Ch. 2: Economic Systems

Section 1: Answering the Three Economics Questions

Economic Systems• An economic system is the method a society uses to

produce and distribute goods and services.1

Three Questions

• Every economic system must ask the three fundamental questions:– What should be produced?– How to produce?– Who consumes what we produce?

What to produce?• What goods and services should be produced

in our economic system?– Due to scarcity, what will be prioritized?

How to produce?

• How should goods and services be produced?– What energy should be used? – Small businesses or large corporations?

For who?

• Who consumes the goods and services produced?– How are resources distributed?

Economic goals and values

• Systems make choices based on their economic goals and values.

• What is most important?– Efficiency – Freedom– Security and predictability– Equity– Growth and innovation– Sustainability

Economic Efficiency

• Economic efficiency is making the most of available resources

Economic Freedom• Economic freedom values individual decision

making and freedom from government intervention.

Economic Security and Predictability

• Economic security is the assurance that goods and services will be available, payments will be made, and safety nets are in place.

Economic Equity

• Economic equity values the fair distribution of wealth.– Safety nets: government protections in place to aid

those in need

Gini Index

• 0 = complete financial equality, 1 = complete financial inequality

Economic growth and innovation

• Economic innovation leads to growth, which leads to a higher standard of living.– Standard of living: level of prosperity and comfort

Economic Sustainability

• Economic sustainability is the ability of an economy and environment to survive.

Economic goals and values

• Systems make choices based on their economic goals and values.

• What is most important?– Efficiency – Freedom– Security and predictability– Equity– Growth and innovation– Sustainability

Four Types of Economies

• Traditional Economies• Market Economies• Command Economies (Centrally Planned)• Mixed Economies

Traditional Economies

• Relies on custom, or ritual to make the three economic decisions.

• Family and community centered.

Market Economies• Economic decisions are made by many

individuals and based on exchange or trade.• Also called free markets or capitalism

Command Economies (centrally planned economies)

• Central government alone decides the key economic questions.• Government acts as the central economic authority.

Mixed Economies

• Market-based economy with limited government involvement in economic decision making.

Economic Continuum

• Most economies are not entirely market or command, but mixed to varying degrees.

Command (Centrally Planned)

Free Market

Economic Continuum

• Most economies are not entirely market or command, but mixed to varying degrees.

Command (Centrally Planned)

Free Market

North KoreaCuba

IranChina

Russia

Mexico

South AfricaJapan

France

Poland United StatesCanada

United KingdomHong Kong

Singapore

Section 2: The Free Market

• A market is any arrangement that allows buyers and sellers to exchange things.

Specialization• Specialization allows for individuals or businesses to

concentrate on a limited good or service.• Markets allow for the exchange of these goods or services.

Firms and Households

• Firms (businesses) and households (a person or group of people living together) are the primary players and decision makers in a free market.

Profit

• Profit, the financial gain made in transaction, is the goal of the free market.

Adam Smith: Free Market Philosopher

• Adam Smith wrote The Wealth of Nations in 1776.

• Known as the father of capitalist (market) theory

• Proposed that self-interest created balance in economics– Beehive metaphor

Incentives

• An incentive is anything that encourages people to behave in certain ways.

• Smith observed that people respond predictably to positive and negative incentives (ex. Low or high prices).– Interest rates

Competition

• Competition: the struggle between producers for the business of consumers.

• Competition is the driving force of capitalism, or free markets.• Competition lowers prices and improves the quality of goods

and services.

The Invisible Hand• Self-interest and competition naturally regulate

markets.• Supply and demand create accurate pricing.• Adam Smith called this the “invisible hand of the

marketplace”

Consumer Sovereignty

• In free markets, consumers are king.• Through their demands, consumers determine what is

produced and how much they will pay for it.

Circular Flow of Market Economy

• Consumers and producers continually trade goods and services for labor and capital.

FirmsHouseholds

Money

Money

Goods and Services

Labor

Free Market Goals

• Free Market systems meet some economic goals, but no all.

• What is most important?– Efficiency – Freedom– Security and predictability– Equity– Growth and innovation– Sustainability

Section 3: Command Economies(Centrally Planned)

• In a centrally planned economy, the government answers the key economic questions.

Communism & Socialism

• Socialism: a philosophy believing that democratic means should be used to evenly distribute wealth.

• Communism: a centrally planned political/economic system controlled by an authoritarian government.

Karl Marx: The Communist Manifesto

• Karl Marx believed the widening gap between rich and poor would lead to an overthrow of the establishment and a new system of shared wealth.

• Government would fade away in utopian society.

Former Soviet Union• Vladimir Lenin led a communist overthrow of the

Russian Czar.• Communist party began centrally planning the Soviet

economy.

Soviet Agriculture

• The government created large state-owned farms.• Collectives were state farms leased to peasant farmers who

were required to produce for the government.• Failure: millions starved

Soviet Industry

• Factories and industry also became state-owned.• Military industry was prioritized. • Opportunity cost was innovative, high-quality consumer goods.

China: Great Leap Forward

• China’s Great Leap Forward was a similar attempt at government control of agriculture and industry.

• Again, millions starved

Soviet Individuals: Workers and Consumers

• Due to government planning, individuals lacked motivation and incentives.

• Consumer goods and opportunities were limited.

Command Economy Goals

• Command systems intend to create equity, but lack other economic goals.

• What is most important?– Efficiency – Freedom– Security and predictability– Equity– Growth and innovation– Sustainability

Communism & Socialism

• Socialism: a philosophy believing that democratic means should be used to evenly distribute wealth.

• Communism: a centrally planned political/economic system controlled by an authoritarian government.

Section 4: Modern Mixed Economies

• Nearly all economies today are a mixture of market and command economies.

Laissez Faire

• Laissez Faire (french): let it be• Means markets should not be

interfered by the government. • Adam Smith and others

believed markets should be largely unregulated and unrestricted.

Limits to Laissez Faire

With no government intervention in economies, what goods or services might not be adequately

addressed?

Limits to Laissez Faire• Some needs fall to the government to provide,

because no private group would.– Roads & Highways– Public Transportation– Parks– Education– Healthcare?

Limits to Laissez Faire

• Governments also regulate and facilitate markets.• Without government, monopolies could develop

which restrict free trade.

Industrial Robber Barons

• With limited government regulation in 19th century markets, monopolies developed.

• Monopolies eliminate competition, the foundation of free markets.

Circular Flow of Mixed Economy

• Government is added into market flow

FirmsHouseholds

Money

Money

Goods and Services

Labor

GovernmentTaxes/SpendingTaxes/Spending

Economic Continuum

• Most economies are not entirely market or command, but mixed to varying degrees.

Command (Centrally Planned)

Free Market

North KoreaCuba

IranChina

Russia

Mexico

South AfricaJapan

France

Poland United StatesCanada

United KingdomHong Kong

Singapore

Example: Sweden

• The Swedish government offers extensive services…– 450 days of paid parental leave– Free healthcare (braces, pt, etc.)– Free college– Employers are required to give a minimum of 30 days (6 weeks)

paid vacation.– Eric’s Story

• But, Swedes pay 56 percent of their gross domestic product in taxes (Americans pay 32 percent).

Public Healthcare Debate

• Should healthcare be nationalized?– Arguments for: • Everyone covered (15% currently aren’t)• Central, consistent system• Cost (advocates argue nationalized care would cut costs)

– Arguments against:• Compromised quality of care• Cost (opponents argue nationalized care would increase

costs)