Chapter 2:Economic Systems

Economics | Mr. Robinson

Review of Basic Principals• Resources are scarce. • Goods only have economic value if they

are scarce.• Because of scarcity all choices involve

trade-offs• The real cost of something is what you

must give up to get it. • “How much?” is a decision at the

margin.

Section 1:Answering the Three Economic Questions

The Three Economic Questions• Because economic resources are

limited, every society must answer three basic economic questions.1. What goods and services should be

produced?2. How should these goods and services

be produced?3. Who consumes these goods and

services?

What goods and services should be produced?• Individuals in every society must

decide what to produce in order to satisfy society’s needs and wants.

• How much of our resources should we devote to national defense, public health and welfare, or consumer goods.

• Because of our limited resources, each production decision that a society makes comes at an opportunity cost.

How should goods and services be produced?• Although there are countless ways

to create all the things we want and need, they all require land, labor and capital.− Should we have classes with 50

Students or 20 − Should we grow crops on corporate

farms or family farms?

Who consumes goods and services?

• Societies must decide how to distribute the available goods and services

• The answer is determined by how societies choose to distribute income− Factor payments are the income people

receive for supplying factors of production (land, labor, capital)

• Workers receive wages• Landowners receive rent• Money lenders receive interest

• This questions lies at the heart of the differences between economic systems today

Economic Goals and Societal Values• Societies answer the three

economic questions based on the importance they place on various economic goals.− Economic Efficiency− Economic Freedom− Economic Security and Predictability− Economic Equity− Economic Growth and Innovation

Economic Efficiency• Making the most of resources• Means a nation is using its scarce

resources to produce the most goods & services to satisfy people’s wants/needs.

Economic Freedom• Freedom from government

intervention in the production and distribution of goods and services− Freedom to decide how to spend or

save income− Freedom to buy or sell whatever you

want− Freedom to change jobs and join

unions− Freedom to start a new business or

close an old one

Economic Security and Predictability• Assurance that goods and services

will be available, payments will be made on time, and a safety net will protect individuals in times of economic crisis

• Each society decides what the risks are, who should be protected and who will pay for the protection (individuals, employers or the government)

Economic Equity• Fair distribution of wealth

• What is fair?• Equal pay for equal work?• Ones consumption depend on how

much one produces?• It is implemented based on what

people think is right or wrong.

Economic Growth and Innovation• Increasing production of goods and

services over time• Innovation → Growth → higher

standard of living• Growth helps achieve other goals

such as stability, security, efficiency, equity

Other Goals• Societies pursue additional goals

− environmental protection− Full employment− Universal medical care

• Achieving any economic goal comes only with some kind of economic trade-off

Economies & Values• An economic system is the method

used by a society to produce and distribute goods and services.

• Traditional economies rely on habit, custom, or ritual to decide what to produce, how to produce it, and to whom to distribute it.

• In a market economy economic decisions are made by individuals and are based on exchange, or trade.

• In a centrally planned economy the central government makes all decisions about the production and consumption of goods and services.

• Mixed economies are systems that combine tradition and the free market with limited government intervention.

Section 2:The Free Market

Why Markets Exist

• Markets exist because none of us produces all the goods and services we require to satisfy our needs and wants.

• A market is an arrangement that allows buyers and sellers to exchange goods and services.

• Specialization is the concentration of the productive efforts of individuals and firms on a limited number of activities.

The Free Market Economy

• Firms purchase factors of production from households

• This arena of exchange is called the factors market−Purchase / rent land−Hire workers, paying wages or

salaries−Borrow money from households to

purchase capital

monetary flow

physical flow

monetary flow

physical flow

Circular Flow Diagram of a Market Economy

Households Firms

Product market

Factor market

Households pay firms for goods and services.

Firms supply households with goods and services.

Households supply firms with land, labor, and capital.

Firms pay households for land, labor, and capital.

The Free Market Economy

• In a free market economy, households and business firms use markets to exchange money and products.

• Households own the factors of production and consume goods and services.

In the factor market, the people, who own the factors of production, sell their services to the companies that produce products. In exchange, the companies give the workers wages and, rent, and interest. In the factor market, the people are the sellers, and the companies are the buyers. The people are selling their services to the production firms. The most important component of the factor market is labor.

Diagram of a Market Economy

The product market is used to exchange a final good or service. Companies sell the products they have produced to the people who pay money to the companies for them. The money is flowing in the opposite direction.

The Self–Regulating Nature of the Market

• In every transaction, the buyer and seller consider only their self-interest, or their own personal gain.

• Self-interest is the motivating force in the free market.

• Producers in a free market struggle for the dollars of consumers.

The Self–Regulating Nature of the Market

• This is known as competition, and is the regulating force of the free market.

• The interaction of buyers and sellers, motivated by self-interest and regulated by competition, all happens without a central plan.

• This phenomenon is called “the invisible hand of the marketplace.”

Advantages of the Free MarketEconomic Efficiency

• As a self-regulating system, a free market economy is efficient.

Economic Freedom• Free market economies

have the highest degree of economic freedom of any economic system.

Economic Growth• Because competition

encourages innovation, free markets encourage growth.

Additional Goals• Free markets offer a

wider variety of goods and services than any other economic system.

Advantages of the Free Market• No pure market exists on any

meaningful scale• Economic equity & security

are difficult to achieve in a pure market system

Section 3:Centrally Planned Economies

Organization of Centrally Planned Economies

• Government owns the land and capital and controls where individuals work and what they are paid.

• The government decides what to produce, how much to produce, and how much to charge.

Organization of Centrally Planned Economies

• The free market forces of self-interest and competition are absent.

• Consumers do not have consumer sovereignty.

• Centrally planned economies face problems of poor-quality goods, shortages, and diminishing production.

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Organization of Centrally Planned EconomiesSocialism• A social and political philosophy based

on the belief that democratic means should be used to distribute wealth evenly throughout a society.

• Economic equality is possible only if the public controls the centers of economic powers.

• Requires a high degree of central planning.

• Governments can be democratic.

Organization of Centrally Planned EconomiesCommunism • A political system characterized by a

centrally planned economy with all economic and political power resting in the hands of the government.

• Believe a socialist society can only come about after a violent revolution.

• Governments are authoritarian.

The Former Soviet Union

• Soviet Agriculture− In the Soviet Union, the government

created large state-owned farms and collectives for most of the country’s agricultural production.

• Soviet Industry− Soviet planners favored heavy-industry

production (such as steel and machinery), over the production of consumer goods.

• Soviet Consumers− Consumer goods in the Soviet Union were

scarce and usually of poor quality.

The Former Soviet Union

• Soviet Agriculture

• Soviet Industry

• Soviet Consumers

Free Market vs. Centrally Planned• The primary difference between a free

market and a centrally planned economy is who decides on how scarce resources are allocated.

• Under socialism it could be the government, the public, or common ownership that decides.

• In a free market the interaction between buyers and sellers directs the allocation of resources.

Section 4: Modern Economies

Modern Economics• No system is the answer for all

economic questions for all people fairly− Centrally Planned – Bad for consumers− Traditional – Little potential for growth− Market – No incentive to produce public

goods• Market economies, with all their

advantages, have certain drawbacks.

The Rise of Mixed Economies

• Laissez faire is the doctrine that government generally should not interfere in the marketplace.

• Governments create laws protecting property rights and enforcing contracts and encourage innovation through patent laws.

• Some needs and wants in society are difficult to answer in the marketplace

• Government usually is responsible for defense, public health, police, health, education, social security, and a variety of other “public goods”

The Rise of Mixed Economies

• An economic system that permits the conduct of business with minimal government intervention is called free enterprise.

• Most free enterprise systems consist of four components: households, businesses, markets and governments.

• The degree of government involvement in the economy varies among nations.

monetary flow

physical flow

monetary flow

physical flow

Circular Flow Diagram of a Mixed Economy

Households Firms

Product market

Factor market

Government expendituresexpenditures

governm

ent-

owned facto

rstaxes

taxesgovern

ment

purchases

Government’s Role in a Mixed Economy

In a mixed economy:

• The government purchases land, labor, and capital from households in the factor market, and

• Purchases goods and services in the product market.