Chapter 4: The Market System

Three fundamental questions: What? How? For whom?

What? In the words of Adam Smith:

It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their self-interest. (Adam Smith, Wealth of Nations, Book I, Chapter I)

[A producer,]...by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. It is an affectation, not very common among merchants, and very few words need be employed in dissuading them from it. (Smith, Book IV, Chapter II)

Consumer sovereignty?

Demand P profits S P Q

How? In a market economy:

profit maximization requires least-cost production (holding quantity and quality constant).

new technology is introduced only if it lowers total cost.

sellers of a resource have an incentive to supply the resource to its most highly valued use.

For whom? In a market economy, both output and

resource (factor) markets determine who receives which goods.

Distribution of income (wages, interest, rent, and profit) is determined in the resource market. Individuals who own more highly valued

resources receive higher incomes. The allocation of goods and services is

determined in the output market (given the distribution of income).

Government and the three fundamental questions Government influences the responses to each

of the three fundamental questions. Examples: What?

government spending product safety and consumer protection laws

How? safety regulations minimum wage laws environmental protection

For whom? tax structure welfare programs

Households As defined by the Census Bureau,

a household consists of one or more individuals sharing living quarters

Firms Types of firms

sole proprietorship partnership corporation

Sole proprietorship Single owner Advantages:

autonomy single taxation

Disadvantages difficult to acquire funds unlimited liability

Most common form of business organization (by number of firms)

Accounts for a small share of total output.

Partnership Two or more individuals share

ownership Advantages:

Pooled wealth and resources Single taxation

Disadvantages: Loss in autonomy (relative to sole

proprietorship) Unlimited liability

Corporation A legal entity separate from its

owners Advantages

limited liability Disadvantages

double taxation separation of ownership from control

Most output is produced by corporations

International sector The international sector has been

expanding as a share of output in the U.S. Both imports and exports have been rising.

A trade deficit occurs when imports exceed exports

A trade surplus occurs when exports exceed imports

Circular flow

Circular flow

Circular flow w/financial intermediaries

Circular flow w/ financial intermediaries and the foreign sector