Chapter 4: The Market System

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Chapter 4 The Market System
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Three fundamental questions

• What?
• How?
• For whom?

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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)

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Consumer sovereignty?
S
Demand
P
profits
P
Q
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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.

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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).

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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

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Households

• As defined by the Census Bureau, a household
  consists of one or more individuals sharing
  living quarters

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Firms

• Types of firms
• sole proprietorship
• partnership
• corporation

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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.

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Partnership

• Two or more individuals share ownership
• Advantages
• Pooled wealth and resources
• Single taxation
• Disadvantages
• Loss in autonomy (relative to sole
  proprietorship)
• Unlimited liability

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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

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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

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Circular flow
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Circular flow
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Circular flow w/financial intermediaries
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Circular flow w/ financial intermediaries and the
foreign sector