Circular flow of income

From Wikipedia, the free encyclopedia

Basic diagram of the circular flow of income. The functioning of the free-market economic system is
represented with firms and households and interaction back and forth.[1]

The circular flow of income or circular flow is a model of the economy in which the major
exchanges are represented as flows of money, goods and services, etc. between economic agents.
The flows of money and goods exchanges in a closed circuit and correspond in value, but run in the
opposite direction. The circular flow analysis is the basis of national accounts and hence
of macroeconomics.
The idea of the circular flow was already present in the work of Richard Cantillon.[2] Franois
Quesnay developed and visualized this concept in the so-called Tableau conomique.[3]Important
developments of Quesnay's tableau were Karl Marx' reproduction schemes in the second volume
of Capital: Critique of Political Economy, and John Maynard Keynes' General Theory of
Employment, Interest and Money. Richard Stone further developed the concept for theUnited
Nations (UN) and the Organisation for Economic Co-operation and Development to the system,
which is now used internationally.
Contents
[hide]

1Overview

2History
o

2.1Cantillon

2.2Quesnay

2.3Marx

2.4Further developments

3Types of models
o

3.1Two sector model

3.2Three sector model

3.3Four sector model

3.4Five sector model

4Circular flow of income topics

o

4.1Leakage and injections

4.2The state of equilibrium

4.3Difference between real flow and money flow

4.4Phases or stages of circular flow of income

5Significance of study of circular flow of income

6See also

7References

8Further reading

9External links

Overview[edit]
The circular flow of income is a concept for better understanding of the economy as a whole and for
example the National Income and Product Accounts(NIPAs). In its most basic form it considers a
simple economy consisting solely of businesses and individuals, and can be represented in a socalled "circular flow diagram." In this simple economy, individuals provide the labour that enables
businesses to produce goods and services. These activities are represented by the green lines in
the diagram.[4]

Model of the circular flow of income and expenditure

Alternatively, one can think of these transactions in terms of the monetary flows that occur.
Businesses provide individuals with income (in the form of compensation) in exchange for their labor.
That income is, in turn, spent on the goods and services businesses produce. These activities are
represented by the blue lines in the diagram above. [4]
The circular flow diagram illustrates the interdependence of the flows, or activities, that occur in the
economy, such as the production of goods and services (or the output of the economy) and the
income generated from that production. The circular flow also illustrates the equality between the
income earned from production and the value of goods and services produced. [4]
Of course, the total economy is much more complicated than the illustration above. An economy
involves interactions between not only individuals and businesses, but also Federal, state, and local
governments and residents of the rest of the world. Also not shown in this simple illustration of the
economy are other aspects of economic activity such as investment in capital (producedor fixed
assets such as structures, equipment, research and development, and software), flows of financial
capital (such as stocks, bonds, and bank deposits), and the contributions of these flows to the
accumulation of fixed assets.[4]

History[edit]
Cantillon[edit]

Representation of Cantillon's primitive circular flow model[5]

One of the earliest ideas on the circular flow was explained in the work of 18th century Irish-French
economistRichard Cantillon,[2] who was influenced by prior economists, especially William Petty.
[6]
Cantillon described the concept in his 1730 Essay on the Nature of Trade in General, in chapter 11,

entitled "The Par or Relation between the Value of Land and Labor" to chapter 13, entitled "The
Circulation and Exchange of Goods and Merchandise, as well as their Production, are Carried On in
Europe by Entrepreneurs, and at a Risk." Thornton eds. (2010) further explained:
Cantillon develops a circular-flow model of the economy that shows the distribution of farm
production between property owners, farmers, and workers. Farm production is exchanged
for the goods and services produced in the cities by entrepreneurs and artisans. While the
property owners are independent, the model demonstrates the mutual interdependence
between all the classes of people that Adam Smith dubbed the invisible hand in The
Theory of Moral Sentiments (1759).[7]
Cantillon distinguished at least five types of economic agents: property owners, farmers,
entrepreneurs, labors and artisans, as expressed in the contemporary diagram of the Cantillons
Circular Flow Economy.[5]

Quesnay[edit]

Tableau conomique

Franois Quesnay further developed these concepts, and was the first to visualize these
interactions over time in the so-called Tableau conomique.[3] Quesnay believed that trade and
industry were not sources of wealth, and instead in his 1758 book Tableau
conomique (Economic Table) argued that agricultural surpluses, by flowing through the
economy in the form of rent, wages, and purchases were the real economic movers, for two
reasons.

First, regulation impedes the flow of income throughout all social classes and therefore
economic development.

Second, taxes on the productive classes such as farmers should be reduced in favor of
higher taxes for unproductive classes such as landowners, since their luxurious way of life
distorts the income flow.

The model Quesnay created consisted of three economic agents: The "Proprietary" class
consisted of only landowners. The "Productive" class consisted of all agricultural laborers. The
"Sterile" class is made up of artisans and merchants. The flow of production and/or cash
between the three classes started with the Proprietary class because they own the land and they
buy from both of the other classes. Quesnay visualised the steps in the process in the Tableau
conomique.

Marx[edit]
In Marxian economics, economic reproduction refers to recurrent (or cyclical) processes[8] by
which the initial conditions necessary for economic activity to occur are constantly re-created. [9]
Economic reproduction involves the physical production and distribution of goods and services,
the trade (the circulation via exchanges and transactions) of goods and services, and
the consumption of goods and services (both productive or intermediate consumption and final
consumption).
Karl Marx developed the original insights of Quesnay to model the circulation of capital, money,
and commodities in the second volume of Das Kapital to show how the reproduction process
that must occur in any type of society can take place in capitalist society by means of the
circulation of capital.[10]
Marx distinguishes between "simple reproduction" and "expanded (or enlarged) reproduction".
[11]
In the former case, no economic growth occurs, while in the latter case, more is produced
than is needed to maintain the economy at the given level, making economic growth possible. In
the capitalist mode of production, the difference is that in the former case, the new surplus
value created by wage-labour is spent by the employer on consumption (or hoarded), whereas
in the latter case, part of it is reinvested in production.

Further developments[edit]

The competitive price system adapted from Samuelson, 1961

An important development was John Maynard Keynes' 1933 publication of the General Theory
of Employment, Interest and Money. Keynes' assistant Richard Stone further developed the
concept for the United Nations (UN) and theOrganisation for Economic Co-operation and
Development to the systems, which is now used internationally.
The first to visualize the modern circular flow of income model was Frank Knight in 1933
publication of The Economic Organization.[12] Knight (1933) explained:
[we may view the] economic organization as a system of prize relations. Seen in the large,
free enterprise is an organization of production and distribution in which individuals or family
units get their real income, their "living," by selling productive power for money to "business
units" or "enterprises", and buying with the money income thus obtained the direct goods
and services which they consume. This view, it will be remembered, ignores for the sake of
simplicity the fact that an appreciable fraction of the productive power in use at any time is

not really employed in satisfying current wants but to make provision for increased wantsatisfaction in the future; it treats society as it would be, or would tend to become, with
progress absent, or in a static state.[13]
Knight pictured a circulation of money and circulation of economic value between people
(individuals, families) and business enterprises as a group, [14]explaining: "The general
character of an enterprise system, reduced to its very simplest terms, can be illustrated by a
diagram showing the exchange of productive power for consumption goods between
individuals and business units, mediated by the circulation of money, and suggesting the
familiar figure of the wheel of wealth."[15]

Types of models[edit]

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Two sector model[edit]

In the basic circular flow of income, or two sector circular flow of income model, the state of
equilibrium is defined as a situation in which there is no tendency for the levels of income
(Y), expenditure (E) and output (O) to change, that is:
Y=E=O

Two sector circular flow diagram

This means that the expenditure of buyers (households) becomes income for sellers (firms).
The firms then spend this income on factors of production such as labour, capital and raw
materials, "transferring" their income to the factor owners. The factor owners spend this
income on goods which leads to a circular flow of income.
This basic circular flow of income model consists of six assumptions:
1. The economy consists of two sectors: households and firms.
2. Households spend all of their income (Y) on goods and
services or consumption (C). There is no saving (S).
3. All output (O) produced by firms is purchased by households through
their expenditure (E).
4. There is no financial sector.

5. There is no government sector.

6. There is no foreign sector

Three sector model[edit]

It includes household sector, producing sector and government sector. It will study a circular
flow income in these sectors excluding rest of the world i.e. closed economy income. Here
flows from household sector and producing sector to government sector are in the form of
taxes. The income received from the government sector flows to producing and household
sector in the form of payments for government purchases of goods and services as well as
payment of subsides and transfer payments. Every payment has a receipt in response of it
by which aggregate expenditure of an economy becomes identical to aggregate income and
makes this circular flow unending.

Four sector model[edit]

A modern monetary economy comprises a network of four sector economy these are:
1. Household sector
2. Firms or Producing sector
3. Government sector
4. Rest of the world sector.
Each of the above sectors receives some payments from the other in lieu of goods and
services which makes a regular flow of goods and physical services. Money facilitates such
an exchange smoothly. A residual of each market comes in capital market as saving which
inturn is invested in firms and government sector. Technically speaking, so long as lending is
equal to the borrowing i.e. leakage is equal to injections, the circular flow will continue
indefinitely. However this job is done by financial institutions in the economy.

Five sector model[edit]

Five Sector Circular Flow of Income Model

In the five sector model the economy is divided into five sectors:[16]
1. Household sector
2. Firms or Producing sector
3. Financial sector : banks and non-bank intermediaries who engage in the borrowing
(savings from households) and lending of money
4. Government sector : consists of the economic activities of local, state and federal
governments.
5. Rest of the world sector: transforms the model from a closed economy to an open
economy.
The five sector model of the circular flow of income is a more realistic representation of the
economy. Unlike the two sector model where there are six assumptions the five sector
circular flow relaxes all six assumptions. Since the first assumption is relaxed there are three
more sectors introduced.

Circular flow of income topics[edit]

Leakage and injections[edit]
In the five sector model the economy there is leakage and injections

Leakage means withdrawal from the flow. When households and firms save part of their
incomes it constitutes leakage. They may be in form of savings, tax payments,
and imports. Leakages reduce the flow of income.

Injection means introduction of income into the flow. When households and firms borrow
the savings, they constitute injections. Injections increase the flow of income. Injections
can take the forms of investment, government spending and exports. As long as
leakages are equal to injections circular flow of income continues indefinitely. Financial
institutions or capital market play the role of intermediaries. This means that income
individuals receive from businesses and the goods and services that are sold to them do
not count as injections or leakages, as no new money is being introduced to the flow
and no money is being taken out of the flow.

Leakage and injections can occur in the financial sector, government sector and overseas
sector:
In the financial sector
In terms of the circular flow of income model the leakage that financial institutions provide in
the economy is the option for households to save their money. This is a leakage because
the saved money can not be spent in the economy and thus is an idle asset that means not
all output will be purchased. The injection that the financial sector provides into the economy
is investment (I) into the business/firms sector. An example of a group in the finance sector
includes banks such as Westpac or financial institutions such as Suncorp.
In the government sector
The leakage that the Government sector provides is through the collection of revenue
through Taxes (T) that is provided by households and firms to the government. For this
reason they are a leakage because it is a leakage out of the current income thus reducing
the expenditure on current goods and services. The injection provided by the government
sector is Government spending (G) that provides collective services and welfare payments
to the community. An example of a tax collected by the government as a leakage is income
tax and an injection into the economy can be when the government redistributes this income
in the form of welfare payments, that is a form of government spending back into the
economy.
In the overseas sector
The main leakage from this sector are imports (M), which represent spending by residents
into the rest of the world. The main injection provided by this sector is the exports of goods
and services which generate income for the exporters from overseas residents. An example
of the use of the overseas sector is Australia exporting wool to China, China pays the
exporter of the wool (the farmer) therefore more money enters the economy thus making it
an injection. Another example is China processing the wool into items such as coats and
Australia importing the product by paying the Chinese exporter; since the money paying for
the coat leaves the economy it is a leakage.
Summary of leakage and injections
LEAKAGES

INJECTION

Saving (S)

Investment (I)

Taxes (T)

Government Spending (G)

Imports (M)

Exports (X)

Table 1 All leakages and injections in five sector model

The state of equilibrium[edit]

In terms of the five sector circular flow of income model the state of equilibrium
occurs when the total leakages are equal to the total injections that occur in the
economy. This can be shown as:
Savings + Taxes + Imports = Investment + Government Spending + Exports
OR
S + T + M = I + G + X.
This can be further illustrated through the fictitious economy of Martinland where:
S+T+M=I+G+X
$100 + $150 + $50 = $50 + $100 + $150
$300 = $300
Therefore, since the leakages are equal to the injections the economy is in a stable
state of equilibrium. This state can be contrasted to the state of disequilibrium where
unlike that of equilibrium the sum of total leakages does not equal the sum of total
injections. By giving values to the leakages and injections the circular flow of income
can be used to show the state of disequilibrium. Disequilibrium can be shown as:
S+T+MI+G+X
Therefore, it can be shown as one of the below equations where:
Total leakages > Total injections
$150 (S) + $250 (T) + $150 (M) > $75 (I) + $200 (G) + $150 (X)
Or
Total Leakages < Total injections
$50 (S) + $200 (T) + $125 (M) < $75 (I) + $200 (G) + $150 (X)
The effects of disequilibrium vary according to which of the above equations they
belong to.
If S + T + M > I + G + X the levels of income, output, expenditure and employment
will fall causing a recession or contraction in the overall economic activity. But if S +
T + M < I + G + X the levels of income, output, expenditure and employment will rise
causing a boom or expansion in economic activity.

Circular Flow of Income effects of saving

To manage this problem, if disequilibrium were to occur in the five sector circular
flow of income model, changes in expenditure and output will lead to equilibrium
being regained. An example of this is if:
S + T + M > I + G + X the levels of income, expenditure and output will fall causing a
contraction or recession in the overall economic activity. As the income falls
households will cut down on all leakages such as saving, they will also pay less in
taxation and with a lower income they will spend less on imports. This will lead to a

fall in the leakages until they equal the injections and a lower level of equilibrium will
be the result.
The other equation of disequilibrium, if S + T + M < I + G + X in the five sector
model the levels of income, expenditure and output will greatly rise causing a boom
in economic activity. As the households income increases there will be a higher
opportunity to save therefore saving in the financial sector will increase, taxation for
the higher threshold will increase and they will be able to spend more on imports. In
this case when the leakages increase they wisituation will be a higher level of
equilibrium.

Difference between real flow and money flow [edit]

1. Real flow is the exchange of goods and services between household and
firms whereas money flow is the monetary exchange between two sectors.
2. In real flow household sector supplies raw material, land, labour, capital and
enterprise to firms and in return firms sector provides finished goods and
services to household sector. Whereas in money flow, firm sector gives
remuneration in the form of money to household sector a wages and
salaries, rent, interest etc.
3. Difficulties of barter system for the exchange of goods and factor services
between households and firms sector in real flow, whereas no such difficulty
or inconvenience arise in money flow.
4. When goods and services flow from one sector of the economy to another,
it is known as real flow.

Phases or stages of circular flow of income[edit]

Production, consumption expenditure and generation of income are the three basic
economic activities of an economy that go on endlessly and are titled as circular
flow of income. Production gives rise to income, income gives rise to demand for
goods and services ; such a demand gives rise to expenditure and expenditure
induces for further production. The whole process forms the basis for circular flow of
income and related activities- production, income and expenditure are known as
phases or stages of circular flow of income.

Significance of study of circular flow of income[edit]

The book A General Approach to Macroeconomic Policy [17][citation needed] identifies four
possible areas of significance:
1. Measurement of National Income - National income is an estimation of
aggregation of any of economic activity of the circular flow. It is either the
income of all the factors of production or the expenditure of various sectors
of economy. However, aggregate amount of each of the activity is identical
to each other.
2. Knowledge of Interdependence - Circular flow of income signifies the
interdependence of each of activity upon one another. If there is no
consumption, there will be no demand and expenditure which in fact
restricts the amount of production and income.

3. Unending Nature of Economic Activities - It signifies that production, income

and expenditure are of unending nature, therefore, economic activities in an
economy can never come to a halt. National income is also bound to rise in
future.
4. Injections and Leakages

Market economy
A market economy is an economy in which decisions regarding investment, production,
and distribution are based on market determined supply and demand,[1] and prices
of goods and services are determined in a free price system.[2] The major defining characteristic of a
market economy is that investment decisions and the allocation of producer goods are mainly made
by cooperative negotiation through markets.[3] This is contrasted with a planned economy, where
investment and production decisions are embodied in a plan of production established by a state or
other body with control over economic resources.
Market economies can range from regulated markets to various forms of stateowned interventionist variants. In reality, market economies and free markets do not exist in pure
form, since societies and governments all regulate them to varying degrees. [4][5] Different perspectives
exist as to how strong a role the government should have in both guiding and regulating the market
economies and addressing (or not addressing) the inequalities the market naturally produces since
some producers are always better than others. Most existing market economies include a degree of
state economic planning or state-directed activity, and are thus classified as mixed economies. The
term free-market economy is sometimes used synonymously with market economy.[6]
Market economies do not logically presuppose the existence of private ownership of the means of
production. A market economy can and often does consist of a mix of various types of cooperatives,
collectives, or autonomous state agencies that acquire and exchange capital goods in capital
markets. These all utilize a market determined free price system to allocate capital goods and labor.
[3]
There are many variations of market socialism, some of which involve employee-owned
enterprises based on self-management; as well as models that involve public ownership of
the means of production where capital goods are allocated through markets.[7]

Capitalism[
Capitalism generally refers to an economic system where the means of production are largely or
entirely privately owned and operated for a profit, structured on the process of capital accumulation.
In general, in capitalist systems investment, distribution, income, and prices are determined by
markets, whether regulated or unregulated.
There are different variations of capitalism with different relationships to markets. In Laissezfaire and free marketvariations of capitalism, markets are utilized most extensively with minimal or
no state intervention and regulation over prices and the supply of goods and services.
In interventionist, welfare capitalism and mixed economies, markets continue to play a dominant role
but are regulated to some extent by government in order to correctmarket failures or to promote
social welfare. In state capitalist systems, markets are relied upon the least, with the state relying
heavily on either indirect economic planning and/or state-owned enterprises to accumulate capital.
Capitalism has been dominant in the Western world since the end of feudalism, but most feel[who?] that
the term "mixed economies" more precisely describes most contemporary economies, due to their

containing both private-owned and state-owned enterprises. In capitalism, prices determine the
demand-supply scale. For example, higher demand for certain goods and services lead to higher
prices and lower demand for certain goods lead to lower prices.

Laissez-faire[edit]
Main articles: Laissez-faire and Economic liberalism
Laissez-faire is synonymous with what was referred to as strict capitalist free market economy
during the early and mid-19th century[citation needed] as a classical liberal (right-libertarian) ideal to achieve.
It is generally understood that the necessary components for the functioning of an idealized free
market include the complete absence of government regulation, subsidies, artificial price pressures,
and government-granted monopolies (usually classified as coercive monopoly by free market
advocates) and no taxes or tariffs other than what is necessary for the government to provide
protection from coercion and theft, maintaining peace and property rights, and providing for basic
public goods. Right-libertarian advocates of anarcho-capitalism see the state as
morallyillegitimate and economically unnecessary and destructive.

Free-market economy[edit]
See also: Free market
Free-market economy refers to an economic system where prices for goods and services are set
freely by the forces of supply and demand and are allowed to reach their point of equilibrium without
intervention by government policy. It typically entails support for highly competitive markets, private
ownership of productive enterprises. Laissez-faire is a more extensive form of free-market economy
where the role of the state is limited to protecting property rights.

Welfare capitalism[edit]
Main article: Welfare capitalism
Welfare capitalism refers to a capitalist economy that includes public policies favoring extensive
provisions for social welfare services. The economic mechanism involves a free market and the
predominance of privately owned enterprises in the economy, but public provision of universal
welfare services aimed at enhancing individual autonomy and maximizing equality. Examples of
contemporary welfare capitalism include the Nordic model of capitalism predominant in Northern
Europe.[8]

Regional models[edit]
Anglo-Saxon model[edit]
Main article: Anglo-Saxon economy

Anglo-Saxon capitalism refers to the form of capitalism predominant in Anglophone countries and
typified by the economy of the United States. It is contrasted with European models of capitalism
such as the continental Social market model and the Nordic model. Anglo-Saxon capitalism refers to
a macroeconomic policy regime and capital market structure common to the Anglophone economies.
Among these characteristics are low rates of taxation, more open financial markets, lower labor
market protections, and a less generous welfare state eschewing collective bargaining schemes
found in the continental and northern European models of capitalism. [9]
East Asian model[edit]
Main article: East Asian model of capitalism
The East Asian model of capitalism involves a strong role for state investment, and in some
instances involves state-owned enterprises. The state takes an active role in promoting economic
development through subsidies, the facilitation of "national champions", and an export-based model
of growth. The actual practice of this model varies by country. This designation has been applied to
the economies of Singapore, Japan, Taiwan, South Korea and the People's Republic of China.
A related concept in political science is the developmental state.
Social market economy[edit]
Main article: Social market economy
This model was implemented by Alfred Mller-Armack and Ludwig Erhard after World War II in West
Germany. The social market economic model (sometimes called "Rhine capitalism") is based upon
the idea of realizing the benefits of a free market economy, especially economic performance and
high supply of goods, while avoiding disadvantages such as market failure, destructive competition,
concentration of economic power and the anti-social effects of market processes. The aim of the
social market economy is to realize greatest prosperity combined with best possible social security.
One difference from the free market economy is that the state is not passive, but takes
active regulatory measures.[10] The social policy objectives include employment, housing and
education policies, as well as a socio-politically motivated balancing of the distribution of income
growth. Characteristics of social market economies are a strong competition policy and
a contractionary monetary policy. The philosophical background is Neoliberalism or Ordoliberalism[11]

Market socialism[edit]
Market socialism refers to various types of economic systems where the means of production and
the dominant economic institutions are either publicly owned or cooperatively owned but operated
according to the rules of supply and demand. This type of market economy has its roots in classical
economics and in the works of Adam Smith, the Ricardian socialists and Mutualist philosophers.[12]
The distinguishing feature between non-market socialism and market socialism is the existence of a
market forfactors of production and the criteria of profitability for enterprises. Profits derived from
publicly owned enterprises can variously be used to reinvest in further production, to directly finance

government and social services, or be distributed to the public at large through a social
dividend or basic income system.[13]

Public ownership models[edit]

In the 1930s, the economists Oskar Lange and Abba Lerner developed a model of socialism that
posited that a public body (dubbed the "Central Planning Board") can set prices through a trial-anderror approach until they equaled the marginal cost of production in order to achieve perfect
competition and pareto optimality. In this model of socialism, firms would be state-owned and
managed by their employees, and the profits would be disbursed among the population in a social
dividend. This model came to be referred to as "market socialism" because it involved the use of
money, a price system and simulated capital markets, all of which are absent from traditional nonmarket conceptions of socialism.
A more contemporary model of market socialism is that put forth by the American economist John
Roemer, referred to as Economic democracy. In this model, social ownership is achieved through
public ownership of equity in a market economy. A Bureau of Public Ownership (BPO) would own
controlling shares in publicly listed firms, so that the profits generated would be used for public
finance and the provision of a basic income.

Cooperative socialism[edit]
Libertarian socialists and left-anarchists often promote a form of market socialism in which
enterprises are owned and managed cooperatively by their workforce so that the profits directly
remunerate the employee-owners. These cooperative enterprises would compete with each other in
the same way private companies compete with each other in a capitalist market. The first major
elaboration of this type of market socialism was made by Pierre Joseph Proudhonand was called
"mutualism".
Self-managed market socialism was promoted in Yugoslavia by economists Branko
Horvat and Jaroslav Vanek. In the self-managed model of socialism, firms would be directly owned
by their employees and the management board would be elected by employees. These cooperative
firms would compete with each other in a market for both capital goods and for selling consumer
goods.

Socialist market economy[edit]

Following the 1978 reforms, the People's Republic of China instituted what it calls a "socialist market
economy", in which most of the economy is under state ownership, but the state enterprises are
organized as joint-stock companies where various government agencies own controlling shares
through a shareholder system. Prices are set by a largely free-price system and the state-owned
enterprises are not subjected to micromanagement by a government planning agency. A similar
system called "socialist-oriented market economy" has emerged in Vietnam following the i
Mi reforms in 1986.

However, this system is usually characterized as state capitalism instead of market socialism
because there is no meaningful degree of employee self-management in firms, because the state
enterprises retain their profits instead of distributing them to the workforce or government, and many
function as de facto private enterprises. The profits neither finance a social dividend to benefit the
population at large, nor do they accrue to their employees.
In the People's Republic of China, this economic model is presented as a "preliminary stage of
socialism" to explain the dominance of capitalistic management practices and forms of enterprise
organization in both the state and non-state sectors.

Criticisms[edit]
The economist Joseph Stiglitz argues that markets suffer from informational inefficiency and the
presumed efficiency of markets stems from the faulty assumptions of neoclassical welfare
economics, particularly the assumption of perfect and costless information, and related incentive
problems. Neoclassical economics assumes static equilibrium, and efficient markets require that
there be no non-convexities, even though nonconvexities are pervasive in modern economies.
Stiglitz's critique applies to both existing models of capitalism and to hypothetical models of market
socialism. However, Stiglitz does not advocate replacing markets, but states that there is a
significant role for government intervention to boost the efficiency of markets and to address the
pervasive market failures that exist in contemporary economies.[14]
Robin Hahnel and Michael Albert claim that "markets inherently produce class division."[15] Albert
states that even if everyone started out with a balanced job complex (doing a mix of roles of varying
creativity, responsibility and empowerment) in a market economy, class divisions would arise.
Without taking the argument that far, it is evident that in a market system with uneven distribution of
empowering work, such as Economic Democracy, some workers will be more able than others to
capture the benefits of economic gain. For example, if one worker designs cars and another builds
them, the designer will use his cognitive skills more frequently than the builder. In the long term, the
designer will become more adept at conceptual work than the builder, giving the former greater
bargaining power in a firm over the distribution of income. A conceptual worker who is not satisfied
with his income can threaten to work for a company that will pay him more. The effect is a class
division between conceptual and manual laborers, and ultimately managers and workers, and a de
facto labor market for conceptual workers.[15]
David McNally argues that the logic of the market inherently produces inequitable outcomes and
leads to unequal exchanges, arguing that Adam Smith's moral intent and moral philosophy
espousing equal exchange was undermined by the practice of the free markets he championed. The
development of the market economy involved coercion, exploitation and violence that Adam Smith's
moral philosophy could not countenance. McNally also criticizes market socialists for believing in the
possibility of "fair" markets based on equal exchanges to be achieved by purging "parasitical"
elements from the market economy, such as private ownership of the means of production. McNally
argues that market socialism is an oxymoron when socialism is defined as an end to wage-based
labor.