Chapter 02 – The Market System and the Circular Flow
2-1
CHAPTER 2
The Market System and the Circular Flow
A. Short-Answer, Essays, and Problems
1. Explain the term “laissez faire capitalism.”
2. Explain what is meant by a command economy.
3. Evaluate the statement: “The government should have no place in a capitalistic market system.”
4. List nine characteristics of the market system.
5. Why is the right of private property an essential characteristic of a market system?
6. What role does freedom play in capitalism? How important is it to the operation of a competitive market
economy?
7. Explain the importance of self-interest in the operation of a market system.
8. What is the importance of competition in relation to self-interest in a market system?
9. What conditions are necessary for economic competition to exist?
10. “The regulatory force in the market system bears the seeds of its own destruction.” Explain and evaluate.
11. Explain why the market system is an organizing mechanism.
12. 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?”
13. Describe two types of specialization in production.
14. What are the economic advantages of specialization?
15. Describe three ways that specialization contributes to society’s output.
16. What advantage does a money economy have over a barter economy?
17. How does the use of money differ from the use of barter in the exchange of goods and services?
18. 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?
19. 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 of them to meet together at one
time.
(a) Explain how this situation illustrates the difficulty with a barter economy.
Chapter 02 – The Market System and the Circular Flow
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(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?
20. What are the so-called Five Fundamental Questions that every economy must answer?
21. 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?
22. 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
Output
Profit
A
10
$_____
B
11
_____
C
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?
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 below.
Product
Output
Profit
A
6
$_____
B
19
_____
C
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?
24. How does ‘consumer sovereignty’ determine the types and quantities of the goods produced in an
economy?
Chapter 02 – The Market System and the Circular Flow
2-3
25. How does consumer choice differ from consumer sovereignty in a market system?
26. 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.
27. (Consider This) How is consumer sovereignty at work at McDonalds? Give an example of a hit and a
miss.
28. The demand for a resource is “derived” from the goods and services that the resource is used to produce.
Give three examples.
29. Why does competition force firms to use the least-cost, most efficient, productive techniques?
30. 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 #2
Land
$1
3
Labor
2
3
Capital
3
4
Entrepreneurship
4
4
(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?
31. 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 #2
Land
$4
2
Labor
3
3
Capital
2
4
Entrepreneurship
1
6
(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?
32. What is meant by the guiding function of prices?
33. How can technological advance result in creative destruction?
34. 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.”
35. 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.”
Chapter 02 – The Market System and the Circular Flow
2-4
36. “Competition is the mechanism that brings order out of potential chaos in a price-directed economy.”
Explain.
37. Describe the three major virtues of a market system.
38. What are the two main problems that have caused the demise of the command systems?
39. What is the coordination problem in command economics?
40. 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.
41. What is the incentive problem in central planning?
42. “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.
43. (Consider This) Explain the differences in economic systems between North and South Korea and the
economic outcomes of the two systems.
44. Describe the basic features of the circular flow diagram.
45. What is the relationship between businesses and households in the circular flow diagram?
46. 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).
47. 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.
48. Define the three main categories of businesses.
49. Explain the main characteristics of a corporation.
50. (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.
Chapter 02 – The Market System and the Circular Flow
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B. Answers to Short-Answer, Essays, and Problems
1. Explain the term “laissez faire capitalism.”
2. Explain what is meant by a command economy.
3. Evaluate the statement: “The government should have no place in a capitalistic market system.”
4. List nine characteristics of the market system.
5. Why is the right of private property an essential characteristic of a market system?
6. What role does freedom play in capitalism? How important is it to the operation of a competitive market
economy?
Chapter 02 – The Market System and the Circular Flow
2-6
7. Explain the importance of self-interest in the operation of a market system.
8. What is the importance of competition in relation to self-interest in a market system?
9. What conditions are necessary for economic competition to exist?
10. “The regulatory force in the market system bears the seeds of its own destruction.” Explain and evaluate.
11. Explain why the market system is an organizing mechanism.
12. 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?”
Chapter 02 – The Market System and the Circular Flow
2-7
13. Describe two types of specialization in production.
14. What are the economic advantages of specialization?
15. Describe three ways that specialization contributes to society’s output.
16. What advantage does a money economy have over a barter economy?
17. How does the use of money differ from the use of barter in the exchange of goods and services?
18. 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?
19. 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
Chapter 02 – The Market System and the Circular Flow
2-8
willing to trade cheese for one gallon of wine. It is not possible for all three of them 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?
20. What are the so-called Five Fundamental Questions that every economy must answer?
21. 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?
Output
Product A
Product B
Product C
Profit A
Profit B
Profit C
5
$3.00
$15.00
$35.00
2.00
12.00
20.00
10.00
(10.00)
1.25
9.00
10.00
5.00
(50.00)
Chapter 02 – The Market System and the Circular Flow
2-9
22. 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
Output
Profit
A
10
$_____
B
11
_____
C
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
B
9.00
11
C
.50
300
50.00
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 below.
Product
Output
Profit
A
6
$_____
B
19
_____
C
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
B
5.00
19
C
1.50
100
Chapter 02 – The Market System and the Circular Flow
2-10
24. How does ‘consumer sovereignty’ determine the types and quantities of the goods produced in an
economy?
25. How does consumer choice differ from consumer sovereignty in a market system?
26. 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.
27. (Consider This) How is consumer sovereignty at work at McDonalds? Give an example of a hit and a
miss.
28. The demand for a resource is “derived” from the goods and services that the resource is used to produce.
Give three examples.
Chapter 02 – The Market System and the Circular Flow
2-11
29. Why does competition force firms to use the least-cost, most efficient, productive techniques?
30. 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 #2
Land
$1
3
Labor
2
3
Capital
3
4
Entrepreneurship
4
4
(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?
31. 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 #2
Land
$4
2
Labor
3
3
Capital
2
4
Entrepreneurship
1
6
(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?
Chapter 02 – The Market System and the Circular Flow
2-12
32. What is meant by the guiding function of prices?
33. How can technological advance result in creative destruction?
34. 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.”
35. 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.”
36. “Competition is the mechanism that brings order out of potential chaos in a price–directed economy.”
Explain.
37. Describe the three major virtues of a market system.
Chapter 02 – The Market System and the Circular Flow
2-13
38. What are the two main problems that have caused the demise of the command systems?
39. What is the coordination problem in command economics?
40. 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.
41. What is the incentive problem in central planning?
Chapter 02 – The Market System and the Circular Flow
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42. “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.
43. (Consider This) Explain the differences in economic systems between North and South Korea and the
economic outcomes of the two systems.
44. Describe the basic features of the circular flow diagram.
45. What is the relationship between businesses and households in the circular flow diagram?
Chapter 02 – The Market System and the Circular Flow
2-15
46. 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).
47. 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.
48. Define the three main categories of businesses.
49. Explain the main characteristics of a corporation.
50. (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.