2a The Market System and the Circular Flow

Reading Assignments:

Brief Outline



Entrepreneurs Emerge As Cuba Loosens Control
National Public Radio (NPR), Morning Edition, September 20, 2011

"Since Cuba's communist government loosened its grip on the economy, thousands of small private businesses have sprung up. It's a new frontier for budding capitalists, but competition is fierce and advertising is still tightly restricted."


Lou Dobbs, CNN News commentator and best-selling author, says:

  • "But the consequences of faith-based free-trade will be eye-popping in the disaster it wreaks on our economy and working Americans."

Quotes taken from our textbook (18e):

  •   "Nations specialize and trade for the same reasons as individuals: specialization and exchange results in a greater overall output and income."
  • "I hope they (the new Democratic congressional leadership) can acknowledge that so-called free trade has come at an inordinate cost to working men and women in this country. "

  • "Specialization (i.e. trade) . . . improves global resource allocation. The same total inputs of world resources and technology result in a larger global output."

  • "We've lost three million manufacturing jobs as a result of these so-called free trade agreements that enable corporate America to export plants, production and jobs to cheap foreign labor markets."

  • "Import restrictions alter the composition of employment, but they have little or no effect on the volume of employment."
  • "And yet we persist with our historical ignorance, and we continue to enter poorly negotiated agreements that pose great threats to the U.S. economy and the middle class."

    [NOTE: trade agreement lead to the removal of trade restrictions]

  • "Actually the true benefit created by international trade is the overall increase in output obtained through specialization and exchange.


  • "the gains that US trade barriers create for protected industries come at the expense of much greater losses for the entire economy. (emphasis added)"


  • "Study after study finds that the costs to consumers (of trade restrictions) substantially exceed the gains to producers and government."

President Trump on Trade






  • Structural Adjustment Policies
    • Privatization
    • Promotion of Competition
    • Reduced Role of Government
    • Removing Price Controls
    • Freer Trade and Convertible Currency
    • Foreign Investment
    • Other


  • Problems of SAPs (pages 23W-8 to 23W-9 and 23W-12 to 23W-13)
    • Inflation
    • Initially falling output and living standards
    • Inequality and social costs - equity is not necessarily achieved in a market economy


    Available online at:

    • Click on: http://www.learner.org/resources/series86.html
    • Scroll down to:
      • 11. Economies in Transition: Transforming former Communist countries into market economies. Case studies: state industries vs. private entrepreneurs in Russia; the success of Poland’s “shock therapy.”
    • Click on (A free registration may be required for first time users)
    • Then slide the timer to minute 27:25 for the eight minute the success of Poland’s “shock therapy case study



  • Russia and China have taken different approaches to structural adjustment.
    • Russia used "shock therapy" moving very quickly to privatize state-owned industries and introduce market incentives. Furthermore, Russia, at the same time, changed its political system from and authoritarian communist state to a democracy.
    • China on the other hand began its structural adjustment program earlier, but it moving slowly toward capitalism. It has also retained its authoritarian communist political system



OPTIONAL: A View of Venezuelan Nationalization

Go to: http://www.npr.org/templates/story/story.php?storyId=6849640

Click on: "Listen"

Weekend Edition Saturday, January 13, 2007 - In the global economy where more and more capital is held in private hands or by publicly-traded companies, the South American nation of Venezuela seems to be bucking the trend.

This week, as he assumed power for a second six-year term, President Hugo Chavez announced that Venezuela will nationalize firms in two major sectors of the economy — telecommunications and electricity. [NOTE: "nationalize" means that the government is going to take over these businesses.]

And some companies in those sectors have shareholders in the United States, including Verizon, which owns a large stake in the Venezuelan telecom giant, CANTV.

Economist Moises Naim, a former minister of trade and industry in Venezuela (and now editor of Foreign Policy magazine, reviews the implications of Chavez's plan with Scott Simon.


  • Industries to be nationalized:
    • Telecommunications (telephone)
    • Electricity
  • How they will be nationalized is unknown.
    • Will the government just take them over?, or
    • Will the owners be paid?
  • Why are they doing it?
    • "Political move" toward "socialism"
    • Previous nationalization had poor results
    • Should foreigners own these industries in Venezuela?
    • Would local or state ownership be better? (probably not)
    • Research shows that ownership affect efficiency - state ownership is less efficient

II. Review:

A. What are Structural Adjustment Programs?  
  • What is Structural Adjustment?


    • Privatization
    • Promotion of Competition
    • Reduced Role of Government
    • Removing Price Controls
    • Freer Trade and Convertible Currency
    • Foreign Investment
    • Other
  • Goals of SAPs :
    • to reduce scarcity and achieve the maximum satisfaction possible out of society's limited resources.

    • This means to achieve the 5Es


    • Macroeconomic goals:
      • full employment
      • low inflation
      • economic growth


  • Problems of SAPs (pages 23W-8 to 23W-9 and 23W-12 to 23W-13)
    • Inflation
    • Initially falling output and living standards
    • Inequality and social costs - equity is not necessarily achieved in a market economy


B. Economic Systems:

  • Two main types:
    • Command Economy (chapter 23W of the 16th edition)
    • Market Economy or Capitalism (Ch. 2)


  • Economic systems are ways that countries answer the 5 fundamental questions (p. 34-36):
    1. What will be produced?
    2. How will goods and services be produced?
    3. Who will get the output?
    4. How will the system accommodate change?
    5. How will the system promote progress?


  • Economic Systems:
    • There are no PURE command economies
    • There are no PURE market economies
    • Instead there is a continuum of different characteristics


  • Economic Systems: Characteristics
    • who owns
    • who decides
  • Types of Economic Systems
    • Pure Capitalism
      • also called:
        • market economy
        • competition
        • free enterprise
        • laissez-faire capitalism
    • Command Economy
      • also called
        • socialism
        • state-run economy
        • centrally planned economy
        • communism
      • Examples:
        • North Korea
        • Cuba,
        • Turkmenistan
        • Myanmar
        • Belarus
        • Laos
        • Libya
        • Iran
        • Iraq (until 2003)
  • All economic systems are Mixed Systems


    Pure Capitalism:

    private ownership
    the market system

    Command Economy:

    government ownership
    centralized (or gov't) decision-making

    Mixed Economy

    some private and some government
    some private and some government


III. Characteristics of a Capitalist Economy 

A. Basic Characteristics:



1. private property
2. freedom of enterprise and choice
3. role of self interest
4. competition
5. markets and prices
6. limited role for government
1. private property
2. freedom of enterprise and choice
3. role of self interest
4. competition
5. markets and prices
6. active, but limited government
7. technology and capital goods
9. use of money

B. private property

  • provides an incentive for economic growth
    • Paul Solman Video: Private Property (and Pilgrims too)


    • OPTIONAL: http://www.npr.org/templates/story/story.php?storyId=1565953

      China Considers Private Property Rights on National Public Radio

      All Things Considered, December 22, 2003 · In Beijing, legislators propose an amendment to the Chinese constitution guaranteeing private property rights. The move has great symbolic importance in a country that is nominally communist, but whose people have been buying property and trading stocks for years as the result of economic reforms by Deng Xiaoping. NPR's Rob Gifford reports.


      • "private sector will drive the economy forward" therfore property rights must be protected
      • private property already exists
      • doesn't necessary imply political reform (still communist)- just economic reform

C. markets and prices

  • prices GUIDE resources
    [pickups driving to Florida with plywood]
  • prices RATION goods and services
    [high prices after a hurricane encourage people to conserve]
  • markets and prices affect allocative efficiency

    Quick Quiz:


D. role of self interest

  • Introduction: would you rather have government or private business run the following? WHY?
    • gas station near a desert
    • your e-mail service
    • gas stations
    • other


  • Self interest is a powerful force and IF THERE IS COMPETITION IN AN ECONOMY it will result in improving the social good as if there is some "invisible hand" guiding their decisions.
    • "greed" and productive efficiency
    • "greed" and allocative efficiency
    • "greed" and economic growth

E. freedom of enterprise and choice
(Cuba video - Cubans now have some freedon to start their own businesses)

  • definitions
    • Freedom of enterprise means that entrepreneurs and businesses have the freedom to obtain and use resources, to produce products of their choice, and to sell these products in the markets of their choice.


  • Freedom of choice means:
    • Owners of property and money resources can use resources as they choose.
    • Workers can choose the training, occupations, and job of their choice.
    • Consumers are free to spend their income in such a way as to best satisfy their wants (consumer sovereignty).


  • provides the means for "greedy" people to help the economy achieve allocative and productive efficiency and economic growth

F. competition = capitalism

  • what is competition?
    • 1. Large numbers of sellers mean that no single producer or seller can control the price or market supply.

      2. Large number of buyers means that no single consumer or employer can control the price or market demand.

      3. Depending upon market conditions, producers can enter or leave industry easily.

  • competition is the "invisible hand"
    • plywood after a hurricane
    • monopolies and inefficiency

G. limited role for government (more in chapter 5)

  • What IS the economic role for government?
  • Economic goals: 5 Es
  • Problems with capitalism:
    • at times even market economies achieve allocative INefficiency:
      • overproduction (too much produced) of goods with negative externalities
      • underproduction (too little produced) of goods with positive externalities
      • tendency for business to increase monopoly power, and produce, less to increase profits
    • macroeconomic instability (periods of high unemployment and periods of high inflation)
    • no mechanism to guarantee equity


IV. The Market System at Work

A. Introduction
1. Why is the world moving toward capitalism?

2. What problems might they encounter?

B. The Market and the 5Es

1. Economic Growth
  • market economies have historically achieved higher rates of economic growth

2. Allocative Efficiency: Producing what consumers want

a. Capitalism and incentives
(1) more profits = produce more

(2) losses = produce less (note: losses are important)

(3) consumer sovereignty and "dollar votes"

b. Capitalism tends to achieves allocative efficiency

3. Productive Efficiency: Producing at a minimum cost

a. Capitalism and incentives
(1) profits = total revenues - total cost

(2) minimizing costs means more profits

b. Capitalism tends to achieve productive efficiency

4. Equity

There is no characteristic of capitalism which will guarantee equity

Often, the government gets involved to help achieve equity

5. Full Employment

Economists disagree over whether capitalism will result in full employment
  • Some say yes, and if there is unemployment it is usually caused by government interference
  • Some say no, and at times government involvement is needed to move the economy towards full employment


C. Summary:
1. Capitalism provides the incentives (profit) for a PRODUCTIVELY EFFICIENT use of resources

2. The price mechanism provides for an ALLOCATIVELY EFFICIENT use of resources

3. Capitalism does not have a mechanism to assure EQUITY. This may be a role of government

4. Economists disagree over whether capitalism will guarantee FULL EMPLOYMENT.

5. The move toward capitalism has resulted in high rates of ECONOMIC GROWTH in many countries. Profits, private property, and freedom of enterprise and choice promote growth


IV. Capitalism and the Five Fundamental Questions

A. Introduction
1. The five fundamental questions must be answered by all economic systems.

2. The five fundamental questions are:

a. What goods and services will to be produced?
b. How will the goods and services be produced?
c. Who will get the output?
d. How will the system accommodate change?
e. How will the system promote progress?

B. What will be produced? (Allocative Efficiency)

1. In order to be profitable, businesses must respond to consumers' (individuals, other businesses, and the government) wants and desires.

2. Consumer Sovereignty and "dollar votes"


C. How will the goods and services be produced? (Productive Efficiency)

1. The market system encourages and rewards those producers who are achieving least-cost production.

2. The most productively efficient technique will be the one that produces a given amount of output with the smallest input of limited resources.

D. Who will get the output? (Equity)

1. Determined by how the income is distributed

2. Products go to those who are willing and able to pay for them.

3. The productivity of the resources, the relative supply of particular resources, and the ownership of the resources will determine the income of individuals and households.

4. The resulting distribution of income may NOT be the most equitable (fair).

E. How will the system accommodate change?

1. Markets are dynamic - what is efficient today may not be efficient tomorrow as tastes, technology, and resource supplies change.

2. Prices help signal those changes and the market will respond. This guiding function of prices is essential to a well-functioning market system.

3. In the absence of such signals, government or some similar institution would have to decide where resources are allocated, but without knowing what people in society want the result would most likely be allocatively inefficient.

F. How will the system promote progress?

1. The market system promotes technological improvements and capital accumulation (economic growth).

2. An entrepreneur or firm that introduces a popular new product will be rewarded with increased revenue and profits. (allocative Efficiency)

3. New technologies that reduce production costs, and thus product price, will spread throughout the industry as a result of competition. (economic growth)

4. Creative destruction occurs when new products and production methods destroy the market positions of firms that are not able or willing to adjust. NOTE: this is good for society.


Command Economies

I. Ideology and Institutions

A. History
1. The Russian Revolution of 1917 produced a dictatorship under Vladimir Lenin and later Joseph Stalin.

2. China’s communist takeover took place in 1947 under Mao Zedong

3. Both countries viewed centrally planned socialism as a solution to the instability of what they believed were chaotic market systems.


B. There were two major institutional characteristics of the previous economies of Russia and China.

1. WHO OWNS: There was state ownership of all property, transportation and communication facilities, banking institutions, virtually all industry including retail and wholesale enterprises, and most urban housing structures.

2. WHO DECIDES: There was also central economic planning, which meant that the economy was directed by the government rather than by decentralized market mechanisms.

II. Central planning and its problems

A. Planning goals and techniques.
1. in the SOVIET UNION Industrialization and military strength had the highest priority in terms of resource allocation.

2. In CHINA emphasis was placed on developing small-scale industries scattered throughout the rural areas. Both countries neglected consumer goods industries.

3. Resources were overcommitted, planners committed more resources than were available, so there were persistent SHORTAGES.

4. RESOURCES were initially MOBILIZED to achieve rapid economic growth and this was successful through the 1950s. Both China and the Soviet Union induced or coerced a larger proportion of the population into the labor force. This reduced unemployment.

5. Allocation of inputs was done by directive: GOV'T DIRECTED RESOURCES.

6. Government FIXED PRICES of virtually all inputs and outputs, but prices did not reflect the relative scarcity of the resource or product. The result was often prices that were too low and shortages occurred resulting in allocative inefficiency.

7. The Soviet Union and China aimed at SELF-SUFFICIENCY and avoided trade with western countries if possible resulting in productive inefficiency.


B. Problems of central planning were serious. 

  • was massive;
  • outputs of some industries are inputs in others, so problems in any single sector would immediately be felt in many.
  • There was no price mechanism to provide incentives to eliminate bottlenecks, as is true in a market economy.
  • Planners had to coordinate inputs and outputs for thousands of production enterprises.
  • Bottlenecks were common.


a. In a market system, profits and losses signal success and failure and provide incentives to increase or decrease production. In central planning managers are rewarded for meeting assigned goals and have no incentive to respond to product shortages or surpluses.

b. The centrally planned system also lacked entrepreneurship. Without profit there is no reward for innovation or enterprise.

c. In centrally planned systems business is essentially a government owned monopoly with no reward for improving product quality or developing more efficient production techniques.

d. Workers lack motivation because there are few material incentives.

III. The Collapse of the Soviet Economy: The Soviet Union ceased to exist by that name in November of 1991, and became 15 separate countries.


Soviet Union (U.S.S.R.)


Russia and 15 new independent countries

A. After rapid economic growth through the 1950s and 1960s (about 6 percent reported per year, compared to 3 percent in the U.S.) the rate fell to less than 3 percent in the 1970s, and by late 1980s the Soviet GDP was actually declining.

  • WHY was the initial growth rate so high?
    • Resources were initially mobilized to achieve rapid economic growth and this was successful through the 1950s. Both China and the Soviet Union induced or coerced a larger proportion of the population into the labor force.
  • WHY did the growth rate decline?
    • inefficiency caused by the coordinationand the incentive problems

B. The quality of goods was below international standards, the selection of consumer goods was extremely limited, and technology was primitive by world standards. Shortages of basic goods were common, leading to long lines, black markets, and corruption in product distribution.

C. The lack of ability to fulfill consumer needs contributed to the fall of communism.

D. There was a huge military burden: 15 to 20 percent of GDP was devoted to military as compared with 6 to 7 percent of a much larger GDP in the U.S. (The role of President Ronald Reagan's military build-up.)

E. The agricultural sector experienced great inefficiency and consumed 25 percent of annual investment. It employed 30 percent of the labor force (in the U.S. the number is 2%) while still not producing enough for the population to feed itself. Output per farm worker was 10-25% that of U.S. farm workers.

IV. STRUCTURAL ADJUSTMENT: The Russian Transition to a Market System.

A. Privatization
1. Since 1992 more than two-thirds (more by now) of former state owned enterprises have been privatized, including 90% of small companies and 80% of service sector companies.

2. Land reform has progressed more slowly. It will take many years to develop a functional market for farm land.

B. Price Reform

1. Prices in the former Soviet system bore no relationship to the economic value of either products or resources.

2. Because input prices did not measure the relative scarcity of resources, it was impossible for a firm to minimize real production costs.

3. Prices of many consumer items were fixed at artificially low levels and shortages existed for many of these goods. (See Figure Web-1. We'll study this in chapter 3)

4. In January 1992, the government decontrolled about 90% of all prices including the Russian currency. Domestic prices surged and the international value of the Russian ruble sank.

5. The decontrolled prices began to more closely reflect the marginal cost of producing goods, which helped reallocate resources to best suit consumer wants. RESULT: ALLOCATIVE EFFICIENCY

C. Promotion of competition.

1. The former Soviet Union consisted of large state-owned enterprises—monopolies that produced 30 to 40 percent of total industrial output.

2. Russian reformers realized an efficient market economy requires competition, but only limited change has occurred.

3. Joint ventures between Russia and foreign companies are one possible way to increase competition and recent legislation has opened the door for firms to invest directly in Russia.

D. Joining the world economy by making the ruble convertible.

E. Price Level Stabilization - Keeping inflation down. (See Table 23W-1)

1. The transition to free markets brought hyperinflation.

2. Large government deficits were financed by increases in the money supply.

a. Privatization of state enterprises caused the government to lose profits.

b. The uncertainty of transition led to general disorder and widespread tax evasion.

c. The government extended massive subsidy credits to both industry and agriculture.

d. Pensions and welfare spending was increased by printing more money.

(the result of this increase in the money supply is INFLATION. we will discuss this in unit 3.)

F. Other major problems of the transition:

1. Real output began its fall in the 1980s but the decline accelerated during the reforms; the magnitude resembles that associated with the Great Depression in the United States. Causes of the declined include:
a. Rapid inflation, which caused an uncertain environment.

b. Unraveling trade relationships with former Soviet Bloc trading partners.

c. Bankruptcy and closing of many former state-owned enterprises.

d. Massive reallocation of resources including major cuts in military spending.

2. Because real output equals real income, the Russian living standard has declined dramatically; at least 30,000 scientists have left Russian to work elsewhere.

3. Economic inequality has increased during the transition. This is a common problem with market economies. Greater economic freedom has brought greater economic insecurity; medical and educational services have declined, alcohol abuse has increased.

4. While some new wealth has been created through entrepreneurship, others have enriched themselves via corruption and illegal activities. The major disruptions, swift changes, and lack of regulatory oversight created major opportunities for organized crime.

6. A remaining concern about the transition to markets in Russia is the weakness of government in law enforcement, particularly the collection of taxes.

G. Recent Revival

1. Aided by rising oil prices and production, and greater political stability, Russia's real GDP has increased by at least 5 percent per year since 1999. The unemployment rate fell from 13 percent in 1999 to about 8 percent in 2002.

2. Recent income growth and stronger enforcement of tax collection has increased tax revenues, helping to turn the government's 1998 budget deficit into a surplus in 2002.

3. The most severe economic dislocations seem to have ended, but the transition to a fully functioning market economy will require additional time.

V. Market Reforms in China

A. China has taken a different path to market reform than Russia.
  • The reforms began earlier,
  • were more gradual,
  • and allowed the old systems to function along with the new.
  • Also maintained an authoritarian, Communist, government system

B. Market reform began in agriculture in 1978. The key elements were the leasing of land to individual farmers and the establishment of a two-track price system (lower prices for government orders and market prices for the surplus). Responding to the profit motive, individual farmers increased their productivity and agricultural output soared.

C. The success of reforms in agriculture led the central government to extend the reforms to state-owned enterprises (SOEs) in urban areas.

1. The two-track price system was again employed, gradually increasing the portion of inputs and outputs that could be sold at market prices.

2. The government also encouraged the formation of urban collectives—enterprises owned jointly by managers and their workforces. The urban collectives experienced explosive growth, some at the expense of the SOEs. However, the competition spurred productivity advance and innovation in many of the SOEs.

D. In 1980 China created special economic zones (SEZs) open to foreign investment, private ownership, and international trade. Spatially isolated.

E. Reforms in China also included building institutions to facilitate the market system and its macroeconomic control.

1. A central bank, a stock market and currency exchange facilities were established.

2. China replaced the system of "profit transfers" from state enterprises to the central government with an enterprise tax system.

F. Transformation of the State Owned Enterprises (SOEs).

1. In the 1990s the market reforms continue as the Communist Party operatives running the SOEs are replaced with professional business managers.

2. In a competitive environment many SOEs found that they were producing the wrong goods (allocative inefficiency), in the wrong amounts (allocative inefficiency), using the wrong combinations of inputs (productive inefficiency). In short they were inefficient, in both production techniques and in allocation of resources. Some will be allowed to fail, others will issue stock with the government holding a controlling interest.

VI. Outcomes and Prospects

A. China’s economic growth rate in the past two decades is among the highest on record for any country during any period of world history. (See Table 23W-2)

B. The growth of per capita income in China has resulted from increased use of capital, improved technology, and shifts of labor away from lower-productivity toward higher productivity uses.

Which definition of growth is the author using?
  • "increased use of capital" = more resources = economic growth
  • "improved technology" = economic growth
  • "and shifts of labor away from lower-productivity toward higher productivity uses" = using resources where they are best suited - productive efficiency

C. Rapid expansion of international trade from $5 billion in 1978 to $195 billion in 1999 took place = productive efficiency

D. China still faces some significant economic problems in its transition to the market system.

1. Outright ownership of farm land is still prohibited and this inhibits investment in farm equipment and capital improvements on the land = less economic growth

2. The financial and monetary control systems in China are still weak and inadequate. Many unprofitable SOEs owe colossal sums of money on loans made by banks.

3. Unemployment is a problem in China, with an estimated 10 percent unemployment rate in 2002. The problem is especially acute in the interior regions of the country.

4. China still has much work to do to fully integrate its economy into the world's system of international finance and trade.

5. There is great regional unevenness in China's economic development.

VII. Conclusion

A. China’s gradual path has been more successful so far, but questions remain about future prospects.

B. Once Russia stabilizes, it may be in a stronger position than China because it has become more democratic.



WHAT ARE THEY DOING? - Structural Adjustment Program policies

There are a great variety of policies that comprise Structural Adjustment. Here is a list of some of the most important ones:

  • Privatization - the selling of government owned industries to the private sector. This is a fundamental change that is occurring around the world - even in the United States.
  • Promotion of Competition - we'll find out that the word "competition" has a special meaning in economics, but here all we mean is that many firms compete with each other for your business.
  • Reduced Role of Government - but we are not saying no government. How much the government should get involved in the economy is currently an important political question here in the US.
  • Removing Price Controls - As we will see, a fundamental part of structural adjustment is to allow markets to set prices rather than the government. If people are used to government controlled LOW prices they often oppose the removal of these price controls.
  • Freer Trade and Convertible Currency - another major change occurring worldwide is the removal of trade barriers. More on this later
  • Foreign Investment - along with free trade goes the free movement of capital.


We can assume that the governments that are undertaking structural adjustment programs want to improve the standard of living for their citizens. They hope to do this by achieving the 5Es of economics:
  • economic growth
  • productive efficiency
  • allocative efficiency
  • equity
  • full employment

They also want to achieve the macroeconomic issues of:

  • full employment
  • low inflation
  • economic growth

We will soon discuss whether they are achieving these goals.


Often, as countries begin to implement their structural adjustment policies, things get worse before they get better - or they get worse for some and better for others. Common problems associated, at least initially, with structural adjustment programs would include.
  • Inflation as the governments removes price controls
  • Rising unemployment as people are laid off from inefficient government owned enterprises resulting in falling output and lower living standards
  • Inequality and other social costs as some people gain but others lose


Although many people protest SAPs,


most economists, and governments, believe the benefits of greater efficiency achieved through globalization outweigh the costs.

Therefore all around the world governments are moving their economies from command economies towards capitalism. The goal of unit 1 is to learn some fundamental economic principles to help us better understand these changes.


When countries undertake structural adjustment programs they move FROM a command economy TO a market economy with the following results:




ownership of resources:


government ownership


private ownership

decision making:


centrally planned


by the market



"the social good"


self interest and profit

prices and wages:


set by the government
often distorted


set by the market
change with market



full employment
low inflation
low standard of living
more equal distrib


economic efficiency
periods of unemploy.
periods of inflation
high standard of living
wide range available
less equal distrib.



corruption=self interest

lack of incentives (the incentive problem)

distorted prices (the coordination problem)



monopoly= inefficiency
changing prices
instability (UE, IN)




and a lower standard of living



and a higher standard of living


Pure Capitalism and the Market System:
The Market and the 5 Es

Characteristics of a Market Economy (Capitalism)

A. private property
B. markets and prices
C. role of self interest: incentives
D. freedom of enterprise and choice
E. competition
1. large numbers
2. free entry and exit
3. produce standardized products

F. limited role for government

The Market and the 5Es

1. Economic Growth
Capitalist economies tend to have more rapid rates of growth

2. Allocative Efficiency: Producing what consumers want

a. Capitalism and incentives
(1) more profits = produce more

(2) losses = produce less

(3) consumer sovereignty and "dollar votes"

b. Capitalism tends to achieves allocative efficiency

3. Productive Efficiency: Producing at a minimum cost

a. Capitalism and incentives
(1) profits = total revenues - total cost

(2) minimizing costs means more profits

b. Capitalism tends to achieve productive efficiency

4. Equity

There is no characteristic of capitalism which will guarantee equity

Often, the government gets involved to help achieve equity

5. Full Employment

Economists disagree over whether capitalism will result in full employment
  • Some say yes, and if there is unemployment it is usually caused by government interference
  • Some say no, and at times government involvement is needed to move the economy towards full employment