Chapter 2: Economic Systems Economics | Mr. Robinson Chapter 2: Economic Systems

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. What goods and services should be produced? How should these goods and services be produced? 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

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. 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.

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 Market Economic 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. 30

Socialism Communism but = Communism Socialism

Organization of Centrally Planned Economies Socialism 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 Economies Communism 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.

Government’s Role in a Mixed Economy monetary flow physical flow Circular Flow Diagram of a Mixed Economy Households Firms Product market 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. taxes government purchases Government expenditures government-owned factors taxes Factor market