978-0077660772 Chapter 2 Solution Manual

Chapter 02 – The Market System and the Circular Flow

McConnell Brue Flynn 20e

DISCUSSION QUESTIONS

1. Contrast how a market system and a command economy try to cope with economic scarcity.

LO1

Answer: A market system allows for the private ownership of resources and

coordinates economic activity through market prices. Participants act in their own

The command economy is characterized by public ownership of nearly all

2. How does self-interest help achieve society’s economic goals? Why is there such a wide

variety of desired goods and services in a market system? In what way are entrepreneurs and

businesses at the helm of the economy, but commanded by consumers? LO2

Answer: The motive of self-interest gives direction and consistency to the

economy. The primary driving force of the market system is self-interest.

Entrepreneurs try to maximize their profits; property owners want the highest

price for their resources; workers choose the job with the best wages, fringe

Each individual consumer will choose a variety of goods and services that in

Although producers are free to choose what products they will produce, if the

producers are to maximize profits, these good and services must be what

3. Why is private property, and the protection of property rights, so critical to the success of the

market system? How do property rights encourage cooperation? LO2

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Chapter 02 – The Market System and the Circular Flow

Answer: The ownership of private property and the protection of property rights

encourages investment, innovation, and, therefore, economic growth. Property

4. What are the advantages of using capital in the production process? What is meant by the term

“division of labor”? What are the advantages of specialization in the use of human and material

resources? Explain why exchange is the necessary consequence of specialization. LO2

Answer: Capital goods enable producers to operate more efficiently and to

The advantages of specialization for workers are that they can choose work

according to their natural aptitudes, have the opportunity to perfect those skills,

When resources are specialized, they are no longer self-sufficient. To obtain the

5. What problem does barter entail? Indicate the economic significance of money as a medium of

exchange. What is meant by the statement “We want money only to part with it”? LO2

Answer: Barter requires the “double coincidence of wants.” If someone wants

With money as a medium of exchange, one knows the purchase price of the item

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Chapter 02 – The Market System and the Circular Flow

Money itself has value only in relation to the resources, goods, and services that

6. Evaluate and explain the following statements: LO2

a. The market system is a profit-and-loss system.

b. Competition is the disciplinarian of the market economy.

Answer:

(a) The quotation is accurate. In a market system, producer decisions are

motivated by the attempt to earn profits. Those products that enable a firm to

(b) Competition provides discipline in two ways. First, it forces firms to seek the

least-cost production methods or face being driven out of business by their

rivals. Second, it prevents successful producers from charging whatever the

market will bear. Competition keeps prices at a level where total revenue will

just cover the total cost of production including a normal profit, but no more

7. Some large hardware stores such as Home Depot boast of carrying as many as 20,000 different

products in each store. What motivated the producers of those individual products to make them

and offer them for sale? How did the producers decide on the best combinations of resources to

use? Who made those resources available, and why? Who decides whether these particular

hardware products should continue to be produced and offered for sale? LO3

Answer: The quest for profit led firms to produce these goods. Producers looked

for and found the least-cost combination of resources in producing their output.

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Chapter 02 – The Market System and the Circular Flow

8. What is meant by the term “creative destruction”? How does the emergence of MP3 (or iPod)

technology relate to this idea? LO3

Answer: Creative destruction refers to the process by which the creation of new

products and production techniques destroys the market positions of firms

9. In a sentence, describe the meaning of the phrase “invisible hand.” LO4

Answer: Market prices act as an “invisible hand,” coordinating an economy by

10. In market economies, firms rarely worry about the availability of inputs to produce their

products, whereas in command economies input availability is a constant concern. Why the

difference? LO4

Answer: In market economies, buyers of inputs know that sellers want to make

resources available for sale because that is how they earn their profits. If there

11. Distinguish between the resource market and the product market in the circular flow model. In

what way are businesses and households both sellers and buyers in this model? What are the

flows in the circular flow model? LO5

Answer: The resource markets are where the owners of the resources (the

households) sell their resources to the buyers of the resources (businesses). In the

Households (individuals) either own all economic resources directly or own them

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In the product market, businesses are the sellers and householders are the buyers;

12. How does shielding employees and suppliers from business risk help to improve economic

outcomes? Who is responsible for managing business risks in the market system? LO6

Answer: This process allows the owners of a business to attract employees and

suppliers. If some of the business risk was put on these groups, most of them

13. LAST WORD What explains why millions of economic resources tend to get arranged

logically and productively rather than haphazardly and unproductively?

Answer: The institution of private property is a primary reason why resources are

arranged logically and productively. Private property eliminates randomness to

REVIEW QUESTIONS

1. Decide whether each of the following descriptions most closely corresponds to being part of a

command system, a market system, or a laissez-faire system. LO1

a. A woman who wants to start a flower shop finds she cannot do so unless the central

government has already decided to allow a flower shop in her area.

b. Shops stock and sell the goods their customers want but the government levies a sales tax on

each transaction in order to fund elementary schools, public libraries, and welfare programs for

the poor.

c. The only taxes levied by the government are to pay for national defense, law enforcement, and

a legal system designed to enforce contracts between private citizens.

Answer:

a. command system because there is central government planning of even minor things

b. market system because while the government is using its power to tax to promote

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Chapter 02 – The Market System and the Circular Flow

c. laissez-faire system because the government restricts itself to only engaging in

2. Match each term with the correct definition. LO2

private property

freedom of enterprise

mutually agreeable

freedom of choice

self-interest

competition

market

a. An institution that brings buyers and sellers together.

b. The right of private persons and firms to obtain, control, employ, dispose of, and bequeath

land, capital, and other property.

c. The presence in a market of independent buyers and sellers who compete with one another and

who are free to enter and exit the market as they each see fit.

d. The freedom of firms to obtain economic resources, decide what products to produce with

those resources, and sell those products in markets of their choice.

e. What each individual or firm believes is best for itself and seeks to obtain.

f. Economic transactions willingly undertaken by both the buyer and the seller because each feels

that the transaction will make him or her better off.

g. The freedom of resource owners to dispose of their resources as they think best; of workers to

enter any line of work for which they are qualified; and of consumers to spend their incomes in

whatever way they feel is most appropriate.

Answer: a. Market; b. Private Property; c. Competition; d. Freedom of Enterprise; e.

3. True or False: Money must be issued by a government for people to accept it. LO2

Answer: False

Many things have been used as money without having been approved by or produced by

4. Assume that a business firm finds that its profit is greatest when it produces $40 worth of

product A. Suppose also that each of the three techniques shown in the table below will produce

the desired output. LO3

Resource units required

Resource Price per unit Technique #1 Technique #2 Technique #3

Labor $3 5 2 3

Land $4 2 4 2

Capital $2 2 4 5

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Entrepreneurial ability $2 4 2 4

a. With the resource prices shown, which technique will the firm choose? Why? Will production

using that technique entail profit or loss? What will be the amount of that profit or loss? Will the

industry expand or contract? When will that expansion or contraction end?

b. Assume now that a new technique, technique 4, is developed. It combines 2 units of labor, 2 of

land, 6 of capital, and 3 of entrepreneurial ability. In view of the resource prices in the table, will

the firm adopt the new technique? Explain your answer.

c. Suppose that an increase in the labor supply causes the price of labor to fall to $1.50 per unit,

all other resource prices remaining unchanged. Which technique will the producer now choose?

Explain.

d. “The market system causes the economy to conserve most in the use of resources that are

particularly scarce in supply. Resources that are scarcest relative to the demand for them have the

highest prices. As a result, producers use these resources as sparingly as is possible.” Evaluate

this statement. Does your answer to part c, above, bear out this contention? Explain.

Answer:

a. To calculate the cost of each technique, multiply the price per unit of resource by the

amount of the resource employed by the technique and add these together. For

d. The statement is logical. Increasing scarcity of a resource causes its price to rise.

5. Identify each of the following quotes as being an example of either: the coordination problem,

the invisible hand, creative destruction, or the incentive problem. LO4

a. “If you compare a list of today’s most powerful and profitable companies with a similar list

from 30 years ago, you will see lots of new entries.”

b. “Managers in the old Soviet Union often sacrificed product quality and variety because they

were being awarded bonuses for quantitative, not qualitative, targets.”

c. “Each day, central planners in the old Soviet Union were tasked with setting 27 million prices

— correctly.”

d. “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.”

Answer:

a. creative destruction because this quote is a reflection of how fast new technologies

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Chapter 02 – The Market System and the Circular Flow

b. incentive problem because this quote reflects how the poorly designed financial

c. coordination problem because this quote reflects the impossible complexity of

d. invisible hand because this quote (from Adam Smith’s book The Wealth of Nations)

reflects the idea that producers end up doing things that their customers want not out of a

6. True or False: Households sell finished products to businesses. LO6

Answer: False. Households sell resources to businesses, which use those resources to

7. Franklin, John, Henry, and Harry have decided to pool their financial resources and business

skills in order to open up and run a coffee shop. They will share any profits or losses that the

business generates and will be personally responsible for making good on any debt that their

business undertakes. Their business should be classified as a: LO6

Answer:

Partnership. The coffee shop that these guys are starting should be classified as a

Both sole proprietorships and partnerships share that same feature—that those who own

By contrast, the owners of a corporation are not personally responsible for their firm’s

8. Ted and Fred are the owners of a gas station. They invested $150,000 each and pay an

employee named Lawrence $35,000 per year. This year revenues are $900,000, while costs are

$940,000. Who is legally responsible for bearing the $40,000 loss? LO6

a. Lawrence

b. Ted

c. Fred

d. Ted and Fred

e. Lawrence, Ted, and Fred

Answer:

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Chapter 02 – The Market System and the Circular Flow

Ted and Fred. A firm’s owners bear the firm’s business risk, including the risk of

running a loss (rather than breaking even or generating a profit.) So in this case, the loss

PROBLEMS

1. Table 2.1 contains information on three techniques for producing $15 worth of bar soap.

Assume “$15 worth of bar soap” means the selling price of soap is $3 per bar and all three

techniques produce 5 bars of soap ($15 = $3 per bar x 5 bars). So you know each technique

produces 5 bars of soap. LO3

a. What technique will you want to use if the price of a bar of soap falls to $2.75? What if the

price of a bar of soap rises to $4? To $5?

b. How many bars of soap will you want to produce if the price of a bar of soap falls to $2.00?

c. Suppose that the price of soap is again $3 per bar but that the prices of all four resources are

now $1 per unit. Which is now the least-profitable technique?

d. If the resource prices return to their original levels (the ones shown in the table), but a new

technique is invented that can produce 3 bars of soap (yes, 3 bars, not 5 bars!) using 1 unit of

each of the four resources, will firms prefer the new technique?

Answers: (a) Technique 2, Technique 2, Technique 2; (b) Zero—it is not profitable to

Feedback: As stated in the question, also assume that we said “$15 worth of bar soap”

because soap cost $3 per bar and all three techniques produce 5 bars of soap ($15 = $3

If the price falls to $2.75 total revenue (price multiplied by units sold) equals $13.75 (=

$2.75 x 5). This does not change the total cost of each technique, so the firm will

Part b: Consider the following value for part b. How many bars of soap will you want to

produce if the price of a bar of soap falls to $2.00?

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Chapter 02 – The Market System and the Circular Flow

Part c: Consider the following values for part c. Suppose that the price of soap is again $3

per bar but that the prices of all four resources are now $1 per unit.

Part d. Consider the following values for part d. Assume the resource prices return to

their original levels (the ones shown in the table) but a new technique is invented that can

produce 3 bars of soap (yes, 3 bars, not 5 bars!) using 1 unit of each of the four resources.

2. Suppose Natasha currently makes $50,000 per year working as a manager at a cable TV

company. She then develops two possible entrepreneurial business opportunities. In one, she will

quit her job to start an organic soap company. In the other, she will try to develop an Internet-

based competitor to the local cable company. For the soap-making opportunity, she anticipates

annual revenue of $465,000 and costs for the necessary land, labor, and capital of $395,000 per

year. For the Internet opportunity, she anticipates costs for land, labor, and capital of $3,250,000

per year as compared to revenues of $3,275,000 per year. (a) Should she quit her current job to

become an entrepreneur? (b) If she does quit her current job, which opportunity would she

pursue? LO3

Feedback: Natasha should quit her job only if the net revenue from the entrepreneurial

business opportunity exceeds that of her current wage (net revenue equals revenue minus

cost. This could also be defined as accounting profit).

For example, consider the following values. Suppose Natasha currently makes $50,000

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Chapter 02 – The Market System and the Circular Flow

The net revenue from WiFi company equals $3,275,000 (revenue) minus $3,250,000

3. With current technology, suppose a firm is producing 400 loaves of banana bread daily. Also

assume that the least-cost combination of resources in producing those loaves is 5 units of labor, 7

units of land, 2 units of capital, and 1 unit of entrepreneurial ability, selling at prices of $40, $60,

$60, and $20, respectively. If the firm can sell these 400 loaves at $2 per unit, what is its total

revenue? Its total cost? Its profit or loss? Will it continue to produce banana bread? If this firm’s

situation is typical for the other makers of banana bread, will resources flow toward or away from

this bakery good? LO3

Feedback: Consider the following example. A firm is producing 400 loaves of banana

To calculate total profit multiply the selling price by the number of units sold. For our

example, total revenue equals $2 (price) multiplied by 400 (loaves of bread sold). So,

The profit for this firm equals total revenue minus total cost. Here, profit equals $800

(total revenue) minus $760 (total cost) = $40. If total cost happened to be greater than

4. Let’s put dollar amounts on the flows in the circular flow diagram of Figure 2.2. LO5

a. Suppose that businesses buy a total of $100 billion of the four resources (labor, land, capital,

and entrepreneurial ability) from households. If households receive $60 billion in wages, $10

billion in rent, and $20 billion in interest, how much are households paid for providing

entrepreneurial ability?

b. If households spend $55 billion on goods and $45 billion on services, how much in revenues

do businesses receive in the product market?

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Chapter 02 – The Market System and the Circular Flow

Feedback: (a) $10 billion for entrepreneurial ability (= $100 billion in total factor

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