Chapter 2 Fundamental Concepts

Economics Questions What goods/services to produce? Something that individuals will purchase How will goods/services be produced? In the most cost efficient manner Who will consume the goods and services? Whomever is willing and able to pay the price How will the system accommodate change? - Through prices and profits How will the system promote progress? - With technological advance and and capital accumulation

Economic Goals Economic Efficiency (Productivity) Using the fewest resources to produce the maximum number of goods and services. Economic Freedom (not absolute) Consumers freely choosing how to spend their money and use their resources. Businesses/Entrepreneurs freely choosing to produce what they want or to start whatever business they want.

Economic Goals (continued) Economic Security & Predictability A safety net is in place in times of disaster. Consumers will receive what they have purchased. Businesses will be paid for what they have sold. Economic Equity (NOT equality) People are treated fairly and provided with the same opportunities.

Economic Goals (continued) Economic Growth & Innovation Produce more this year than last year. A country’s standard of living increases from one year to the next Develop new ideas and more efficient ways of doing things. Additional Goals Environmental protection, full employment, universal health care.

Economic Systems Method used by society to produce and distribute goods and services. No pure economic systems in the world today. All economies are mixed. Reflects its prioritization of economic goals. Reflects the values of its internal societies.

Traditional Economy Answers economic questions according to custom or tradition. Tradition dictates the role each individual plays. Things are done the way they have always been done. Ways of doing things are handed down from one generation to another. Exist today in limited areas of Asia, the Middle East, Africa and Latin America. The Amish are very good examples. Allocation of resources is based on ritual, habit, or custom. Roles of individuals are defined by customs or ancestors.

Command Economy Individual has little, if any influence over how economic questions are answered. Gov’t controls the factors of production and how they will be used. Gov’t decides how to distribute G & S and who does what. Economy can change direction easily. Not designed to meet the needs and wants of individuals. Lacks incentives for individuals to work hard. Common to have shortages of what people need and surpluses of what the government knows how to produce. Cuba, North Korea, and the former U.S.S.R. are examples.

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.

Market Economy Gov’t does not directly intervene. Individuals own the factors of production and decide the answers to the economic questions. Economic decisions are made through the interaction of buyers and sellers. People and firms act in their own best interests. Variety of goods and services are provided. High degree of consumer satisfaction. Rewards only productive resources. “Western” economies such as the United States, Japan and Germany are examples. For years, Hong Kong was the closest thing we had to a pure market system.

Mixed Economy Combines the elements found in a market economy with those of a command economy. Found in most economies of the world today. Typically combines a market type economy with government intervention or involvement in the marketplace.

The Rise of Mixed Economies Market economies, with all their advantages, have certain drawbacks. Limits of Laissez Faire Laissez faire is the doctrine that government generally should not interfere in the marketplace. Governments create laws protecting property rights and enforcing contracts. They also encourage innovation through patent laws.

Adam Smith Laissez-faire government should be the approach toward the economy (leave it alone – hands off) Competition provides incentives for businesses to attract consumer dollars. If people followed their own self-interest, not only would they benefit as a individual, but so would society as a whole. Specialization increases productivity. There is this “invisible hand” at work, in the economy, guiding resources toward their most productive use.

Comparing Mixed Economies An economic system that permits the conduct of business with minimal government intervention is called free enterprise. The degree of government involvement in the economy varies among nations. Continuum of Mixed Economies Centrally planned Free market Source: 1999 Index of Economic Freedom, Bryan T. Johnson, Kim R. Holmes, and Melanie Kirkpatrick Iran North Korea Cuba China Russia Greece Peru United States South Africa France United Kingdom Botswana Canada Singapore

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.

Circle Flow Diagram/Model

The Free Market Economy 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. Households pay firms for goods and services. Product market Firms supply households with goods and services. Households supply firms with land, labor, and capital. Firms pay households for land, labor, and capital. Factor market

Circle Flow Diagram/Model (continued) Two Markets operate simultaneously Product Market – Businesses produce goods and services which they sell to the Households in exchange for money. Factor (Resource) Market – Households sell their resources to the Businesses for which they receive payment.

Circle Flow Diagram/Model (continued) The two markets depend on each other. The Businesses must purchase the factors of production (resources) from the Households in the Factor Market in order to be able to produce and sell the goods and services in the Product Market. The Households must sell their factors of production to the Businesses in the Factor Market in order to have money with which to buy the goods and services in the Product Market.

Circle Flow Diagram/Model (continued) The two markets are of equal importance. Neither the product nor the factor (resource) market is any more important than each other. Each carries the same weight in the economy. This model is considered to be a representation of the US market economy.

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