Economic Systems and The Circular Flow Model

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Economic Systems andThe Circular Flow Model

• Unit 1
• Lecture Notes

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Key Understandings

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

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3 Basic Economic Questions all societies must
answer

• What to Produce
• How to Produce
• For Whom to Produce

?
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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

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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.
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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
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Types of Economic Systems

• Market System (Pure Capitalism)
• Command System (Communism)
• Traditional System (Customary)
• Mixed System

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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

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In a market economy, the economy relies on prices
and the forces of supply and demand to answer the
3 basic questions
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• The system relies on the independence of buyers
  and sellers of each resource and assumes that
  economic power and influence will be widely
  dispersed.
• 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
  market

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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

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In a Command economy, governmental planning
groups make all the economic decisions to answer
the 3 basic economic questions
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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
  individuals
• Economic activity often secondary to religious
  and cultural values and status quo

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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
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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

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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.
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The Circular Flow of Economic Activity Model

• For a Market Economy

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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

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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
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Understanding the Model Components

• 2 groups of decision makers Households and
  Businesses
• 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

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PRODUCT MARKET
FACTOR MARKET
Resource Owners(Households)
Factor Markets
Product Markets
Business Organ.(Producers)
The Circular Flow Model
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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

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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 moneyBlack Arrows
represent flow of goods/services
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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
selling.
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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
  work
• E. EZ Bakery sold two cakes to Mr. Smith

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• F. ARM Corporation paid stockholders a 5
  dividend
• G. Frank was paid 15,000 for his 6-week stage
  performance
• 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
  account

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• 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