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