Lecture slides of Chapter 2, of Microeconomics by McConnel and Brue book

1. Mc Connell and
Brue
Introduction to
Economics and
the Economy
Chapter 02
The Market
System and the
Circular Flow
Prof. Dr. Musarrat Adnan

2. Learning Objectives
 Differentiate between laissez-
faire capitalism, the command
system, and the market system.
 List the main characteristics of
the market system.
 Describe the mechanics of the
circular flow model.

3. Learning Objectives
 Explain how the market system
answers the five fundamental
questions of what to produce,
how to produce, who obtains the
output, how to adjust to change,
and how to promote progress.

4. Economic Systems
 Every society needs to develop
an economic system—a
particular set of institutional
arrangements and a coordinating
mechanism—to respond to the
economizing problem.

5. Economic Systems
 The economic system has to
determine what goods are
produced, how they are
produced, who gets them, how
to accommodate change, and
how to promote technological
progress

6. Economic Systems
Economic systems differ in:
a. Who owns the factors of
production
b. What is the method used to
motivate, coordinate and direct
economic activity.

7. Laissez-Faire Capitalism
 laissez-faire capitalism—or “pure
capitalism”—
Limited role of the government.
a. to protect private property
b. establishing a legal environment in which
contracts would be enforced and people could
interact in markets to buy and sell goods,
services, and resources

8. Command system
Command system, in which governments
have total control o.
The command system is also known as
socialism or communism.
Examples: The Soviet Union, China,
North Korea and Cuba.

9. A central planning board appointed by the
government makes all the major
decisions concerning the use of
resources, the composition and
distribution of output, and the
organization of production. The
government owns most of the business
firms, which produce according to
government directives.

10. The Market System/ Mixed Economy
The vast majority of the world’s
economies utilize the market
system, which is also known as
capitalism or the mixed economy

11. The Market System/ Mixed Economy
The market system is
characterized by a mixture of
centralized government
economic initiatives and
decentralized actions taken by
individuals and firms. The
precise mixture varies from
country to country

12. Characteristics of the Market System
Private Property.
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

13. Characteristics of the Market System
Freedom of Enterprise and
Choice.
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.
Freedom of choice producer whatever and however to
produce goods and services and allows workers to try to
enter any line of work for which they are qualified and
ensures consumers free will to buy the goods and services
that best satisfy their wants and that their budgets allow.

14. Characteristics of the Market System
Self-Interest
People work in their best interest. Self-interest implies each
economic unit tries to achieve its own particular goal.
Examples:
Entrepreneurs try to maximize profit or minimize loss.
Property owners try to get the highest price for the sale or rent
of their resources.
Workers try to maximize their utility (satisfaction) by finding
jobs that offer the best combination of wages, hours, fringe
benefits, and working conditions.
Consumers try to obtain the products they want at the lowest
possible price

15. Characteristics of the Market System
Competition
The size of the firm, the size of the market and the
level of dependence of firms on each other
determine the level of competition between them.
Competition also implies the freedom of entry and
exit of a firm in and from the market/industry.
The diffusion of economic power inherent in
competition limits the potential abuse of that
power .

16. Characteristics of the Market System
Markets and Prices
A market is an institution or mechanism that
brings buyers (“demanders”) and sellers
(“suppliers”) into contact.
The decisions made by buyers and sellers in
the market determine a set of product and
resource prices that influence producers and
consumers and consumers to their choices
and pursue their self-interest.

17. Characteristics of the Market System
Technology and Capital Goods.
Market system encourages extensive use and
rapid development of technology advanced
capital goods; tools, machinery, large-scale
factories, and facilities for storage,
communication, transportation, and
marketing.

18. Characteristics of the Market System
Specialization.
Specialization means using the resources of an
individual, firm, region, or nation to produce one or a
few goods or services rather than the entire range of
goods and services.
a. Division of Labor /Human specialization.
-Specialization makes use of differences in ability
-Specialization fosters learning by doing
-Specialization saves time

19. Characteristics of the Market System
b. Geographic Specialization
Specialization also works on a regional and
international basis.
Examples:
Oranges—Florida
Coffee– Brazil
Rice—Pakistan
Mango– Pakistan
Automobile– Japan

20. Characteristics of the Market System
Use of Money
Money performs several functions:
a. Medium of exchange.
b. Unit of Value.
c. Store of Value

21. Active, but Limited, Government
An active, but limited, government is the final
characteristic of market systems in modern
advanced industrial economies.
Market Failure
Although market system promotes a high degree of
efficiency in the use of its resources, it has certain
inherent shortcomings, called “market failures.

22. Five Fundamental Questions
a. What goods and services will be
produced?
b. How will the goods and services be
produced?
c. Who will get the goods and services?
d. How will the system accommodate
change?
e. How will the system promote
progress?

23. The Circular Flow Model

24. The Circular Flow Model
Household
One or more persons occupying a housing unit.
Business
An organizational unit which unit and organize factors of
Productions to produce and distribute output.
Resource Market
Market where factors of productions or resources are bought
and sold.
Product Market
Market where goods and services are bought and sold.

25. Types of Businesses
a. Sole proprietorship
b. Partnership
c. Corporations

26. Types of Business Structures
Proprietorship
A proprietorship (single ownership) is a firm with a
single owner who has unlimited liability, or legal
responsibility for all debts incurred by the firm—up
to an amount equal to the entire wealth of the
owner.
The proprietor also makes management decisions
and receives the firm’s profit.
Profits are taxed the same as the owner’s other
income.

27. Types of Business Structures
Partnership
A partnership is a firm with two or more
owners who have unlimited liability.
Partners must agree on a management
structure and how to divide up the profits.
Profits from partnerships are taxed as the
personal income of the owners.

28. Types of Business Structures
Corporation
A corporation is owned by one or more
stockholders with limited liability, which means the
owners who have legal liability only for the initial
value of their investment.
The personal wealth of the stockholders is not at
risk if the firm goes bankrupt.
The profit of corporations is taxed twice—once as
a corporate tax on firm profits, and then again as
income taxes paid by stockholders receiving their
after-tax profits distributed as dividends.

29. Risk and Profit in various Business
Structures
Proprietorship
 Proprietorships are easy to set up
 Managerial decision making is simple
 Profits are taxed only once
 But bad decisions made by the manager are
not subject to review
 The owner’s entire wealth is at stake
 The firm dies with the owner
 The cost of capital and labor can be high

30. Risk and Profit in various Business
Structures
Partnership
 Partnerships are easy to set up
 Employ diversified decision-making processes
 Can survive the death or withdrawal of a partner
 Profits are taxed only once
 But partnerships make attaining a consensus about
managerial decisions difficult
 Place the owners’ entire wealth at risk
 The cost of capital can be high, and the withdrawal of
a partner might create a capital shortage

31. Risk and Profit in various Business
Structures
Corporation
 A corporation offers perpetual life
 Limited liability for its owners
 Large-scale and low-cost capital that is readily
available
 Professional management
 Lower costs from long-term labor contracts
 But a corporation’s management structure may lead
to slower and expensive decision-making
 Profit is taxed twice—as corporate profit and
shareholder income.

32. Profit System
 Types of Profits
Economic profit equals a firm’s total revenue
minus its opportunity cost of production.
Economic profit= Total Revenue-total cost
(Implicit + explicit)
Accounting profit= Total Revenue-Total cost
(Explicit)
A firm’s opportunity cost of production is the sum
of the explicit costs and implicit costs.
Normal profit is the return on implicit cost and is
part of the firm’s opportunity costs, so economic
profit is profit over and above normal profit.

33. Chapter 2- END