Lecture 3: An Overview of the Market Economy

Outline:

1. The development of market economies

i. Surplus, specialization, and trade

ii. The division of labor (Adam Smith)

iii. Markets and resource allocation

2. Decision makers in the market economy

i. Households

ii. Firms

iii. Government

3. The circular flow of income (Figure 3-1)

4. Definitions

i. Markets

ii. Economy

iii. Market sector vs. non-market sector

iv. Private sector vs. public sector

1. Development of market economies

Surplus, specialization, and trade:

*The transition from hunter-gatherer societies to agricultural societies changed the nature of provisioning.

* Hunter-gatherers because of their nomadic life-style did not accumulate surplus food - they obtained what they needed at any given time and no more.

* The agricultural revolution and permanent settlement created surplus agricultural production for the first time.

* Surplus allowed the creation of new occupations - people specialized in the production of goods and services and traded what they produced in excess of what they needed to obtain other goods and services.

Gains from specialization of labor:

* Specialization of labor into different occupations creates the potential for increased output of goods and services.

* Two reasons for this are:

a. Given different talents and abilities people can do what they do best.

b. Concentrating on one activity allows a person to become better at that activity - "learning by doing".

Gains from trade:

* Specialization necessitates trading.

* Trade allows the gains from specialization to be realized.

* Trade is assumed to be mutually beneficial to both parties since it is undertaken voluntarily.

The division of labor

* With the advent of the industrial revolution and revolution in technology which brought it about, there was a change in the scale of production.

* New technology made it possible to organize industry and agriculture on a large scale.

* The factory system emerged with opportunities for the "division of labor" - a further specialization of labor in the production process - with individuals doing specialized tasks in the production of a particular good or service.

Markets and resource allocation

Definition:

Resource allocation refers to the distribution of resources among the various uses to which they can be put.

In a market economy the allocation of resources is the outcome of the independent decisions of producers and consumers acting through the medium of markets.

2. The decision makers in the market economy

Households:

A household is defined as all the people who live under one roof and make joint financial decisions or are subject to those financial decisions.

Households are often referred to as consumers because they are the main consumers of consumption goods and services.

Assumptions economists make about households:

1. They make consistent unified decisions (as if the household was a single individual).

2. They are the principal owners of the factors of production and they sell the services of the factors to firms in exchange for income.

3. They seek to maximize well-being or utility subject to the resources that they have.

Firms:

A firm is defined as the unit that employs factors of production to produce goods and services that it sells to other firms, households or to the government.

Firms are often referred to as producers because they hire factors of production and transform them into goods and services.

Assumptions economists make about firms:

1. They are assumed to make consistent unified decisions (as if the firm was a single individual).

2. They are the principal users of the factors of production and they buy the services of the factors.

3. They make their decisions with a single goal in mind - to maximize profits.

Government:

The government is used in economics in a broad sense to include all public officials, agencies, government bodies, and other organizations under the direct control of the federal, state, or local governments.

The essence of the government as a decision maker in the economy is - that it is an organization that has legal and political power to exert control over individual decision makers and over markets.

Assumptions economists make about the government:

There is no generally accepted set of assumptions about government behavior - for example, there are different levels of the government, different responsibilities for decision making, public officials are often motivated by objectives other than or in addition to the public good.

Specific assumptions about the government are made in the context of the problem being studied.

3. The Circular Flow of Income

* Graphical representation of the interactions between households and firms in markets.

4. Definitions:

Market: Refers to any situation in which buyers and sellers can negotiate the exchange of some product.

Economy: Refers to a loosely defined as a set of interrelated production and consumption activities.

Market sector: Refers to the part of the economy where producers expect to cover their costs of production with their revenues.

Also called the "for-profit" sector

Non-market sector: The part of the economy where producers must cover their costs of production from some source other than sales revenue.

Also called the "non-profit" sector

Note: The distinction between the market and non-market sectors is an economic distinction - whether or not costs of production are covered by sales revenue

Private sector: Refers to all production that is in private hands.

Public sector: Refers to all production that is in public hands - owned by the government.

Note: The distinction between the private sector and the public sector is a legal distinction - who owns the enterprise.