Chapter 02 – The Market System and the Circular Flow
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Chapter 02 The Market System and the Circular Flow
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 self-interest and
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;
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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
Answer: The ownership of private property and the protection of property rights
encourages investment, innovation, and, therefore, economic growth. Property rights
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 produce more
output.
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
something, he/she will have to find someone who wishes to part with that good and at the
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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 earn at least a normal
profit (minimum compensation for the entrepreneur for his/her time and talents) will
7. 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
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.
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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
8. 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
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9. 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
10. In a sentence, describe the meaning of the phrase “invisible hand.” LO4
Answer: Market prices act as an “invisible hand,” coordinating an economy by rationing
11. 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
12. 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 product markets,
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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 the
PROBLEMS
1. Table 2.1 contained information on three techniques for producing $15 worth of bar soap.
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 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
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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?
Here the answer is different (from that in part a) because total revenue equals $10.00 (=
$2 x 5). Here it is unprofitable to produce any output because the least cost technique 2 is
$13.
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.
The total revenue from this new technique equals $3 (price per bar) multiplied by 3 (units
sold and produced), or $9. The total cost of this technique equals the sum of the resource
prices, in the table above, because this technique employs one unit of each input. Thus,
total cost equals $9 (+ $2 (labor) + $1 (land) + $3 (capital) + $3 (entrepreneurial ability)).
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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
Answers: (a) Yes; (b) She should pursue the soap business.
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).
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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
bread daily. 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. The firm can sell these 400 loaves at $2
per unit.
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
total revenue this firm would have a loss.
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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?
Answers: (a) $10 billion for entrepreneurial ability; (b) $100 billion in revenues.