Economic Systems and Tools Economic Questions and Economic Systems Production Possibilities Frontier Comparative Advantage and Specialization CHAPTER 2

© 2013 Cengage Learning. All Rights Reserved. Learning Objectives LO1Identify the three questions all economic systems must answer. LO2Describe a pure market economy, and identify its problems. LO3Describe a pure command economy, and identify its problems. LO4Compare mixed, transitional, and traditional economies. 2.1ECONOMIC QUESTIONS AND ECONOMIC SYSTEMS 2 CHAPTER 2

© 2013 Cengage Learning. All Rights Reserved. Key Terms  economic system  pure market economy  pure command economy  mixed economy  market economy  transitional economy  traditional economy CHAPTER 2 3

© 2013 Cengage Learning. All Rights Reserved. The Three Economic Questions All economies must answer three questions: 1.What goods and services will be produced? 2.How will goods and services be produced? 3.For whom will goods and services be produced? 4 CHAPTER 2

© 2013 Cengage Learning. All Rights Reserved. Economic System  An economic system is the set of mechanisms and institutions that resolves the what, how, and for whom questions.  Some standards used to distinguish among economic systems:  Who owns the resources?  What decision-making process is used to allocate resources and products?  What types of incentives guide economic decision makers? 5 CHAPTER 2

© 2013 Cengage Learning. All Rights Reserved. Pure Market Economy  All resources are privately owned.  Coordination of economic activity is based on the prices generated in free, competitive markets.  Any income derived from selling resources goes exclusively to each resource owner. 6 CHAPTER 2

© 2013 Cengage Learning. All Rights Reserved. Invisible Hand of Markets  According to Adam Smith (1723–1790), market forces coordinate production as if by an “invisible hand.” 7 CHAPTER 2

© 2013 Cengage Learning. All Rights Reserved. Problems with Pure Market Economies  Difficulty enforcing property rights  Some people have few resources to sell  Some firms try to monopolize markets  No public goods  Externalities  Economic fluctuations 8 CHAPTER 2

© 2013 Cengage Learning. All Rights Reserved. Pure Command Economy  All resources government-owned  Production coordinated by the central plans of government officials  Sometimes called communism 9 CHAPTER 2

© 2013 Cengage Learning. All Rights Reserved. The Visible Hand of Central Planners  Central planners direct the allocation of resources and products  Control resources  Direct production  Allocate products 10 CHAPTER 2

© 2013 Cengage Learning. All Rights Reserved. Problems with Command Economies  Consumers get low priority  Little freedom of choice  Central planning can be inefficient  Resources owned by the central authority are sometimes wasted  Environmental damage  No role for entrepreneurs 11 CHAPTER 2

© 2013 Cengage Learning. All Rights Reserved. Mixed Economy  United States is a mixed economy.  Because markets play a relatively large role, it is considered a market economy.  Government regulates the private sector in a variety of ways. 12 CHAPTER 2

© 2013 Cengage Learning. All Rights Reserved. Transitional Economy  A transitional economy is in the process of shifting from a command economy to a market economy.  This transition involves converting government enterprises into private enterprises—privatization.  The transition now under way will shape economies for decades to come. 13 CHAPTER 2

© 2013 Cengage Learning. All Rights Reserved. Traditional Economy  A traditional economy is shaped largely by custom or religion.  Family relations also play significant roles in economic activity. 14 CHAPTER 2

© 2013 Cengage Learning. All Rights Reserved. Learning Objectives LO1Describe the production possibilities frontier, and explain its shape. LO2Explain what causes the production possibilities frontier to shift. 2.2PRODUCTION POSSIBILITIES FRONTIER 15 CHAPTER 2

© 2013 Cengage Learning. All Rights Reserved. Key Terms  production possibilities frontier (PPF)  efficiency  law of increasing opportunity cost  economic growth  rules of the game CHAPTER 2 16

© 2013 Cengage Learning. All Rights Reserved. Efficiency and Production Possibilities Frontier  Simplifying assumptions  PPF model  Inefficient and unattainable production  Shape of the PPF 17 CHAPTER 2

© 2013 Cengage Learning. All Rights Reserved. Production Possibilities Frontier CHAPTER 2 18 Figure 2.1

© 2013 Cengage Learning. All Rights Reserved. Shifts of the PPF  Changes in resource availability  Increases in stock of capital goods  Technological change  Improvements in the rules of the game  Lessons from the PPF 19 CHAPTER 2

© 2013 Cengage Learning. All Rights Reserved. Shifts of the PPF CHAPTER 2 20 Figure 2.2

© 2013 Cengage Learning. All Rights Reserved. Learning Objectives LO1Explain the law of comparative advantage. LO2Understand the gains from specialization and exchange. 2.3COMPARATIVE ADVANTAGE AND SPECIALIZATION 21 CHAPTER 2

© 2013 Cengage Learning. All Rights Reserved. Key Terms  absolute advantage  law of comparative advantage  specialization  barter  money  division of labor CHAPTER 2 22

© 2013 Cengage Learning. All Rights Reserved. Comparative Advantage  Absolute advantage—the ability to make something using fewer resources than other producers require  Law of comparative advantage—the worker, firm, region, or country with the lowest opportunity cost of producing an output should specialize in that output  Specialization—occurs when individual workers focus on single tasks, enabling each one to be more efficient and productive 23 CHAPTER 2

© 2013 Cengage Learning. All Rights Reserved. Gains from Specialization  Absolute advantage focuses on which worker uses the fewest resources, but comparative advantage focuses on what else those resources could have produced—that is, on the opportunity cost of those resources.  The law of comparative advantage indicates who should do what. 24 CHAPTER 2

© 2013 Cengage Learning. All Rights Reserved. Exchange  Barter—a system of exchange in which products are traded directly for other products  Money—anything that everyone is willing to accept in exchange for goods and services 25 CHAPTER 2

© 2013 Cengage Learning. All Rights Reserved. Wider Application  Resources are allocated most efficiently across the country and around the world when production and trade conform to the law of comparative advantage. 26 CHAPTER 2

© 2013 Cengage Learning. All Rights Reserved. Specialization  Because of specialization based on comparative advantage, most people consume little of what they produce and produce little of what they consume.  Division of labor organizes the production so that each worker specializes in a separate task. 27 CHAPTER 2

© 2013 Cengage Learning. All Rights Reserved. Specialization in the Production of Cotton Shirts CHAPTER 2 28 Figure 2.3

© 2013 Cengage Learning. All Rights Reserved. Division of Labor  Takes advantage of individual preferences and natural abilities  Allows workers to gain experience at a particular task  Reduces the need to shift between different tasks  Permits the introduction of labor-saving machinery 29 CHAPTER 2

© 2013 Cengage Learning. All Rights Reserved. Specialization that Results with Division of Labor  Does not occur among individuals only  Also occurs among firms, regions, and entire countries 30 CHAPTER 2