Chapter 2: Economic Systems1. Answering three Economic Questions?2. The Free Market3. Centrally Planned Economics4. Mixed Economics

Government AllocationMarket Allocation

Free Market EconomyCommand, or Central Authority Economy

Mixed Economy

1. Answering three Economic Questions

• What goods and services should be produced?

• How should these goods and services be produced?

• Who consumes these goods and services?. . . Because resources are scarce

WHAT? HOW? WHO?

Goods and Services

Economic System• The structure of methods and principles a society

uses to produce and distribute goods and services• A way a society answers these questions defines its

economic system

Economic Goals and Societal Values

• Different societies answer the questions based on importance they attach to various economic goals

Economic Goals• Efficiency-Societies try to maximize their

resources• Freedom-the opportunity to make your own

choices• Security-”Safety net”-programs that protect

people who face unfavorable economic conditions

• Equity-How should we divide the pie?• Growth-innovation plays a huge role in

economic growth

Traditional Economies• An Economic system that relied on

habit, custom, or ritual to decide the three economic questions.

• There is little room for innovation or change in traditional economies

• Led to more modern economic systems

Three Economic Systems• Dominates the modern world• The free market economy (capitalism)• The centrally planned economy

(communism) (socialism)• The mixed economy –a little of both

Differing Systems• The United States

• Freedom• Security

• Efficiency• Equity• Growth

• The Soviet Union• Equity• Growth

• Security• Efficiency• Freedom

2. The Free Market• Economic Freedom -highly valued by

American Society• Markets -any arrangement that allows

buyers and sellers to exchange things• We are not producers of all our wants• Examples – fishing market, farmers

market, Sporting goods store, New York Stock Exchange Market

Why Markets Exist

• Specialization -concentration of the productive efforts of individuals and businesses on a limited number of activities

• Buying and Selling -sell what we produce and buy what we want

Free Market Economy• An economic system in which decisions

on the three key economic questions are based on voluntary exchange in markets

• Individuals make their own decisions• Capitalism -the capital that

entrepreneurs invest in businesses are vital

• Individuals and businesses own the factors of production

The United States Economy

• Free enterprise economy -private or corporate ownership of capital goods

• Government of the U.S. plays a major role in the economy

• “promote the general welfare”• Some people think that the government

intervenes too much in the economy• What do you think?

Households and Firms

• Household -person or group of people living in a single residence

• Firm - business or an organization that uses resources to produce a product, which it then sells

Factor and Product Markets

• Factor Market -the arena of exchange in which firms purchase the factors of productions from households

• Product Market -the arena of exchange in which households purchase goods and services from firms

Land CapitalLabor

Product Market

Circular Flow Model

Monetary Flow

Product Flow

Product Flow

Factor Market

Product Market

Factor MarketMonetary Flow

Factor Market

Product Market

The Self-Regulating Nature of the Marketplace

• Self Interest -an individual’s own personal gain

• Incentive -the hope of reward or fear of penalty that encourages a person to behave in a certain way

• Competition -the struggle among producers for the dollars of consumers

• The Invisible hand-Adam Smith-the self regulating nature of the market place

• “Give me that which I want, and you shall have this which you want . . . . It is in this manner that we obtain from one another the far greater part of those good [services] which we stand in need of. It is not from the benevolence of the butcher, the brewer, or that baker that we expect our dinner, but from their regard to their own interest.” –Adam Smith, The Wealth of Nations

Adam Smith

Advantages of the Free Market

• Efficiency -produce what consumers want

• Freedom -work where you want, produce what you want, consume what you want

• Growth -innovations• Consumer Sovereignty - having the

power to decide

And here are some disadvantages of the free market economy, or capitalism

3. Centrally Planned Economics

• How Central Planning Works • Government makes all the decisions on

three questions (command economy)• Government owns all factors of

production• Direct contrast to free market

structure

Socialism and Communism• Socialism – range of economic and social systems based on belief

that wealth should be distributed evenly throughout a society• Communism- political system in which government owns all

resources and means of production and makes all economic decisions

• “Capitalist production . . . Develops technology and the combining together of various processes . . . Only by sapping the originalsources of all wealth- the soil and the laborer.” – Karl Marx, The Communist Manifesto

• All my hard work and all the moneyends up in the hands of capitalists

Authoritarian

• Form of government that limits individual freedoms and requires strict obedience from its citizens

• Communist governments are always authoritarian

Three Communist Economies• The Soviet Union -1917-Bolshevik Revolution-

Joseph Stalin-broke up in 1991• China - 1949 to late 1970’s-government

planners controlled all aspects of Chinese society; adopted some free market

• Cuba – Fidel Castro – 1959 – Cuban Revolution

Disadvantages of Centrally Planned Economies

• Efficiency -no incentive to work hard• Freedom -discourages competition • Growth -no innovation no growth• Equity -human intuition prohibits equity

The need to satisfy all wants and needs

4 Mixed Economies

• Reasons for Government Involvement • Laissez-faire -government generally

should not intervene in the marketplace• Private Property -property owned by

individuals not the government• Mixed economy -market-based

economics in which government is involved to some extent

Government in Market

• Factor Market -government instead of individual owns factors of productionProduct Market -government purchases all goods and services and provides them the public

Greatest Expenditure in U.S. Government – Social Security

Product Market

Factor MarketMonetary Flow

Factor Market

Product Market

Continuum of Mixed EconomiesCentral Planned

Mixed Free Market

North Korea Mexico, France,

United States

Cuba South Africa United Kingdom

Iran, China Germany Canada

Russia Japan, Poland Hong Kong