“Introduction to Economic Systems” Critical Questions What key economic questions must every society answer? What basic economic goals do societies have? What types of economic systems exist today?

What is an economic system? The method used by a society to produce and distribute goods and services

The Three Questions that Determine a Societies Economic System Because ALL economic resources are scarce, every society must answer three questions: What goods and services should be produced? Guns or butter? How should these goods and services be produced? What combination of factor resources should we use? Who consumes these goods and services? How will income be distributed?

Four Economic Systems 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 centrally planned economy the central government makes all decisions about the production and consumption of goods and services. In a market economy economic decisions are made by individuals and are based on exchange, or trade. Mixed economies are systems that combine the free market with limited government intervention.

The Free Market System (a.k.a. Capitalism) Why do 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.

Free Markets monetary flow physical flow Circular Flow Diagram of a Market Economy Households Firms 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.

Comparing Economic Systems Traditional Market Centrally Planned Mixed Who answers the 3 ?’s Custom Individuals Central Government Individuals with some government involvement

Economic Goals Societies answer the three economic questions based on their goals and values. Economic Goals Economic Goals Making the most of resources Economic efficiency Freedom from government intervention in the production and distribution of goods and services Economic freedom Assurance a safety net will protect individuals in times of economic disaster Economic security and predictability Fair distribution of wealth Economic equity Innovation leads to economic growth, and economic growth leads to a higher standard of living. Economic growth and innovation Environmental protection, variety Other goals

Free Markets A purely free market can rarely exist, but in theory a market economy would answer the three economic questions through a system of exchange and trade. In this system, supply and demand determine prices and prices serve as signals to both producers and consumers. Advantages: Freedom, Efficiency, Growth, Flexibility, Variety The core factors that allow a market system to work efficiently: Profit motive Flow of information Accurate price levels Ease of product movement

“The Father of Economics” Adam Smith (1723-90) Laissez Faire Economic Theory/Free Enterprise Scottish social philosopher/professor “The Wealth of Nations” (1776) 10 years to write/5 volumes Established Economics as its own discipline

Core Principles of Adam Smith On the Division of Labor … the “Assembly Line Model” Increase in quantity of work 1. Dexterity of workers 2. Saves time: no switch from one activity to the next 3. Machines replace manual labor Division of physical and mental labor/professional specialization = expertise Increased productivity = increased wealth for everyone Motivation for labor Disposition to barter Invisible Hand of the Marketplace: highest quality and quantity of goods produced Differences in talents are placed in the marketplace NPR

Adam Smith and the Invisible Hand 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. 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.” Back to Principles

Potential Problems in Free Markets The provision of public goods and services Income inequalities Existence of shortages and surpluses Existence of negative externalities

Centrally Planned Economies Definition ~The government, or a central authority, controls the factors of production. Modern Day Forms of Central Planning: Socialism~ a social and political philosophy based on the belief that democratic means should be used to distribute wealth evenly throughout a society. Communism~ a political system characterized by a centrally planned economy with all economic and political power resting in the hands of the government. Communist governments are authoritarian in nature.

Communist Theory (Today, Marxism): Karl Marx (1818-1883) German philosopher, political economist and historian Developed radical approach to understanding and coping with the problems that occurred in free market systems, namely the Industrial Revolution Published the Communist Manifesto in 1848 with Engels He argued that history is a series of class struggles between the rich capitalists and the working class. He believed that eventually workers needed to unite and revolt against the capitalists. This revolution would then breed a classless society.

Advantages and Disadvantages of Centrally Planned Economies Public goods and services provided by the state (i.e. healthcare, education, housing) Wasteful competition is avoided Peaceful labor conditions Welfare of citizens is the primary goal of the state Business cannot act against the interest of the people Poor-quality goods and shortages Failure to meet set ideals/ consumer needs Lack of incentive to work hard Lack of innovation Expensive and inflexible government Sacrifice of individual freedoms for society

Mixed Economies Most modern economies mix features of both systems (centrally planned and free market). An economic system that permits the conduct of business with minimal government intervention is called free enterprise. This is the system that exists in the United States. American Free Enterprise (Freedom vs. Protection) Americans have favored economic freedom over economic regulation, but we still expect the government to protect us from the problems that can exist in free markets. All Americans act to decide when the benefits of government protection outweigh the drawbacks to free enterprise.

Advantages and Disadvantages of the American System Freedom Competition Contracts Self Interest Profits Private Property Voluntary Exchange Unemployment (Types, Calculation) Inflation (CPI, Causes) Poverty (Determinants, Programs) Dangerous business practices See additional slides for more detail on #1-3

Types of Unemployment Frictional Unemployment- Occurs when people change jobs, get laid off from their current jobs, take some time to find the right job after they finish their schooling, or take time off from working for a variety of other reasons Structural Unemployment- Occurs when workers' skills do not match the jobs that are available. Technological advances are one cause of structural unemployment Seasonal Unemployment- Occurs when industries slow or shut down for a season or make seasonal shifts in their production schedules Cyclical Unemployment- Unemployment that rises during economic downturns and falls when the economy improves                                              

Unemployment Rates A nation’s unemployment rate is an important indicator of the health of the economy. The Bureau of Labor Statistics polls a sample of the population to determine how many people are employed and unemployed. The unemployment rate is the percentage of the nation’s labor force that is unemployed.

Going….UP!!!!!!!!!! Inflation is a general increase in prices. Purchasing power, the ability to purchase goods and services, is decreased by rising prices.

To Market, To Market A price index is a measurement that shows how the average price of a standard group of goods changes over time. The consumer price index (CPI) is computed each month by the Bureau of Labor Statistics. The CPI is determined by measuring the price of a standard group of goods meant to represent the typical “market basket” of an urban consumer. There are over two hundred categories of products that are included in the basket. These categories fall under 8 major groups: FOOD AND BEVERAGES HOUSING APPAREL TRANSPORTATION MEDICAL CARE RECREATION EDUCATION AND COMMUNICATION OTHER GOODS AND SERVICES

Inflation Theory Quantity Theory Demand-Pull Cost-Push Too much $ in the economy Demand-Pull Demand exceeds supply Cost-Push Increased input costs for the supplier

Danger…Prices on the Rise High inflation is a major economic problem, especially when inflation rates change greatly from year to year. The three main problems are: Reduced Purchasing Power Erosion of Interest Income Erosion of Wages/Income

The Poverty Problem Although the free market is the most successful economic system at producing wealth—distribution is HIGHLY uneven. The poverty threshold is an income level below what is needed to support families or households. What is the current threshold?!?!?!?!?!?!!?? POVERTY...THE FORGOTTEN STATE

What factors contribute to poverty? Lack of jobs Lack of educational opportunities Changes in family structure Economic shifts Racial and gender discrimination Culture of poverty

Who does the government provide a safety net for? Elderly Disabled Children Poor

Welfare Programs Welfare is a general term that refers to government aid to the poor 1930’s- Under Roosevelt the government began welfare programs to reduce the impact of the Great Depression. 1960’s- Lyndon Johnson launched the “War on Poverty” 1990’s- Clinton transformed welfare program to Temporary Assistance to Needy Families (TANF)

Redistribution Programs Type of Program Description Example Cash Transfers Direct payment of cash to qualifying individuals Temporary Assistance to Needy Families Unemployment Compensation In-Kind Benefits Goods and services for free or reduced prices Food Stamps Subsidized housing Medical Benefits Health insurance to those that cannot provide it for themselves Medicare Medicaid Education Benefits Federal, state, and local government all provide money for the poor and disabled to ensure all people receive educational opportunities. Pell Grants Head Start