A Picture of Prices and Markets

“We can picture the circular flow of economic life in Figure 2·1 on page 29. The diagram provides an overview of how consumers and producers interact to determine prices and quantities for both inputs and outputs. Note the two different kinds of markets in the circular flow.At the top are the product markets, or the flow of outputs like pizza and shoes; at the bottom are the markets for inputs or factors of production like land and labor.Further, see how decisions are made by two different entities, consumers and businesses.

We see here the circular flow of a market economy. Dollar votes of consumers (households, governments, and foreigners) interact with business supply in the product markets at top,helping to determine what is produced. Business demand for inputs meets the supply of labor and other inputs in the factor markets below to help determine wage, rent, and interest payments; incomes thus influence fur whom goods are delivered. Business competition to buy factor inputs and sell goods most cheaply determines how goods are produced.

Consumers buy goods and sell factors of production;businesses sell goods and buy factors of production.Consumers use their income from the sale of labor and other inputs to buy goods from businesses;businesses base their prices of goods on the costs of labor and property. Prices in goods markets are set to balance consumer demand with business supply; prices in factor markets are set to balance household supply with business demand.

All this sounds complicated. But it is simply the.total picture of the intricate web of interdependent supplies and demands, interconnected through a market mechanism to solve the economic problems of what, how, and for whom. Look at Figure 2-1 carefully. A few minutes spent studying it will surely help you understand the workings of a market economy.

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