Lesson 5: The Price System and The Mixed Economy

By: But, Judy Ann A.

Objectives Examine the framework of pure market

economy and show how the circular flow of income and expenditure in a capitalist economy keeps it functioning;

Explain how the price system allocates resources in terms of what is produced, how it is produced and how it is distributed; and

Identify the defects of pure market system; and

Give a brief outline of how the modern, mixed and open economy function.

Capitalism and the Market Economy Capitalism is an economic system characterized

by private ownership of economic resources and freedom of enterprise in which owners of factories and other capital hire workers to produced goods and services.

Mixed Economy. Provides goods and services to government as well as business firms in such economies governments supply roads defense, pensions, and schooling directly to citizens. They also commonly intervene in markets to control and correct prices.

Price System is a mechanism by which resource use in a market economy is guided by price.

Characteristics of CapitalismFreedom of Enterprise. The right of

business firm owners to employ private economic resources for whatever purpose they want.

Economic Rivalry. A situation in which large numbers of buyers are competing for available supplies of goods and services for sale in markets.

Free Markets is the situation which exists when there are no restrictions that prevent buyers or sellers from entering or exiting from a market.

Specialization and Exchange Specialization and division of labor mean that

workers and entrepreneurs spend most of their time in producing one or a few goods and services. These specialist sell the goods and services they specialize in and then use their income to buy goods and services they want that are offered for sale by other specialists. Such exchange allow mutual gains to the traders.

Barter is the process of exchanging goods for services or vice versa. This is an inconvenient means of exchange because it requires double incidence of wants.

How Production Generates Income in the Market Economy: Circular Flow of Income and Expenditures

Business firms are buyers of resources offered for sale in input markets. Households supply economic resources as sellers in these input markets. The competition among the many buyers and sellers of inputs results in market prices for labor, the use of funds, capital and natural resources. The prices depend on conditions of supply and demand in each input market.

How the Price System Influences What is Produced

What gets produced in a market economy is determined chiefly by profitability.

How the Price System Influences Production Market The pursuit of profit also influences how goods and

services are produced. Business firms can earn more profit by producing any given quantity of goods.

‘Who Gets the Goods and Services? Your ability to buy goods and services in

product markets depends on your ability to register a demand for products. Demand is much more than the desire for an item. Demand is a desire that can be backed up with the willingness and ability to pay. It is on this basis that the price system allocates goods and services among consumers. Your ability to pay in turn depends greatly on your money income.

Some Common Defects in the Prices System

Pubic Goods are those consumed equally by all of us, whether we pay or not. Example: Environmental protection and national security. These public goods benefit all of us, regardless of whether we are tax payers or not.

Box 1: The Circular Flow of Income and Expenditure in a Market Economy

ProductMarket

BusinessFirms

InputMarket

Households

Business Firms acquire resources for households in input markets. The income earned by households is then spent on goods and services offered for sale in product markets by business firms.

One common problem in a pure market economy is that not all the goods we want and paid for willingly can easily be sold in neat packages that can be priced.

Externalities are cost or benefits of market transaction that are not reflected in the prices buyers and sellers use to make their decision.

Other Common Problems in a Market System

Lack of Competition impairs the ability of the price system to

respond to changes in demand. Monopolization of supply prevents profits from serving as a signal for entry of new firms and more output in market in which additional output from serving would be profitable.

Income Inequality and Poverty In pure market economy, income depends

entirely on the quantity, quality and types of resources of people are able and willing to sell. Income influences the willingness and ability to pay for goods. People with very low income maybe unable to buy the minimal amounts of goods and services required for their survival.

Instability Fluctuations in demand and supply and

consequent periods of market disequilibrium are an inherit problem that results from lack of coordination of decision making in the price system.

Modern Mixed and Open Economy

There is another circular flow of expenditures and income where the governments fits into Governments participate in input markets of purchasing labor and other productive resources. They borrow funds from credit markets when their expenditures exceed their tax revenue. Governments also participate in product market to purchase the output of business firms.

The Role of the Government

Although governments seeks to correct the defects in the price system, it is also has an impact on revenue use. When voters approve programs for which marginal cost exceeds benefits there is government failure because resources are allocated to be used for which the net gain is negative.

Basic Functions of Government Establishment of rights to use productive

resources and the regulation of private action. Government guarantees rights and enforce contracts. It serves as a rule maker and rule enforcer in the economy.

Provision of goods and service. Government purchases input services to provide national defense, education, roads and health services.

Redistribution of income. Welfare programs, government Social Security pension and subsidies are being established and administered to distribute income among citizens.

Government transfers are payments made directly to certain people in organization that do not provide a good service in return at a given time.

ProductMarket

BusinessFirm

InputMarket

House Holds

Government

Income

Taxes

Subsidies Taxes

The Mixed Economy

Government

ServiceGovernmen

tService

The mixed economy, governments compete in input markets and product markets to obtain the resources and products they need to supply goods and services. Governments obtain funds to finance their operation by taxing households and business firms and by borrowing in credit markets. Governments use some of their revenues to provide income support to the elderly, the poor, and other groups and also to subsidize some business firms.

Stabilization of the economy. The government pursues policies designed to affect the overall level of demand and supply in the economy so as to control economic fluctuations. This is achieved through control of the government’s spending and taxation and through control of the nation’s supply of money and credit.

Categories of Government Provided Goods Goods that are made available to all citizens free of

charge, the cost of which are financed by taxes or borrowing.

Example: National defense, public health, sanitation, roads and bridges.

Goods and services that are tax financed but are available only to individuals who meet predetermined eligibility criteria.

Example: Public education is provided only to people of a certain age.

Principles of TaxationThe bulk of government spending is

financed by taxes which are compulsory payment associated with income, consumption or wealth that individuals and corporations are required to make each year to governments.

Tax Equity- Different Points of View Regressive tax is one for which the fraction of

income used to pay it decrease as income increases.

Progressive tax is one for which the fraction of income paid increases as income increases.

Proportional tax is one for which the percentage of income paid in taxes is the same no matter how much the taxpayer’s income is.