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Economic Systems and The Circular Flow Model


The Basic Economic Problem of Scarcity forces every society to develop some type ... O. Paul bought 10 pounds of hot dogs to sell from his hot dog cart ... – PowerPoint PPT presentation

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Title: Economic Systems and The Circular Flow Model

Economic Systems and The Circular Flow Model
  • Unit 1
  • Lecture Notes

Key Understandings
  • The Basic Economic Problem of Scarcity forces
    every society to develop some type of economic
    system to answer the three basic economic

3 Basic Economic Questions all societies must
  • What to Produce
  • How to Produce
  • For Whom to Produce

Key Understandings Cont.
  • Different societies answer these 3 questions
    differently based upon the structure of their
    economic system and the broad social goals of
    their society

Economic System Defined
The combination of government and individual
decision making a society uses to answer the
three basic questions of what, how and for whom
to produce.
Economic system structure is determined
by 1. Who owns the means of production in
the society 2. The method of coordinating
and directing economic activity
Types of Economic Systems
  • Market System (Pure Capitalism)
  • Command System (Communism)
  • Traditional System (Customary)
  • Mixed System

Market System
  • Laissez faire or let it be focus
  • private ownership of resources
  • use of a system of markets and prices to
    coordinate and direct economic activity
  • each participant motivated by self interest
  • individual decision making by each economic unit

In a market economy, the economy relies on prices
and the forces of supply and demand to answer the
3 basic questions
  • The system relies on the independence of buyers
    and sellers of each resource and assumes that
    economic power and influence will be widely
  • There is little need for government interference
    because the market system is inherently efficient
  • Governments role is to protect private property
    and to set up the legal framework for the free

The Command System
  • There is public ownership of virtually all
    property resources
  • All economic decision making is through central
    economic planning
  • Current examples N. Korea, Cuba

In a Command economy, governmental planning
groups make all the economic decisions to answer
the 3 basic economic questions
Traditional System
  • Generally used by less developed nations
  • Production methods, exchange, and distribution of
    income are all sanctioned by custom
  • Heredity and caste determine economic roles of
  • Economic activity often secondary to religious
    and cultural values and status quo

In a Traditional economic system, all economic
decisions are based upon custom and historical
precedent. Protection of the status quo takes
precedence over economic growth and development
Mixed System
  • Most real world economic systems fall between
    market and command.
  • This type of system contains elements of more
    than one economic system.
  • Examples include United States, Russia, and China

In a Mixed economic system, the economy may rely
partly on the forces of supply and demand, partly
on government, and partly on custom and tradition
to answer the 3 basic economic questions.
The Circular Flow of Economic Activity Model
  • For a Market Economy

Why Study the Circular Flow Model?
  • Model locates product and resource markets and
    shows the major income expenditure flows and
    resource output flows
  • Model helps identify and define the relationships
    of the major groups of decision makers and markets

Key Idea The coordinating mechanism that
brings the decisions of households and businesses
into alignment with one another is the market
system and in particular, the Resource (Factor)
and Product Markets
Understanding the Model Components
  • 2 groups of decision makers Households and
  • 2 major markets are represented Resource
    (Factor) Market and Product Market
  • Arrows represent either flows of money or flows
    of goods and services
  • Money flows and goods and services flows move in
    opposite directions

Resource Owners (Households)
Factor Markets
Product Markets
Business Organ. (Producers)
The Circular Flow Model
Resource and Product Markets
  • Resource Market
  • Households directly or indirectly own all
    economic resources and supply these to businesses
  • Businesses demand resources and make payments to
    owner as rent, interest, wages, or profit income
  • Product Market
  • Income received from the selling of economic
    resources is used to purchase goods and services
    in the product market
  • Interaction of supply and demand determines prices

Spend Income
Resource Owners (Households)
Earn Income
Sell Scarce Resources
Buy Goods Services
Factor Markets
Product Markets
Buy Scarce Resources
Sell Goods Services
Receive Revenue
Pay for Resources
Business Organ. (Producers)
Green Arrows represent flow of money Black Arrows
represent flow of goods/services
Circular Flow model implies a complex,
interrelated web of decision making and economic
activity. Households and Businesses participate
in both basic markets but on different sides of
each. Each group is involved in buying and
Circular Flow Activity
  • Indicate where these transactions should be
  • located within the Circular Flow Model
  • A. Carl bought a gift for his mother
  • B. ABC Corporation bought a new computer
  • C. Mrs. Jones paid rent to her apartment manager
  • D. XYZ Corporation paid Barbara 250 for a weeks
  • E. EZ Bakery sold two cakes to Mr. Smith

  • F. ARM Corporation paid stockholders a 5
  • G. Frank was paid 15,000 for his 6-week stage
  • H. Eric bought a quart of mile at the store
  • I. Mr. Gonzales purchased a new typewriter for
    his son
  • J. Cora earned 25 interest from her bank savings

  • K. Bill paid the barber 4 for his haircut and
    gave a 50 cent tip
  • L. Hazels partner gave her a 1,000 bonus from
    the months profits
  • M. ZIGON Company paid 10 interest on the bonds
    John owned
  • N. ACTION rented a car to Peggy for her weekend
    ski trip
  • O. Paul bought 10 pounds of hot dogs to sell from
    his hot dog cart