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Market economies and how firms and households interact Market Economy

Economy according to (Mankiw & Taylor 2006) is a Greek word for “one who manages a household” Household and economies are seen to be similar in the sense that they both face many decisions, decisions ranging from who does what, and who gets what must be made daily in a household. Likewise in our societies, decisions must be made on different issues such as who will do a certain job and so on. All these decisions would have not been difficult to make if lived in a world of abundance where everybody can have all they want, instead we live in a world of limitations which mean that household cannot provide all the wants of its member, likewise economies cannot provide everything people wish to have because of scarcity of resources, therefore choices must be made of what to have and what not to have, so economics studies the “choices of consumers, businesses, and government official s make to attain their goals given their scarce resources” (Hubbard &O`Brien 2008).

In making these choices, there are three major questions that any economy must answer, which are:

What good and services to be produced? How to produce these goods and services? And who will receive these products.

To be able to answer these questions economies are organised in two major ways which are:

Centrally planned or command economy in which all economic decisions are taken by the government.

Free market or market economy in which there is no government intervention at all, all economic decisions are taken by households and firms.

This essay intend to focus on free or market economy, how it works the role of market in it and describes the interaction among market and economic agents with the use of a simple circular diagram.


In order to efficiently examine market economy, there is a need to understand what market is, Market is an institution or arrangement by which a group of buyers and sellers of goods and services come together to trade (Hubbard & O`Brien 2008). It is a place where consumers and suppliers interact to exchange their goods, services and information. Generally market is a place where any type of trade takes place. Market is totally dependent on consumers who are the demanders of commodities and sellers who are the suppliers of these commodities. There are different forms of market set up, markets can be physical places where buyers and sellers gathered together to trade like pizza chops, or supermarket stores, they can also be an invisible set up like telephone or online stores.

In a Market economy set up, all decision such as resources allocation, production, consumption, prices and competition are made by the coming together of two sets of people known as the economic agents these are households and firms as they interact in market of goods and services. A British economist Adam smith made a very famous observation in economics in his book An inquiry into the nature and causes of the wealth of nations1776, he observe that “households and firms interacting in the market acts as if they are guided by an invisible hand that leads them to desirable outcomes”

This concept can be well understood through this use of a simple microeconomic model known as the circular flow diagram; this diagram shows the interactions between economic agents in various market set up and the flow of money round in the economy. However in market economy decisions concerning production and consumption are made purely by firms and households (krugman et al 2008), there is no government intervention at all, thus a simple circular flow of income diagram below:

Here the central planners are the firms and households, who are called the economic agents, household are the suppliers of factors of production so they decide on who to supply, and what to spend their incomes on, while firms decides what to produce and whom to hire, therefore money will flows from firms to households in form of interest, wages rents and then money flows back to firms in form of consumer expenditure which means that household earn incomes from firms and firms earn income from households.

(Mc Gee M 2004) compared this simple circular flow diagram to a circuit heating system, which heats water and then forces it through the pipes into the radiators to heat the house, it is a closed circuit system where water cannot leak, neither can additional water be added to the system, which implies that anytime one measures the amount of water that flows in the system it will always be the same. The assumptions here are that there are no taxes, no exports, no imports, no investment, no government spending, even the firms cannot sell their goods and services anywhere else neither can they get factors of production from any other source outside this flows, therefore the amount of money in the economy cannot increase nor decrease.

Price is the centre of a market economy, price is the instrument the “invisible hand” uses to drive the economic activities, everyone responds to incentive, in market economy household owns the incentives the firms need to produce their goods and services which are factors of production (land, labour, capital), if firms demand exceeds what the households can supply, there will be shortage of supply which will lead to increase in rate of wages, which will then leads to firms demanding less of that particular factor thereby acting as an incentive for household to supply more of the factor, wages will continue to increase until demand will equal supply, likewise if there is surplus in the supply of a factor the wage will decrease until the demand is again equal to supply. This position of equal demand and supply is known as equilibrium. This implies that prices determine how societies utilises its resources in order to maximize its welfare, and this is how market economies operate.

Again in market economy for firms not to be out of business they always have to produce goods and services that consumers want, therefore this brings about competition among the firms to produce and supply very high quality products at reasonable prices (Hubbard & O’Brien 2008). Individual income here depends on what he has to sell, and this income will determines how much goods and services he can buy. One very important advantage of market economy is that it rewards for hardworking since the more trained a person is, the longer hours he can work and the higher his income will be.

So far Market economy has answers the three major economic questions of what to be produced? How to produce? And who will receive these products; however it has some serious disadvantages some of which are mention below:

Individuals may not be able to negotiate for high wages against powerful businesses and this may result in exploitation of workers where businesses pay their workers very minimal wages.

It lacks equity as people on low income will not be able to pay the goods and services they require.

External such as pollutions, flooding, traffic congestion e.t.c is ignored, thereby posing threat on the welfare of the society.

Demerit goods like drugs, alcohol, cigarettes are overused since the consumers who want them will pay for them to be produced.

Competition between producers may bring about monopoly which results in forcing out smaller firms out of the market.

People who are not able too young, too old or too ill to work will not be able to meet their needs.

These disadvantages are why this concept is theoretical many countries do not practice market economy in the real sense of it. In practice all economies operates a mixed economy economic decisions are partly by market and partly by the government (sloman & wride 2009).

In the illustration above, money flows from firms to households, and then flow from households to firms, In the real world we know this is not true because not all the income gets passed around the all the time, some is withdrawn from the economy and some are injected to the economy from the outside world, this is illustrated in the expanded circular low diagram below:

From this illustration above, not all the income received by either household or firms are put back into the economy, some are withdrawn from the economy in form of savings, taxes and import.

Savings is the proportion of the household income that they decide to put aside for the future these are usually kept in financial institutions (bank, building societies).

Taxes are the amount that the household paid either to the central or local government out of their income.

Import expenses is the ratio of the income that is spent on purchasing imported product, not all the goods consumers purchase are domestically produced.

All these three are known as withdrawal or leakages from the flow of income, and they are written as

W= S+T+M (Where S =savings, T=taxes and M=import.)

Again, firms not only sell their products and services to the households, they also sell them to some other sources other than the household, and the incomes they receive from these sources are known as Injections. Injections are in three forms

Investments, export, and Government spending.

Investments are the money which the firms obtain from financial institution such as banks, it involve putting funds into financial assets like stocks and shares.

Government spending is the money the firms get from government buying their products example is government buying computers for schools.

Export expenditure is the income forms receive from selling their products abroad.

The injections are usually written as

J=I+G+X (where I=investment, G=government spending and X=exports).

There exist an indirect link between all the components of the flow, for example if people saving more, investments will increase, then firms can produce more, or if the government receive more tax, it might lead to increase in government spending which will give more incentive to the firms for more production and this will lead firms employing more workers who will receive income and then spend their income on consumption, their spending will definitely increase demand for goods and services which will lead firms to demand more factors of production. This is known as the multiplier effect.

Aggregate demand is the demand of the whole economy,

The multiplier is a key component in Keynesian theory, Keynesian was an economist who argued that government intervention in the market helps create equilibrium (Mc Gee 2004), he believed that fiscal policy like increasing government spending can help achieve full employment in the economy my increasing aggregate demand. The assumptions before the emergence of Keynes was that “supply will create its own demand”, that is labourers will eventually be employed, he believed that disequilibrium in the labour market is due to low demand for labour and therefore can be dealt with if there is increase in aggregate demand. Keynes theory shows that increase in any of the injections will lead to increase in aggregate demand more than the initial stimulus thereby creating job opportunities in the firms.

there will main determinant of consumption is income if people earn more they will be willing to buy more stuff which will lead to bigger demand and national income for example assuming the government decides to increase spending by £60billion in a firm, which flows to the household in form of wages, rents, or profits, households will use this money in two ways which are injections and withdrawal, let`s say 20% of this amount leaks out as withdrawal i.e £12billion, that means £48billion will go back again to the flow, which implies that we now have £108billion in our flow, this process continues indefinitely, some money will always leak out while some will flow back to the economy but in each round the amount that goes back to the economy becomes less and less as a result of the leakages. The multiplicative effects tells us how much planned expenditure will be as a result of the increase in injections.


Conclude how a market economy works, and how firms and households interact with each other.

Conclude how the circular flow of income operates and how an increase in households spending leads to aggregate expenditure increase bigger than it was before.

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