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CHAPTER 2
The Market System and the Circular Flow
A. Short-Answer, Essays, and Problems
1. Define the term economic system. Discuss the two ways in which economic systems can differ.
2. Explain the term “laissez faire capitalism.”
3. Explain what is meant by a command economy.
4. Evaluate the statement: “The government should have no place in a capitalistic market system.”
5. List nine characteristics of the market system.
6. Why is the right of private property an essential characteristic of a market system?
7. What role does freedom play in capitalism? How important is it to the operation of a competitive market
economy?
8. Explain the importance of self-interest in the operation of a market system.
9. What is the importance of competition in relation to self-interest in a market system?
10. What conditions are necessary for economic competition to exist?
11. “The regulatory force in the market system bears the seeds of its own destruction.” Explain and evaluate.
12. Explain why the market system is an organizing mechanism.
13. Respond to the following question: “Producing capital goods or advanced technology takes time, so how
can that be a more efficient form of production of consumer goods?”
14. Describe two types of specialization in production.
15. What are the economic advantages of specialization?
16. Describe three ways that human specialization contributes to society’s output.
17. What advantage does a money economy have over a barter economy?
18. How does the use of money differ from the use of barter in the exchange of goods and services?
19. What is money and what important function does it perform? Explain how it overcomes the disadvantages
associated with barter. What conditions are necessary for people to accept paper currency in exchange for
the goods and services which they sell?
2-37
20. Suppose Tom, Dick, and Harry live in a barter economy. Tom produces wine, Dick bakes bread, and Harry
makes cheese. Tom wants some bread to go with his wine and is willing to trade 1 gallon of wine for two
loaves of bread. Dick wants some cheese to go with his bread and is willing to trade one loaf of bread for
one-half pound of cheese. Harry doesn’t want bread, but wants some wine to go with his cheese and is
willing to trade cheese for one gallon of wine. It is not possible for all three to meet together at one time.
(a) Explain how this situation illustrates the difficulty with a barter economy.
(b) Devise a money system using precious stones where four stones are equivalent in value to one gallon
of wine. In other words tell how much bread and cheese would be worth in terms of stones in this
economy. In this system, how much cheese must Harry sell in order to buy one gallon of wine?
21. What are the so-called Five Fundamental Questions that every economy must answer?
22. A firm has the choice between producing product A, B, or C. In producing the products the firm faces a
weekly cost of $10 for product A, $130 for product B and $200 for product C. The prices received for each
product at different quantities are listed in the table below.
Output
Product
A
Product
B
Product
C
Profit
A
Profit
B
Profit
C
5
$3.00
$15.00
$35.00
_____
_____
_____
10
2.00
12.00
20.00
_____
_____
_____
15
1.25
9.00
10.00
_____
_____
_____
(a) Compute the firm’s profit for A, B, and C and enter this data into the table.
(b) Which product will the firm choose to produce and how much output will maximize profit?
23. Assume that a firm can produce product A, product B, or product C with the resources it currently employs.
These resources cost the firm a total of $100 per week. Assume, for the purposes of this problem, that the
firm’s costs cannot be changed. The market prices and the quantities of A, B, and C these resources can
produce are given as follows.
Product
Market
pri
ce
Output
Profit
A
$14.00
10
$_____
B
9.00
11
_____
C
.50
300
_____
(a) Compute the firm’s profit when it produces A, B, or C and enter these data in the table.
(b) Which product will the firm produce?
(c) If the price of A rose to $16, which product will the firm produce?
(d) If the firm produces A at a price of $16, what would tend to happen to the number of firms
producing product A?
2-38
24. Assume that a firm can produce product A, product B, or product C with the resources it currently employs.
These resources cost the firm a total of $100 per week. Assume, for the purposes of this problem, that the
firm’s costs cannot be changed. The market prices and the quantities of A, B, and C these resources can
produce are given below.
Product
Market
pri
ce
Output
Profit
A
$10.00
6
$_____
B
5.00
19
_____
C
1.50
100
_____
(a) Compute the firm’s profit when it produces A, B, or C and enter these data in the table.
(b) Which product will the firm produce?
(c) Suppose the quantity of product B the firm was able to produce with the same amount of
inputs now rose to 25. Which product will the firm now produce?
(d) As a result of the rise in quantity of product B to 25 that each firm can produce, what will
happen to the number of firms producing product B?
25. How does ‘consumer sovereignty’ determine the types and quantities of the goods produced in an
economy?
26. How does consumer choice differ from consumer sovereignty in a market system?
27. Explain in detail how a decrease in consumer demand for a product will result in less of the product being
produced and in fewer resources being allocated to its production.
28. (Consider This) How is consumer sovereignty at work at McDonalds? Give an example of a hit and a miss.
29. The demand for a resource is “derived” from the goods and services that the resource is used to produce.
Give three examples.
30. Why does competition force firms to use the least-cost, most efficient, productive techniques?
31. Assume that a firm finds that its profits will be maximized (or losses minimized) when it produces $30
worth of product X. Each of these techniques shown in the following table will produce exactly $30 worth
of X.
Unit resource
prices
Method #1
Method #2
Method #3
Land
$1
6
3
4
Labor
2
4
3
3
Capital
3
3
4
6
Entrepreneurship
4
2
4
1
(a) Which method is most efficient? Why?
(b) Given the above prices, will the firm adopt a new method which involves 10 units of land, 3 of labor, 2
of capital, and 2 of entrepreneurial ability?
(c) Suppose the price of capital falls to $1 without any other prices changing. Which of the methods will
the firm now choose? Why?
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32. Assume that a firm finds that its profits will be maximized (or losses minimized) when it produces $50
worth of product X. Each of these techniques shown in the following table will produce exactly $50 worth
of X.
Unit resource
prices
Method #1
Method #2
Method #3
Land
$4
4
2
1
Labor
3
4
3
6
Capital
2
3
4
3
Entrepreneurship
1
3
6
4
(a) Which method is most efficient? Why?
(b) Given the above prices, will the firm adopt a new method which involves 2 units of land, 2 of labor, 4
of capital, and 8 of entrepreneurial ability?
(c) Suppose the price of labor falls to $1 without any other prices changing. Which of the methods will
the firm now choose? Why?
33. What is meant by the guiding function of prices?
34. How can technological advance result in creative destruction?
35. Adam Smith in his 1776 book the Wealth of Nations describes the concept of “an invisible hand.” Explain
what he means by an “invisible hand.”
36. Explain this quote from 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 own interest.”
37. “Competition is the mechanism that brings order out of potential chaos in a price-directed economy.”
Explain.
38.Describe the three major virtues of a market system.
39. What are the two main problems that have caused the demise of the command systems?
40. What is the coordination problem in command economics?
41. Is the problem of coordination common to all economies? Explain how the problem is met in a market
economy and how coordination was dealt with in a command economy.
42. What is the incentive problem in central planning?
43. “A major reason the economy of the former Soviet Union collapsed was due to a lack of incentives that are
provided by the profit system.” Evaluate.
44. (Consider This) Explain the differences in economic systems between North and South Korea and the
economic outcomes of the two systems.
45. Describe the basic features of the circular flow diagram.
46. What is the relationship between businesses and households in the circular flow diagram?
47. In the below circular flow diagram, the household and business sectors are labeled with arrows representing
2-40
the flows of income and output labeled (a) through (f) and the two appropriate markets labeled (g) and (h).
Supply the correct descriptive titles for each of these labels (a) through (h).
48. Describe the flows that occur between (a) households and the product market, (b) businesses and the
product market, and (c) households and the resource market.
49. In which market would each of the following be determined?
(a) The wage of a lawyer.
(b) The quantity of electric cars produced.
(c) The price of a new television.
(d) The quantity of farm land used to produce corn.
50. Define the three main categories of businesses.
51. Explain the main characteristics of a corporation.
52. In a market system entrepreneurs or the managers they hire must deal with risk. Discuss the incentives of
these individuals when dealing with risk, relative to those of a central planner in a command economy.
53. Describe how business risk affects employees.
54. Discuss the benefits of restricting business risk to owners and investors.
55. Who is the residual claimant of a firm? How are they effected by the firm declaring a profit or loss?
56. (Consider This) How does the market for insurance promote economy growth and investment?
57. (Last Word) Explain why the arrangement in the use of resources in a market system is not random given
the decentralized nature of the system.
2-41
B. Answers to Short-Answer, Essays, and Problems
1. Define the term economic system. Discuss the two ways in which economic systems can differ.
2. Explain the term “laissez faire capitalism.”
Pure capitalism is sometimes called “laissez faire” capitalism which is a French term for “let it be.” In pure
3. Explain what is meant by a command economy.
4. Evaluate the statement: “The government should have no place in a capitalistic market system.”
While having a large government presence in the economy like in a command market system can be
detrimental to efficiency, innovation and growth, there is still a place for government in a capitalistic
5. List nine characteristics of the market system.
6. Why is the right of private property an essential characteristic of a market system?
Property rights are important because they give people private ownership of resources. This ownership
2-42
7. What role does freedom play in capitalism? How important is it to the operation of a competitive market
economy?
8. Explain the importance of self-interest in the operation of a market system.
9. What is the importance of competition in relation to self-interest in a market system?
10. What conditions are necessary for economic competition to exist?
11. “The regulatory force in the market system bears the seeds of its own destruction.” Explain and evaluate.
Competition is the regulatory mechanism of the market economy. However, a successful competitor has
the potential of driving rivals out of business if the most successful firm is more efficient and other firms
12. Explain why the market system is an organizing mechanism.
Markets and price give the economic system its ability to coordinate millions of economics decisions made
2-43
13. Respond to the following question: “Producing capital goods or advanced technology takes time, so how
can that be a more efficient form of production of consumer goods?”
14. Describe two types of specialization in production.
Specialization may be of the human form with division of labor where different workers perform different
15. What are the economic advantages of specialization?
16. Describe three ways that human specialization contributes to society’s output.
17. What advantage does a money economy have over a barter economy?
Trade is difficult with barter because it requires a coincidence of wants. Money overcomes that problem.
A buyer can obtain goods without having to locate a seller who desires what the person has to trade. All
18. How does the use of money differ from the use of barter in the exchange of goods and services?
19. What is money and what important function does it perform? Explain how it overcomes the disadvantages
associated with barter. What conditions are necessary for people to accept paper currency in exchange for
the goods and services which they sell?
Money is anything that is generally acceptable as a medium of exchange. In the United States economy,
money includes currency, coins, and checkable deposits.
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
Note that the money does not have to have any intrinsic value; that is, it does not have to be backed by a
material that has some use like gold or silver.
20. Suppose Tom, Dick, and Harry live in a barter economy. Tom produces wine, Dick bakes bread, and Harry
makes cheese. Tom wants some bread to go with his wine and is willing to trade 1 gallon of wine for two
loaves of bread. Dick wants some cheese to go with his bread and is willing to trade one loaf of bread for
one-half pound of cheese. Harry doesn’t want bread, but wants some wine to go with his cheese and is
willing to trade cheese for one gallon of wine. It is not possible for all three to meet together at one time.
(a) Explain how this situation illustrates the difficulty with a barter economy.
(b) Devise a money system using precious stones where four stones are equivalent in value to one gallon
of wine. In other words tell how much bread and cheese would be worth in terms of stones in this
economy. In this system, how much cheese must Harry sell in order to buy one gallon of wine?
(a) The lack of coincidence of wants is illustrated in this situation. Tom wants the bread that Dick has,
Dick wants Harry’s cheese, and Harry wants Tom’s wine but for any two of them there is no incentive
21. What are the so-called Five Fundamental Questions that every economy must answer?
22. A firm has the choice between producing product A, B, or C. In producing the products the firm faces a
weekly cost of $10 for product A, $130 for product B and $200 for product C. The prices received for each
product at different quantities are listed in the table below.
Output
Product A
Product B
Product C
Profit A
Profit B
Profit C
5
$3.00
$15.00
$35.00
_____
_____
_____
10
2.00
12.00
20.00
_____
_____
_____
15
1.25
9.00
10.00
_____
_____
_____
(a) Compute the firm’s profit for A, B, and C and enter this data into the table.
(b) Which product will the firm choose to produce and how much output will maximize profit?
(a) See table.
Output
Product A
Product B
Product C
Profit A
Profit B
Profit C
5
$3.00
$15.00
$35.00
$ 5.00
($55.00)
($25.00)
10
2.00
12.00
20.00
10.00
(10.00)
0
15
1.25
9.00
10.00
8.75
5.00
(50.00)
(b) The firm will produce product A, because it produces the largest profit of $10 at 10 units of output.
2-45
23. Assume that a firm can produce product A, product B, or product C with the resources it currently employs.
These resources cost the firm a total of $100 per week. Assume, for the purposes of this problem, that the
firm’s costs cannot be changed. The market prices and the quantities of A, B, and C these resources can
produce are given as follows.
Product
Market
price
Output
Profit
A
$14.00
10
$_____
B
9.00
11
_____
C
.50
300
_____
(a) Compute the firm’s profit when it produces A, B, or C and enter these data in the table.
(b) Which product will the firm produce?
(c) If the price of A rose to $16, which product will the firm produce?
(d) If the firm produces A at a price of $16, what would tend to happen to the number of firms producing
product A?
Product
Market
price
Output
Profit
A
$14.00
10
$40.00
B
9.00
11
− 1.00
C
.50
300
50.00
2-46
24. Assume that a firm can produce product A, product B, or product C with the resources it currently employs.
These resources cost the firm a total of $100 per week. Assume, for the purposes of this problem, that the
firm’s costs cannot be changed. The market prices and the quantities of A, B, and C these resources can
produce are given below.
Product
Market
price
Output
Profit
A
$10.00
6
$_____
B
5.00
19
_____
C
1.50
100
_____
(a) Compute the firm’s profit when it produces A, B, or C and enter these data in the table.
(b) Which product will the firm produce?
(c) Suppose the quantity of product B the firm was able to produce with the same amount of inputs now
rose to 25. Which product will the firm now produce?
(d) As a result of the rise in quantity of product B to 25 that each firm can produce, what will happen to
the number of firms producing product B?
Product
Market
price
Output
Profit
A
$10.00
6
−$40.00
B
5.00
19
− 5.00
C
1.50
100
50.00
(a) Profit for A will be −$40 (loss); for B will be −$5 (loss); for C will be $50.
(b) The firm will produce product C.
(c) The firm would still choose product C.
(d) If all firms are identical with identical costs, there will be no change in the number of firms producing
product B because it is still more profitable for each firm to product C. Thus product B is unaffected.
25. How does ‘consumer sovereignty’ determine the types and quantities of the goods produced in an
economy?
26. How does consumer choice differ from consumer sovereignty in a market system?
Consumer choice by itself refers only to consumers’ freedom to choose what they are willing and able to
2-47
27. Explain in detail how a decrease in consumer demand for a product will result in less of the product being
produced and in fewer resources being allocated to its production.
Given the supply schedule or supply curve, a decrease in consumer demand means less quantity demanded
than was previously the case at each possible price. The demand curve shifts to the left.
28. (Consider This) How is consumer sovereignty at work at McDonalds? Give an example of a hit and a
29. The demand for a resource is “derived” from the goods and services that the resource is used to produce.
Give three examples.
30. Why does competition force firms to use the least-cost, most efficient, productive techniques?
31. Assume that a firm finds that its profits will be maximized (or losses minimized) when it produces $30
worth of product X. Each of these techniques shown in the following table will produce exactly $30 worth
of X.
Unit resource
prices
Method #1
Method #2
Method #3
Land
$1
6
3
4
Labor
2
4
3
3
Capital
3
3
4
6
Entrepreneurship
4
2
4
1
(a) Which method is most efficient? Why?
(b) Given the above prices, will the firm adopt a new method which involves 10 units of land, 3 of labor, 2
of capital, and 2 of entrepreneurial ability?
(c) Suppose the price of capital falls to $1 without any other prices changing. Which of the methods will
the firm now choose? Why?
2-48
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
(c) It will choose #3 because it uses relatively more of capital which is now much less expensive and the
total cost of each method now makes #3 the least-cost combination.
32.Assume that a firm finds that its profits will be maximized (or losses minimized) when it produces $50 worth
of product X. Each of these techniques shown in the following table will produce exactly $50 worth of X.
Unit resource
prices
Method #1
Method #2
Method #3
Land
$4
4
2
1
Labor
3
4
3
6
Capital
2
3
4
3
Entrepreneurship
1
3
6
4
(a) Which method is most efficient? Why?
(b) Given the above prices, will the firm adopt a new method which involves 2 units of land, 2 of labor, 4
of capital, and 8 of entrepreneurial ability?
(c) Suppose the price of labor falls to $1 without any other prices changing. Which of the methods will
the firm now choose? Why?
33. What is meant by the guiding function of prices?
34. How can technological advance result in creative destruction?
35. Adam Smith in his 1776 book the Wealth of Nations describes the concept of “an invisible hand.” Explain
what he means by an “invisible hand.”
2-49
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
and services per dollar spent. Through the competitive market, businesses direct resources to their highest
and best use that benefits the businesses and society as if guided by an “invisible hand.”
2-50
36. Explain this quote from 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 own interest.”
37. “Competition is the mechanism that brings order out of potential chaos in a price-directed economy.”
Explain.
38. Describe the three major virtues of a market system.
39. What are the two main problems that have caused the demise of the command systems?
The first problem is that of coordination. In a planned economy, central planners have to coordinate
millions of decisions made by consumers, producers and resource suppliers. This involved planning
anything from production targets and resource allocation. This took a considerable amount of time and
investment.
2-51
40. What is the coordination problem in command economics?
41. Is the problem of coordination common to all economies? Explain how the problem is met in a market
economy and how coordination was dealt with in a command economy.
The problem of coordination is common to all economies. In a market system, prices adjust the quantity
42. What is the incentive problem in central planning?
43. “A major reason the economy of the former Soviet Union collapsed was due to a lack of incentives that are
provided by the profit system.” Evaluate.
A very good case can be made in favor of this statement. The centrally planned system had to rely heavily
on the efficient use of resources through better management and increased productivity, but it was those
aspects of Soviet central planning that had the greatest flaws.
2-52
44. (Consider This) Explain the differences in economic systems between North and South Korea and the
economic outcomes of the two systems.
45. Describe the basic features of the circular flow diagram.
In the simple circular flow diagram, there are two decision-makers: households and businesses. These two
groups are related through the resource and product markets. In the upper part of the circular flow,
households sell economic resources (land, labor, capital, entrepreneurial ability) and businesses buy
46. What is the relationship between businesses and households in the circular flow diagram?
47. In the below circular flow diagram, the household and business sectors are labeled with arrows representing
the flows of income and output labeled (a) through (f) and the two appropriate markets labeled (g) and (h).
Supply the correct descriptive titles for each of these labels (a) through (h).
2-53
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
48 . Describe the flows that occur between (a) households and the product market, (b) businesses and the
product market, and (c) households and the resource market.
(a) Resources flow from the product market to households in the form of goods and services produced by
businesses. Resources flow from households to the product market in the form of consumption
expenditures on goods and services.
(b) Resources flow from businesses to the product market in the form of goods and services the businesses
produce. Resources flow from the product market in the form of revenues earned from the sale of goods
and services to households.
(c) Resources flow to the resource market from households in the form of labor, land, capital and
entrepreneurial ability. Resources flow from the resource market to households in the form of monetary
income, such as wages, rents, interest, and profits.
49. In which market would each of the following be determined?
(a) The wage of a lawyer.
(b) The quantity of electric cars produced.
(c) The price of a new television.
(d) The quantity of farm land used to produce corn.
50. Define the three main categories of businesses.
51. Explain the main characteristics of a corporation.
Corporations are legal business organizations which are distinct and separate entities from the individuals
who own them. As such, corporations are treated as legal persons that can acquire resources, own assets,
52. In a market system entrepreneurs or the managers they hire must deal with risk. Discuss the incentives of
these individuals when dealing with risk, relative to those of a central planner in a command economy.
Entrepreneurs are guided in making decisions by the profit system (profit and loss system). They must deal
2-54
53. Describe how business risk affects employees.
54. Discuss the benefits of restricting business risk to owners and investors.
If business risk is assumed only by the firm’s owners and investors it is easier to attract employees and
suppliers. Many individuals prefer to avoid risk and like the certainty that a regular paycheck offers.
Limiting the risk these individuals bear attracts them to the market.
55. (Consider This) How does the market for insurance promote economy growth and investment?
56. (Last Word) Explain why the arrangement in the use of resources in a market system is not random given
the decentralized nature of the system.
