Economic Systems Chapter 2

The Three Economic Questions Chapter 2, Section 1

Economic Systems Defined as… The method used by a society to produce and distribute goods and services The method used by a society to produce and distribute goods and services The economic system employed by a society depends on its goals The economic system employed by a society depends on its goals To determine goals, a society asks three key economic questions To determine goals, a society asks three key economic questions

3 Key Economic Questions 1. What to produce? 1. What to produce? What should be produced in order to satisfy needs and wants What should be produced in order to satisfy needs and wants How much is devoted to defense, education, health and welfare, etc... How much is devoted to defense, education, health and welfare, etc How should products be produced? 2. How should products be produced? How do we produce electricity? How do we produce electricity? 3. Who consumes the goods? 3. Who consumes the goods? How are goods distributed? How are goods distributed? How is income distributed? (factor payments…income received for providing the factors of production) How is income distributed? (factor payments…income received for providing the factors of production) Note that all three questions involve opportunity costs! Note that all three questions involve opportunity costs!

Economic Goals Efficiency Efficiency Try to maximize the use of resources Try to maximize the use of resources Produce flip phones or smart phones? Produce flip phones or smart phones? Freedom Freedom Governments may or may not intervene in economic freedom Governments may or may not intervene in economic freedom Security and Predictability Security and Predictability Assurance that goods and services will be available Assurance that goods and services will be available A safety net is provided (government programs) A safety net is provided (government programs)

Economic Goals Economic Equity Economic Equity Fair distribution of wealth…WE DO NOT HAVE THIS Fair distribution of wealth…WE DO NOT HAVE THIS Economic Growth and Innovation Economic Growth and Innovation Innovation leads to growth…leading to a higher standard of living  TECHNOLOGY Innovation leads to growth…leading to a higher standard of living  TECHNOLOGY Other goals Other goals Environmental protection, medical care, unemployment…these must be prioritized Environmental protection, medical care, unemployment…these must be prioritized

Economic Goals Not all goals can be met equally…there are trade offs Not all goals can be met equally…there are trade offs This is why there are varying economic systems This is why there are varying economic systems Emphasis on different goals result in societies pursuing different economic goals Emphasis on different goals result in societies pursuing different economic goals

Economic Systems Traditional Economies Traditional Economies Subsistence type lifestyles Subsistence type lifestyles Rely on tradition, habit, custom Rely on tradition, habit, custom Little surplus Little surplus Low Standard of living Low Standard of living Market Economies Market Economies Decisions are made by individuals Decisions are made by individuals Known as free markets or capitalism Known as free markets or capitalism

Economic Systems Centrally planned economies (command) Centrally planned economies (command) Government answers the three economic questions Government answers the three economic questions Communism Communism Mixed economies Mixed economies Combination of traditional, market, and centrally planned economies (gov’t plays a limited role) Combination of traditional, market, and centrally planned economies (gov’t plays a limited role) Most economies today are mixed Most economies today are mixed

Review 1. Each society determines who will consume what is produced based on (a) its unique combination of social values and goals (a) its unique combination of social values and goals (b) the amount of factor payments (b) the amount of factor payments (c) its needs and wants (c) its needs and wants (d) economic equity (d) economic equity 2. To improve its standard of living, a nation’s economy must (a) remain stable (a) remain stable (b) grow through innovation (b) grow through innovation (c) reach economic equity (c) reach economic equity (d) allow the central government to make economic decisions (d) allow the central government to make economic decisions

The Free Market Chapter 2, Section 2

Markets An arrangement that allows buyers and sellers to exchange things An arrangement that allows buyers and sellers to exchange things Markets exist because no one is self sufficient Markets exist because no one is self sufficient No one produces everything to satisfy their needs and wants No one produces everything to satisfy their needs and wants Specialization…the concentration of productive efforts of individuals and firms on a limited number of activities (makes us more efficient as an economy) Specialization…the concentration of productive efforts of individuals and firms on a limited number of activities (makes us more efficient as an economy) We each specialize in producing one or a few goods We each specialize in producing one or a few goods Markets are needed because of specialization…each person needs a way to exchange goods Markets are needed because of specialization…each person needs a way to exchange goods

Free Market Economies Economic system based on voluntary exchanges Economic system based on voluntary exchanges Individuals answer the three economic questions Individuals answer the three economic questions Individuals and firms own the factors of production Individuals and firms own the factors of production They make what they want They make what they want They buy what they want They buy what they want

Chart from Klein Chart from Klein Firms supply households with goods & services Households pay firms for goods & services Firms pay households for land, labor & capital Households supply firms with land, labor & capital TOP HALF is known as PRODUCT MARKET BOTTOM HALF is known as FACTOR MARKET

Households and Firms The players in a free market economy are households and firms The players in a free market economy are households and firms Household…a group of individuals in the same residence Household…a group of individuals in the same residence Serve as consumers and producers Serve as consumers and producers Firms…an organization that uses resources to produce a product which it then sells Firms…an organization that uses resources to produce a product which it then sells Firms transform inputs (factors of production) into outputs (products) Firms transform inputs (factors of production) into outputs (products)

Factor Market The lower half of the circular flow diagram The lower half of the circular flow diagram Firms purchase the factors of production from households (hire workers and pay them) Firms purchase the factors of production from households (hire workers and pay them) Households provide firms with the factors of production Households provide firms with the factors of production This exchange is known as the Factor Market This exchange is known as the Factor Market

Product Market The top half of the circular flow The top half of the circular flow Firms produce goods and services (products) Firms produce goods and services (products) Households purchase the goods and services (products) Households purchase the goods and services (products) This is known as Product Market This is known as Product Market

Self Regulating Nature How does the Free Market Regulate? How does the Free Market Regulate? Self Interest vs. Competition Self Interest vs. Competition According to Adam Smith (Wealth of Nations), the buyer and seller are concerned only with their interests during a transaction…their own personal gain. This self interest is the motivating force According to Adam Smith (Wealth of Nations), the buyer and seller are concerned only with their interests during a transaction…their own personal gain. This self interest is the motivating force producers look to sell and consumers look for the lowest price producers look to sell and consumers look for the lowest price

Competition Competition keeps one firm from trying to gain too much Competition keeps one firm from trying to gain too much Competition is the struggle among firms for customers Competition is the struggle among firms for customers Where self interest is the motivating force in a free market, competition is the regulating force Where self interest is the motivating force in a free market, competition is the regulating force Adam Smith called this regulation: Adam Smith called this regulation: The Invisible Hand

Advantages of the Free Market Economic Efficiency…producers make only what consumers want (can respond to demands) Economic Efficiency…producers make only what consumers want (can respond to demands) Economic Freedom…households and firms make their own choices (A LOT OF FREEDOM) Economic Freedom…households and firms make their own choices (A LOT OF FREEDOM) Economic Growth…competition encourages innovation and therefore, growth Economic Growth…competition encourages innovation and therefore, growth Additional Goals…there is a wider variety of goods and services due to additional incentives Additional Goals…there is a wider variety of goods and services due to additional incentives Consumer Sovereignty…consumers decide what gets produced Consumer Sovereignty…consumers decide what gets produced

Review 1. Why do people need to buy and sell goods and services? (a.) People need to buy and sell goods to make a profit (a.) People need to buy and sell goods to make a profit (b.) People buy and sell to maintain a competitive society (b.) People buy and sell to maintain a competitive society (c.) No one is self – sufficient (c.) No one is self – sufficient (d.) People need to provide the market with goods and services (d.) People need to provide the market with goods and services 2. What factors create the phenomenon of the “invisible hand”? Aincentives and efficiency Aincentives and efficiency Bspecialization and efficiency Bspecialization and efficiency Ccompetition between firms Ccompetition between firms Dcompetition and self - interest Dcompetition and self - interest

Centrally Planned Economies Chapter 2, Section 3

Centrally Planned Economies Centrally Planned Economies (Command Economies) are completely different than Free Market Economies Centrally Planned Economies (Command Economies) are completely different than Free Market Economies The central government answers the three economic questions The central government answers the three economic questions

Factors of Production In CPE’s the government owns the factors of production In CPE’s the government owns the factors of production Labor because they decide where individuals work and what they are paid Labor because they decide where individuals work and what they are paid The government tells what will be produced and how much will be produced The government tells what will be produced and how much will be produced Consumers have no say Consumers have no say

Communism vs. Socialism Socialism…a social and political ideology that uses democratic means to distribute wealth evenly Socialism…a social and political ideology that uses democratic means to distribute wealth evenly Aims to achieve Economic Equality Aims to achieve Economic Equality Communism…an authoritarian political system with all political and economic power resting in the hands of the government Communism…an authoritarian political system with all political and economic power resting in the hands of the government Former Soviet Union Former Soviet Union

The Former Soviet Union and Command Economy Decisions were made completely by the state Decisions were made completely by the state More interested in producing products that made them a world power (military and space) More interested in producing products that made them a world power (military and space) Other products were poor in quality due to Other products were poor in quality due to Allocation of resources Allocation of resources Lack of incentive Lack of incentive Stores had to accept what was produced Stores had to accept what was produced

Problems with CPE’s Poor Quality Poor Quality No incentive to innovate No incentive to innovate Shortage of non priority goods & services Shortage of non priority goods & services Consumer demand is not met for wants Consumer demand is not met for wants Diminishing production Diminishing production Surplus is not produced nor is there the desire to produce it Surplus is not produced nor is there the desire to produce it

Mixed Economies Chapter 2, Section 4

Mixed Economies There are no economies today that rely on exclusively Free Market System or a Centrally Planned System There are no economies today that rely on exclusively Free Market System or a Centrally Planned System Most are mixed economies Most are mixed economies

Why Mixed Economies? Free Markets do not provide for all needs: Free Markets do not provide for all needs: Education Education Health Care Health Care Defense Defense Infrastructure Infrastructure Social Programs Social Programs Even Adam Smith and other supporters of laissez – faire feel there is some need for government intervention Even Adam Smith and other supporters of laissez – faire feel there is some need for government intervention

Control vs. Freedom In a mixed economy, a balance needs to be met between the individual and the government. In a mixed economy, a balance needs to be met between the individual and the government. Society needs to decide on priorities and evaluate opportunity costs Society needs to decide on priorities and evaluate opportunity costs Do you want to: Do you want to: Subsidize the military Subsidize the military Save endangered species Save endangered species Subsidize education Subsidize education Provide health care Provide health care Etc… Etc…

Circular Flow for the Mixed Economy Government in the Factor Market Government in the Factor Market Government purchases land, labor and capital Government purchases land, labor and capital U.S. pays roughly 2.8 million employees $9.7 billion a year in wages U.S. pays roughly 2.8 million employees $9.7 billion a year in wages Government in the Product Market Government in the Product Market Governments purchase finished goods for their operations Governments purchase finished goods for their operations Cars, office supplies, defense hardware, benefits for employees Cars, office supplies, defense hardware, benefits for employees The government also provides finished products The government also provides finished products Example…roads Example…roads

TOP HALF = PRODUCT MARKET BOTTOM HALF = FACTOR MARKET

Government’s Role in a Mixed Economy The government purchases goods and services in the product market, and Purchases land, labor, and capital from households in the factor market

Levels of Government Intervention Some economies are very centrally planned (North Korea, Cuba) Some economies are very centrally planned (North Korea, Cuba) There are privatized goods and sales on the Black Market There are privatized goods and sales on the Black Market China and Russia are in a state of transition. China and Russia are in a state of transition. The federally owned assets of the past are being privatized The federally owned assets of the past are being privatized Others are quite free (Hong Kong, US, Canada) Others are quite free (Hong Kong, US, Canada)

Hong Kong Hong Kong…special administrative district of China Hong Kong…special administrative district of China World’s freest market… World’s freest market… Few barriers on foreign trade Few barriers on foreign trade Open to foreign investment Open to foreign investment Independently operated banks Independently operated banks

Continuum of Mixed Economies IranSouth AfricaUnited KingdomHong Kong North KoreaChinaBotswanaCanadaSingapore CubaRussiaPeruUnited States