The reason markets work so well is that one person's output always becomes another person's input. Goods are produced and consumed. Money comes in and goes out. This flow keeps the economy running. Economists use the circular flow model [circular flow model: a diagram that shows the circular movement of money, resources, and goods and services among households and producers in an economy] to illustrate these interactions.

Question

The reason markets work so well is that one person's output always becomes another person's input. Goods are produced and consumed. Money comes in and goes out. This flow keeps the economy running. Economists use the circular flow model [circular flow model: a diagram that shows the circular movement of money, resources, and goods and services among households and producers in an economy] to illustrate these interactions.

In the simplified market economy, there are two kinds of participants: households and firms. A household [household: a person or a group of people living together] is made up of a person or of a group of people living together. The model assumes that households own the factors of production. A firm [firm: an organization that uses resources to produce and sell goods or services; a business] is an organization that uses these factors to make and sell goods or services.

The model also includes two kinds of markets. One is the product market [product market: a market in which firms sell goods and services to households] , in which goods and services are sold by firms and purchased by households. Your local mall or supermarket is part of the product market. The other is the factor market [factor market: a market in which households sell land, labor, and capital to firms] , in which households sell their land, labor, and capital to firms. A household, for example, might rent land to a firm. Or members of a household might sell their labor to a firm for wages. They might loan money to a firm in exchange for interest payments, or they might buy a firm's stock in the hopes of receiving dividend payments. The funds paid to households—whether in the form of rent, wages, interest, or dividends—are known as factor payments [factor payment: income earned when an individual sells or rents a factor of production that he or she owns; for example, wages are a factor payment made to workers in exchange for their labor] .

This model is circular. Households buy products from firms with money that they receive in the factor market. Firms acquire land, labor, and capital from households using money that they receive in the product market. For example, you (as part of a household) might buy a pair of jeans from a firm with money that you earned by working at a local ice cream parlor (another firm). The ice cream parlor, in turn, pays you for your labor with money that it receives from selling ice cream cones to other households.

All these transactions are conducted by people and businesses who want something for themselves. People work so that they can buy things. Firms employ people so that they can make things to sell. In a market economy, everybody chooses what is best for him or herself. As Adam Smith observed, “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.”

Capitalism Gives Rise to Socialism and Communism
Market economies emerged in Europe in the 1700s and began to grow rapidly in the 1800s. This economic growth was a direct result of the Industrial Revolution [Industrial Revolution: a period of rapid industrial growth and development during the 1700s and 1800s] . During the Industrial Revolution, new inventions and manufacturing processes spurred the growth of industry. Individual investors, called capitalists [capitalist: an individual investor who accumulates capital, such as machinery, factories, and railroads] , grew wealthy by accumulating capital, such as machinery, factories, and railroads. The term capitalism [capitalism: the free market economic system] came to be synonymous with the free market economic system.

The headlong growth of capitalism had profound effects on society. As more and better goods became widely available, people's standard of living improved. But capitalism did not improve the quality of life for everybody. The workers who filled the factories and mills labored under harsh conditions. Most worked extremely long hours for meager wages. Critics of capitalism blamed the capitalists for exploiting workers and keeping them in poverty.

In 1848, economist Karl Marx and philosopher Friedrich Engels published The Communist Manifesto. In it, they advocated the overthrow of capitalism. They proposed an alternative vision of society known as socialism. Socialism [socialism: a political and economic philosophy based on collective or government ownership of a society’s resources and means of production, with the goal of achieving social and economic equality] is a political and economic philosophy that calls for property to be owned by society as a whole, rather than by individuals, for the equal benefit of all.

To bring about this socialist vision of society, Marx and Engels called on workers everywhere to revolt against their governments. Once the workers had gained power, private property and the free market would be replaced with national ownership of industry and more equal distribution of income.

The final phase of socialism, in the view of Marx and Engels, is communism [communism: a political and economic system in which all property and wealth is collectively owned by all members of society; the final stage of socialism in Marxist theory] , a political and economic system in which all property and wealth are owned by all members of society. In a communist society, class differences—and the conflicts they create—disappear. Once that happens, government is no longer needed to keep order. Instead of self-interest, people in a communist society are guided by Marx's famous slogan: “From each according to his ability, to each according to his needs.”

This Soviet-era postage stamp celebrates the heroes of the world’s first socialist command economy. Karl Marx and Frederick Engels, authors of The Communist Manifesto, appear to the left. Vladimir Lenin, the revolutionary first leader of the Soviet Union, is to their right. Joseph Stalin, who ruled the Soviet Union with an iron fist until his death in 1953, is shown
at the far right.
Modern Command Economies: Decision Making by the State
The ideas of Marx and Engels spurred the development of political movements dedicated to the creation of a workers' paradise. But when the first successful communist revolution took place in Russia in 1917, it did not lead to the utopian society Marx had envisioned. Instead, the revolutionaries formed an authoritarian government that pursued its socialist goals with brutal force. The renamed Union of Soviet Socialist Republics, or Soviet Union for short, became the first modern command economy.

In the Soviet Union, private ownership of property was forbidden. The state owned the factors of production. Economic planning [economic planning: the process by which economic decisions are made or influenced by central governments rather than by private individuals] was done by government committees of economists, production experts, and political officials. These central planning committees attempted to perform the functions of a market. They decided what goods and services should be produced. They decided which farms and factories should get which resources to produce what was planned. Committees also controlled prices and wages and decided how goods and services should be distributed.

chart, pie chart
In theory, this kind of planning was supposed to ensure economic equity and security—two important goals of a modern command economy--but the reality was very different. The planning committees could not keep track of the millions of products and prices in the Soviet system. Two Soviet economists described what happened when Goskomsten, the committee in charge of prices, raised the price that the government would pay hunters for moleskins.

State purchases increased, and now all the distribution centers are filled with these pelts. Industry is unable to use them all, and they often rot in warehouses before they can be processed. The Ministry of Light Industry has already requested Goskomsten twice to lower purchasing prices, but the “question has not been decided” yet. And this is not surprising. Its members are too busy to decide. They have no time: besides setting prices on these pelts, they have to keep track of another 24 million prices.

—Nikolai Shmelev and Vladmir Popov, The Turning Point: Revitalizing the Soviet Economy, 1990
As you read the section, fill out this chart about different economic systems. Then, record key features of that system and which economic goals it emphasizes.

Economic System
Key Features
Economic Goals
Traditional economy
Ancient command economy
Market economy
Modern command economy

Answer 1

Economic System | Key Features | Economic Goals