Characteristics of Market Economy

Prices, Profit, and the Economic Flow Chart

Roles

• Three key roles with in a Market Economy– Profit

• Acts as an incentive

– Competition• Acts as a regulator

– Prices• Acts as a coordinator

Profit Motive•Acts as an incentive because people would not start or engage in business if monetary gains were not possible.

•It is the money that remains after all costs are deducted.

•Every business venture includes risk , for if it fails the people involved will loose money.•Therefore, people will only enter a market if the potential reward outweighs the risks.•Investors will not provide capital if the potential for their invest to grow is unlikely.•Entreprenuers would not risk their money or time if the potential for profit was absent. •Therefore, without profit economic advancements will not occur.

Competition

• Assumes most productive economy encourages competition

• Producers compete against each other for buyers– This drives prices down

• This increases efficiency because producers have to charge less, so in order to remain profitable they must increase efficiency

• Workers compete against each other for wages• Division of labor increases productivity by dividing

work• Example: assembly line, specialization

Prices

• Smith argued that market economies regulate themselves for maximum productivity through price

• Prices set the costs of goods and services• By setting costs, prices balance and

regulate a capitalist economic system• Producers can make the most profit &

consumers can get the most goods & services

Consumer Sovereignty

• Recent important development in understanding market economies is called consumer sovereignty

• Choices of consumers influence the economy more than the choices of producerso Producers only make a profit if

consumers buy their products

The Role of Government in Capitalism• To balance the economy, Smith argued, prices

must be set by free choices between producers & consumers – not by the government

• French made this point with the term laissez-faire:o “let them do”

• Smith believed that capitalism would meet the needs of society through the so-called “Invisible Hand”o Producers following their own self interest

would benefit everyone because producers make the most profit by serving the wants & needs of consumers

Pros & Cons

Pros: efficient, rewards innovation, opportunities for growth, can become wealth

• Cons: income inequality, lack of regulation can harm consumers and/or environment

The Role of Modern Governments

• As discussed yesterday, most economies are mixed.• In the U.S., the government intervenes it certain

cases:– Control the flow of money and interests rates in order to

control inflation and encourage or discourage lending (Federal Reserve in US; IMF; World Bank)

– Ensure competition through breaking up monopolies and other anti-trust laws

– Provide public goods when there is no profit motive for private industries such as

• Education, parks, and roads

The Role of Modern Governments

• Protection of private property– Property rights ensure that producers can profit

from their innovations.• Free from intellectual theft

– Without it people the profit motive would diminish and therefore there would be no incentive.

• Copyright laws• Patents• Plagiarism

The Ups and Downs of a Market Economy

Two competing models for government intervention during recessions and depressions:

a. A. Keynesianism says that fiscal policy (government spending & taxation) and deficit spending (the spending of borrowed money by the government to combat recession) can balance the economy

b. B. Classical response argues that government spending only prolongs the downturn and it is better to do nothing and let it bottom out, so the market can begin its own natural recovery.

THE FLOW OF A MARKET: CIRCULAR FLOW CHART

Explain the circular flow of economic activities & how interactions determine the prices of goods & services

GETTING THE IDEA

• It is common to hear that there is a circular flow of economic activity

• This means economic activity is an ongoing, two-way relationship between:o The factor market (individuals)o The product market (business)

THE FACTOR MARKET (HOUSEHOLDS)

THE FACTOR MARKET (HOUSEHOLDS)

• The factor market is where businesses buy two factors of production:o Labor to do the worko Capital to buy the things needed

to create the service or product

• Households are the source (supply) for both of these factors of production

HOUSEHOLDS

• Provide labor in the form of household members

• Provide capital in the form of savings available to invest in capital in the form of: o Lando Truckso Machineso Raw materialso Other things needed for

production

HOUSEHOLDS

• The amount of money available to pay for capital & labor determines how much the firm can produce

• The amount of money a household earns selling the factors of production determines how much it can consume & save

HOUSEHOLDS & LABOR

• The price of labor is determined in the market

• Households offer their labor to firms for a price and firms offer a price for labor

HOUSEHOLDS & LABOR

• When a household & a business agree on a price for labor & the amount of labor to be provided then the household member agrees to work for the firmo This agreement is a contracto The price may not be determined on the

first round of offerso It may take a series of offers & counter-

offers to arrive at a price that both sides agree upon

HOUSEHOLDS & CAPITAL

• The price of capital (interest)is the rate of return that households require firms to pay to get the households to invest in the firm

• The investment can be:o A loan (also called a bond)o Equity (also called stock)

HOUSEHOLDS & CAPITAL

• A base interest rate is usually set by each country’s central banko That is the lowest interest rate that any household would accept

on a loano Usually loans to businesses are at higher interest rates than the

rate set by the central bank

• The rate of return on equity is the amount of profit available to each owner divided by the owner’s investment

• If a firm does not offer a high enough rate of return, then households will not invest in the firm

THE PRODUCT MARKET (BUSINESSES)

THE PRODUCT MARKET

• Is where firms supply goods & services for sale to households

• Households buy the goods & services they need or want to consume & do not buy the others

THE PRODUCT MARKET

• If the firm can sell its product for more than the cost of producing the products, the firm has a profito The profit is paid out to the owners

(equity holders)

• If the firm does not make a profit, there is nothing to pay the ownerso This type of firm will not be able to

get more equity to buy capital & will go out of business

THE CIRCULAR FLOW OF ECONOMIC ACTIVITY• The households return the money either by purchasing

goods & services or by investing in the firm

• Money is flowing one way for products; factors of production are flowing the other way

• These flow require both firms & householdso Also create the economic interdependence of the participants

in the economyo Households & firms need each other to keep the economy

going

THE CIRCULAR FLOW OF ECONOMIC ACTIVITY

• Is the flow of money from firms to households as wages & salaries

• Households either spend the money on products for consumption or save the money to generate income in the future