and are charged with the task of devising a central plan to follow over time. • 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. Learning Objective 2-1 Slide 7 Are command systems efficient? Generally speaking, command economic systems are not very efficient. Accurately predicting the future needs in terms of consumer goods and services and capital goods and services is very difficult in command systems for a number of reasons, but particularly so because systems are dynamic with changing needs and committees are entities making static decisions. In summary, command economic systems cannot change quickly. Chapter 2 Learning Objective 2-1 7 Command systems are notoriously 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 even small 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 quandary, consider the notion that 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. 3 Chapter 2: The Market System and The Circular Flow Slide 8 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 Market System The market system is characterized by the private ownership of resources and the use of markets and prices to coordinate and direct economic activity. The core motivator within the market system is selfinterested behavior. All parties in the system are free to make choices perceived to be in their own best interest. The process is self-sustaining (almost always) by individuals acting in their own self-interest. Chapter 2 8 Learning Objective 2-2 Slide 9 How does a market system differ from a command system? Market systems allow for private ownership of capital goods. • Communication to answer the questions about production (what to produce, what to use to produce it, and who gets it) is facilitated through price in the market. • Competition and the potential for profit provide very efficient processes to facilitate the functions of market systems automatically. Chapter 2 Learning Objective 2-2 9 Market systems and command systems differ in both the way resources are allocated, 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 and this feedback loop creates a perennial stimulus for change. • The very core of the market process is comprised of the private ownership of resources. We are free to use these resources any way we see fit so long as we are prepared to live with the consequences of our choices. • In the event that we make poor resource use choices, the market will punish us because of our inefficiency. Alternatively in the event that we make efficient choices with regard to the use of our resources, we are rewarded in the market. • Finally, the freedom of information exchange transmits signals to everyone so that we may continue to make increasingly more efficient production and consumption decisions over time. 4 Chapter 2: The Market System and The Circular Flow Slide 10 Does the United States have a pure market economy? No. Pure market systems, or pure capitalism is a system in which the only role the government plays is that of protecting private property and maintaining a market economy environment. The reality of our current system is that our government plays several stabilizing roles, but the dominant driving force behind our economy continues to be the market system or capitalism. Chapter 2 10 Learning Objective 2-2 Slide 11 Important Facets of a Market System Technology and Capital Goods—Advanced technology and capital goods are essential elements of market systems. Technology is a critical facet in that it allows for gains in productivity (more output with no more input) and capital goods are critical in that their development (factories, equipment, etc.) leads to more abundant output. Imagine a farm without tractors! Chapter 2 Learning Objective 2-2 11 A very common question most often arises at this juncture: Is the United States economy a pure market system? Stated differently, do we depend on pure capitalism? Our response to this is no. We were once a pure market system, but we discovered that pure capitalism had some inherent weaknesses at the extreme, too. • In pure capitalism, the role of government is diminished to that of protecting private property, maintaining a market environment, and providing national defense. Although our government continues to perform these functions, we have also evolved to the point at which our government performs many other functions, too. • We will discuss these additional functions in much greater detail at a later point. The greatest amount of change in this regard in our own economic system coincided with the Great Depression. Keep this in mind for a future discussion soon to come. A number of essential elements of the market system need to be mentioned as we attempt to comprehend how such a system is efficient. The first of these is 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. Secondarily the development and use of capital goods represents a significant contributor to efficiency in market systems, too. Making initial investments in capital goods prevents us from having to continually seek to produce goods with no specialized tools or equipment. 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. 5 Chapter 2: The Market System and The Circular Flow Slide 12 Specialization Specialization is also a critical component of a market system in that resources (human and otherwise) are most often better suited to producing a single good or small range of goods than producing everything. Therefore we gain a great deal of output by allowing resources to be used in specialized manners. For example, a jack-of-all-trades is usually not a very efficient producer. Chapter 2 The process of specialization is an additional dimension of market systems that brings about substantial gains in productivity as well. The concept of specialization occurs quite naturally in most respects. For example, most of us seek to establish a career in an area that may be at least to some extent a natural fit for us. People preferring mathematics and logic will often seek to establish careers in engineering or computer science because these fields are a natural fit for their reasoning skills. The same general concept applies to other factors of production in that they are most often better suited to produce one good or service than others. 12 Learning Objective 2-2 Slide 13 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 is a subset of resource • Division of labor affords us the luxury of using specialization and it serves the market system in that people with skills best suited for certain activities it allows us to employ differences in ability among in the way they will be most productive. laborers strategically. • In addition, there are usually related gains in productivity because practice makes perfect. It also allows gains in specialization from fostering learning by doing (we get better at what we do the Stated differently, we continue to improve at the most). things we do the most. • Finally, division of labor enables us to use another Specialization also saves another resource in that it resource more efficiently. As labor improves enables us to save time. productivity, additional time becomes available for Chapter 2 13 alternative uses. Division of Labor Learning Objective 2-2 6 Chapter 2: The Market System and The Circular Flow Slide 14 Geographic Specialization Geographic specialization also serves market systems in favorable ways in that it allows us to use land in the most productive possible manner. • Imagine how much orange production would be lost if we used a majority of the acreage in south Florida to produce wheat. • We allow Nebraska (a state in which oranges cannot grow) to produce wheat and trade wheat with Florida for oranges so the people of both regions are better off (and more productive). Chapter 2 14 Learning Objective 2-2 Slide 15 Use of Money Market systems rely heavily on the use of money due to the functions money performs in an economy. Medium of exchange is one of the most basic functions of money in that it makes trade easier to accomplish, prevents the need for barter, and prevents people from having to be in the same place with what one another needs at a specific time (coincidence of wants). Chapter 2 Learning Objective 2-2 Geographical location is important when it comes to specialization, too. 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. 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 a coincidence of wants must exist in order to conduct a trade. Stated otherwise, 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. 15 Our nation was once a barter economy and the location of trade centers in areas with access to waterway transportation serves as evidence of how barter trade centers evolved. Money was eventually introduced and the use of barter in our nation fell by the wayside. Interestingly, cities located along waterways have continued to persist. One reason for this persistence is due to the fact that waterways continued to represent an efficient way of transporting resources and as such many of our early trade centers evolved into production centers. 7 Chapter 2: The Market System and The Circular Flow Slide 16 The final critical component of a market system we examine is the existence of an active, but limited, government. Active, but Limited, Government The final critical component of market systems in advanced industrial economies is that of an active, but limited, government. In market systems, governments protect the right to own property and maintain national defense. Both are Although market systems have highly efficient essential to assure market systems function at efficient automatic market functions in place, there are levels. In addition, the government must also also market failures that prompt the need for compensate for a certain amount of market failure. a compensating (and sometimes regulating) Although market systems are highly efficient, they are body. not perfect and thus prompt a certain amount of inherent failure. Market failure is another area we will Chapter 2 16 revisit at a later date. Learning Objective 2-2 Slide 17 Key Market System Characteristic #1. Private Property —Most property (land and capital) is owned by individuals and firms when a market system exists in a society. • The process of private property ownership is facilitated through the use of contract law which allows individuals to create lawfully binding agreements among one another. Property rights facilitate exchange, and motivate owners to maintain and improve property so as to preserve or increase its value. Chapter 2 17 Learning Objective 2-2 Slide 18 Market Systems Protect Intellectual Property As Well Market systems recognize and protect intellectual property through the use of legal documents such as patents, copyrights, and trademarks. Such protective processes encourage the development of computer programs, books, music, new inventions, new products, and new production processes all of which provide a fertile foundation for economic growth. Chapter 2 In addition to the previously mentioned critical components of a market system, there also five key characteristics of market systems that run a close parallel. 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. Doing so allows us to create law between ourselves regarding private property to some extent and further promotes advanced functions within market systems. 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. There would be no protection from competition and the potential for profit from such sources would be minimized. 18 Learning Objective 2-2 8 Chapter 2: The Market System and The Circular Flow Slide 19 Key Market Systems Characteristic #2 Freedom of Enterprise and Choice Freedom of enterprise ensures that entrepreneurs and businesses are free to obtain and use resources to produce goods of their choice and satisfy market demand. Freedom of choice enables owners to employ or dispose of their property and money as they see fit. Freedom of choice also ensures that consumers are free to buy the goods and services that best satisfy their wants. Chapter 2 19 Learning Objective 2-2 Slide 20 Key Market System Characteristic #3 Self-Interest becomes the motivating force of the various economic units as they express their free choices. • Self-interest, in this context, simply means that each economic unit tries to achieve its own particular goal. • This same concept allows consumers to make their own self-interested choices in the market as well. • In summary, self-interest creates order in an otherwise chaotic economic process. Chapter 2 20 Learning Objective 2-2 Slide 21 Key Market System Characteristic #4 Competition represents the freedom of choice exercised in pursuit of a monetary return. Inherent within competition of this nature are independently acting sellers and buyers operating in product and resource markets and the freedom for buyers and sellers to enter and exit these markets based on their economic self-interest. Chapter 2 21 Another key market characteristic of market systems involves 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. Alternatively, consumers are afforded total freedom of choice in the market place as well. Although most free market participants take these functions for granted, someone living in a command system would immediately recognize exactly how important freedom in the market truly is. Freedom to choose and quickly change on the production level equates to even more freedom of choice for consumers. Self-interested behavior results in increasing efficiency in a market system. The presence of selfinterested behaviors and their effect is our third key characteristic of market systems. 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. The culmination of each group behaving in such selfinterested manners constitutes the heart of a market system in that both supply and demand for goods and services emanates from these behaviors. In addition, producers and consumers behave in selfinterested ways when we are generous. When we give, we receive some internal benefit from our gifts to others. And finally, the assurance that everyone will behave in self-interested ways brings order to a process that would otherwise be very disorderly and chaotic. We have distinctly identified the importance of freedom of choice to market systems in an earlier section, but we are not quite finished with the concept just yet. The freedom of choice among producers leads to competition between them as well, and competition assures efficiency. Competition represents our fourth key characteristic of market systems. 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. Learning Objective 2-2 9 Chapter 2: The Market System and The Circular Flow Slide 22 Our final key characteristic of market systems is the capacity of price in the market to automatically coordinate markets and their activities. Key Market System Characteristic #5 Markets and prices give the system the ability to coordinate millions of daily economic decisions by bringing buyers (demanders) and sellers (suppliers) into contact. • The self-interested actions taken on both sides of the market transaction bring agreement on prices and quantities provided. • Through this process the questions each economy must answer are addressed automatically. Chapter 2 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 and represent our fifth key characteristic of market systems. 22 Learning Objective 2-2 Slide 23 Five Fundamental Questions An Economic System Must Answer 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 (enable technological progress and capital accumulation)? Chapter 2 23 Learning Objective 2-3 Slide 24 What will be produced? The market process and price automatically address what we will produce in that producers are able to recognize how much demand exists for different goods and so long as profit potential exists to meet this demand (price is high enough), producers will respond. Consumers make this determination by voting with dollars and behaving with consumer sovereignty (being in command). Chapter 2 Learning Objective 2-3 24 Each economic system must address the following five questions: 1. What goods and services will be produced? 2. How will the goods and services be produced (or what combination of resources will be used)? 3. Who will get the goods and services once they are produced? 4. How will the system accommodate change? 5. How will the system promote progress? Over the following several slides, we will examine how market system responds to each question. I believe our observations should shed more light for us regarding exactly how phenomenal a market system truly tends to be. What goods will be produced? Market systems address this question automatically since producers in the market will provide the goods consumers wish to purchase. Consumers approach their purchasing decisions with sovereignty (independence of action and thought) and vote with their dollars. These dollar votes result in the mix of goods and services that will be made available. In the event there are more dollars chasing some goods than others, producers recognize that consumers desire to own more of the most popular good and increase production accordingly. Alternatively, when goods go begging for owners in the market, producers recognize this trend as well and decrease production accordingly. In summary, the action of consumers voting with their dollars in the market by responding to product and service prices communicates production information clearly without the need for additional information exchange. 10 Chapter 2: The Market System and The Circular Flow Slide 25 What resources will we use to produce our goods? The market process and price also automatically answer this question for us in that producers are prompted to use the least-cost combination of input resources in order to assure themselves of maximizing profits. Therefore, producers maximize profits in that they seek out the resource combination with the lowest cost and as such the price of resources indirectly answers this question automatically as well. Chapter 2 25 Learning Objective 2-3 Slide 26 What resources will we use to produce our goods? Market systems have the capacity to address this question and come to an efficient resolution automatically as well. Producers recognize that controlling cost of production is their primary line of defense in maximizing profits. Their secondary line of defense is seeking to have some control over the prices of the goods and services they produce, but this is a story for another day. Producers choose the mix of resources resulting in the least-cost combination of producing the goods while continuing to maintain a concern for quality of the finished product. Prices of relevant resources used in production helps answer this question. In conclusion, it is important to accentuate the importance of the function of price in the market system. Price drives almost every critical production and consumption decision. Who will receive the goods once they have been produced? Who will receive the goods and services once they have been produced? The market process and price (of the good or service) answers this question automatically in that those who can afford the goods will receive them. You and I can answer this question easily because we completely understand that we can have the goods and services if we can afford them within our budget. This is referred to as the rationing function of price in the market. Chapter 2 The market system is at work in the bigger picture here, too. Price in the market rations goods and services to those who can afford them. 26 Learning Objective 2-3 Slide 27 How will the system accommodate change? The market system (and prices) automatically address this question in that our production and consumption trends will change as prices in the marketplace send signals that change is essential. For example, when certain goods become too expensive we seek out substitutes for these goods and indirectly force producers to alter their production choices. Chapter 2 Learning Objective 2-4 27 How will the system accommodate change? The market system and reactions to prices therein, will automatically address this question as well. When prices for certain goods become comparatively too expensive, consumers will choose alternatives (substitutes). 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 be relatively radical. Domestic producers, for example, may eventually respond to consumer choices by deciding they can no longer compete with foreign competitors. Therefore the resources they were using become available for alternative uses domestically. In summary, the market process is very efficient at communicating the need for change automatically and once again, prices send the signals. 11 Chapter 2: The Market System and The Circular Flow Slide 28 How do we promote technological progress? This final question is addressed automatically in the market process (through prices), too. We choose to employ the most efficient (and leastcost) production processes available at any given time. When technological advances enable us to employ technology in ways that yield greater efficiency (and lower costs), we alter our choices. Chapter 2 28 Learning Objective 2-4 Slide 29 The “Invisible Hand” Adam Smith in his 1776 book, The Wealth of Nations, described the process of a market economy at work as though it were guided by an “invisible hand.” The market process he described as an invisible hand allows consumers and producers to behave in self-interested ways while simultaneously assuring that our resources are used efficiently. Chapter 2 Learning Objective 2-4 29 How do we promote technological progress? Just as you would expect, market systems automatically address this question as well. Technological advances usually result in productivity gains among producers. To state this differently, gains in technological knowledge enable producers to use improved technological advances to gain production advantages because they can produce more output with no more input. 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 able to address integration of technological progress into the market system automatically because we will employ whatever makes us more efficient and yields lower production costs. Adam Smith mentioned an “invisible hand” that seemed to direct economic activity when describing the newly founded market system of America in 1776. To comprehend exactly what he was attempting to describe, it is important to put ourselves in place to view the situation from his perspective. He was observing an experiment. This new nation had decided to let freedom be their guide in terms of religious choices, choices of behavior, and choices of economic activity. The world had not known of such a system, at least it terms of recorded history. He was attempting to describe a process that functioned in what he perceived to be awesome ways. Although we are fairly certain that diminished forms of market systems existed prior to the formation of the American system, we also know that these market systems were limited in their function because property and resources were most often owned by either a ruling class (Royalty) or a system dominated by military rulers. It further stands to reason that the dominant leadership in any given country would move to diminish the power and influence of anyone who gained too much material benefit from market processes. This was not the case in the United States and as such he was able to observe the natural function of price in the market place without intervention. His reference to the process as an “invisible hand” suggests he perceived it to be a semimagical process in that all decisions regarding production, distribution and purchases for consumption occurred automatically and efficiently. Adam Smith was incapable of understanding exactly how the process worked, but he did recognize how unique it was. Interestingly enough, he was observing and being impressed by the very functions you and I take very much for granted today. 12 Chapter 2: The Market System and The Circular Flow Slide 30 In summary, we review all the major automatic functions. Market systems are efficient in terms of production and consumption and this is accomplished due to natural incentives inherent in the process. Virtues of the Market System Efficiency - The system promotes the efficient use of resources. All decisions are enabled through freedom of choice in the market system. When we consider the synergistic effect of these facets working in conjunction, we also grasp a deeper meaning of freedom from a social perspective as well. Incentives - The system encourages skill acquisition, hard work, and innovation. Freedom - The market system emphasizes personal freedom. Chapter 2 30 Learning Objective 2-4 Slide 31 Although we had a precursory view of command systems earlier in this section, we didn’t talk much about their recent demise in global popularity. It would be beneficial to take a few moments and do so at this juncture. The Demise of the Command Systems Command economic systems in the Soviet Union, eastern Europe, and China (prior to market reforms) failed. Why? The command systems in China and the former Soviet Union have taken definitive steps toward becoming market systems in the not so distant past. There are reasons for these transitions. Command systems encounter considerable problems over time. The challenges of coordination are daunting and the lack of automated incentives amplifies similar issues. • The Coordination Problem • The Incentive Problem Chapter 2 31 Learning Objective 2-1 Slide 32 The Coordination Problem in Command Systems Central planners must coordinate (and attempt to anticipate) the millions of decisions that will be made by consumers, resource suppliers, and businesses. Since the outputs of many industries serve as inputs to others, the failure of any industry to meet its target (planning failure) causes a chain reaction of other missed targets in other industries. Chapter 2 Learning Objective 2-1 32 The coordination problem in command systems emanates from the fact that people are responsible for making coordination decisions. Anticipating 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 system planning process. There are literally millions of resources available to be combined in numerous different ways to provide finished goods and services. Invariably, planning participants will underestimate the need for some goods and services, and over-estimate the need for others. Secondarily, in economic systems an error in judgment in the production of capital goods will become even more pronounced as it translates into a chain reaction in the production of consumer goods and services. Stated differently, the outputs of one industry become the inputs of others, and an error in one will become magnified through the chain reaction over time. In summary, poor coordination eventually equates to inefficiency. 13 Chapter 2: The Market System and The Circular Flow Slide 33 The Incentive Problem in Command Systems Command systems lack incentives for changes to occur. Production managers are rewarded for meeting quotas, not satisfying needs and wants. When central planners misjudged the necessary amount of outputs of goods and services, shortages of some goods existed and surpluses of others. Consequently, so long as production managers meet quotas, they remain in good stead and any changes in incentive must be mandated by a planning committee. However, production managers were rewarded for meeting assigned targets, as opposed to meeting demand and thus they had no incentive to adjust production in response to shortages and surpluses. Chapter 2 We know of several problems command systems encountered from the experiences of citizens in the former Soviet Union. Their system was notorious for having surpluses of certain goods available and shortages in the production of other goods. 33 Learning Objective 2-4 Slide 34: The Circular Flow Model The circular flow model represents a visual illustration of a simple market system. This visual illustration depicts the major participants in the system as businesses and households, and the major resource and product markets. The Circular Flow Model The Circular Flow Model The dynamic market The dynamic market economy creates economy creates continuous, repetitive continuous, repetitive flows of goods and flows of goods and services, resources, services, resources, and money. and money. Private decision Private decision makers are grouped makers are grouped into businesses and into businesses and households and households and markets are divided markets are divided into resource and into resource and product categories. product categories. Learning Objective 2-5 Chapter 2 Chapter 2 34 34 14 Chapter 2: The Market System and The Circular Flow Slide 35: The Resource Market (Learning Objective 2-5) The Resource Market The Resource Market The top half of the circular flow model represents the resource market. • Notice how money flows from businesses to households for the purchase of resources. Although households own all resources, the single resource most of us will identify with most strongly is that of labor. • The upper half of the model includes the exchange of money for our labor. The upper half of the The upper half of the circular flow diagram circular flow diagram represents the resource represents the resource market. market. Households sell their Households sell their resources (labor and resources (labor and otherwise) to businesses in otherwise) to businesses in this market and money from this market and money from the sale of the resources flows the sale of the resources flows to households. to households. Chapter 2 Chapter 2 35 35 Slide 36: The Product Market (Learning Objective 2-5) The lower half of the circular flow model illustrates the product markets. This market process is facilitated when households bring the money they earn from selling their resources and select from among the many different products available from businesses. The lower half of the circular flow completes the process. Although the circular flow illustration is overly simplified, it does represent a significant dimension of reality in market systems. The Product Market The Product Market The lower half of the The lower half of the circular flow model depicts circular flow model depicts the product market. the product market. Products are provided to Products are provided to the market when businesses the market when businesses convert the resources they convert the resources they purchased into goods and purchased into goods and services, and the households services, and the households bring the money they were bring the money they were paid for their resources to paid for their resources to purchase them. purchase them. Chapter 2 Chapter 2 Secondarily, by viewing this illustration we can easily identify the interdependent relationship existing between businesses, households, and the two major markets. We will be expanding our view of the circular flow model in the future, but for now you have a good grasp of not only what a market system looks like, but also how it functions efficiently. 36 36 15 ...
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