“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 SystemBecause 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?

Economic Goals

Economic Goals

Making the most of resourcesEconomic 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 wealthEconomic equity

Innovation leads to economic growth, and economic growth leads to a higher standard of living.

Economic growth and innovation

Environmental protection, varietyOther goals

Economic GoalsSocieties answer the three economic questions based on their goals

and values.

An economic system is the method used by a society to produce and distribute goods and services.

Four Economic Systems

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.

Comparing Economic Systems

Economic System

• Traditional • Market • Centrally Planned• Mixed

Who answers the 3 ?’s

• Custom• Individuals• Central Government• Individuals with some government

involvement

Traditional System• Agricultural and hunting societies.• There is little room for innovation

or change. • They tend to lack modern

conveniences and have a low standard of living.

• Close knit communities with focus on the family unit.

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.

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

Free Markets

monetary flow

physical flow

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.

Adam Smith (1723-90)

• Scottish social philosopher and professor• “An Inquiry into the Nature and Causes of

the Wealth of Nations” (1776)– 10 years to write – 5 volumes

• “Laissez faire” • The Invisible Hand

– Self Interest (Motivating Force)– Competition (Regulating Force)

Advantages of the Free MarketEconomic Efficiency

As a self-regulating system, a free market economy is efficient.

Economic GrowthBecause competition

encourages innovation, free markets encourage growth.

Economic FreedomFree market economies have

the highest degree of economic freedom of any economic system.

Additional Goals, i.e. varietyFree markets offer a wider

variety of goods and services than any other economic system.

Centrally Planned Economies

The government,o

r central

authority controls the economy.

In a centrally planned economy, the government owns both land and capital. The government

decides what to produce, how much to produce, and how much to charge.

Socialism is a social and political philosophy based on the belief that democratic means should be used to distribute wealth evenly throughout a society.

Communism is 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.

Organization of Centrally Planned Economies

KARL MARX(1818-1883)

• German philosopher• Radical approach to fix the problems in free

market systems• Communist Manifesto (1848) with Frederick

Engels.• Argued that history is a series of class struggles

between the rich capitalists and the working class “proletariat”.

• He believed that eventually workers needed to unite and revolt against the capitalists. This revolution would create a classless society.

Frederick Engels Karl Marx

The Soviet Union• The Bolshevik

Revolution (1917)• Lead by Vladimir

Lenin• Creates a

centrally planned economy

The Soviet Experiment• Factors of production controlled by the state • Resources= armed forces, space program, capital

goods• Government committees decided the quantity,

process and distribution of products• The government created large state-owned farms

and collectives• Little incentive to produce, decline in the

production of goods.

Problems in Centrally Planned Economies

• Poor-quality goods, shortages, and diminished production

• Fail to meet consumer needs and wants

• Little individual incentives to work • Lack of innovation• Expensive and inflexible government

structure• Sacrifice of individual freedoms

Mixed Economies• It is doubtful that any nation can exist successfully under a pure centrally planned economy or a pure market economy.

• Most economies mix features of both systems.

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

Hong Kong

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. Nations are placed on a continuum (a range with no

clear divisions) of mixed economies. On one end are centrally planned economies and on the opposite end are free markets economies.

Comparing Mixed Economies

Chapter 3 and 13American Free

EnterpriseUnderstanding

America’s Economic Structure

Tradition of Free Enterprise

The Economic Trade-off (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 (market failure, externalities)

Rights and Roles of the American Consumer

• Rights • Property Rights• Contracts • Taxation

• Roles• Consumer• Voter

The Role of Government1. Protect the Public Interest

2.Provide Information 3. Promote Growth and Stability

PovertyKey Indicators

Inflation

Employment

Gross Domestic Product

Gross Domestic Product

The main indicator used to determine overall health of the economy is gross domestic product (GDP) which is the dollar value of all final goods and services produced within a country’s borders in a given year.

This will allow them to better determine upcoming business cycles to determine prosperity, recession or depression.

Limitation of GDP• Non-market

activities• Underground

economy• Quality of lifeGDP vs. GNP

Annual income earned by US owned firms and citizens.

Types of Unemployment1. 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

2. Structural Unemployment- Occurs when workers' skills do not match the jobs that are available. Technological advances are one cause of structural unemployment

3. Seasonal Unemployment- Occurs when industries slow or shut down for a season or make seasonal shifts in their production schedules

4. Cyclical Unemployment- Unemployment that rises during economic downturns and falls when the economy improves

                                             

Unemployment Rates

The Bureau of Labor Statistics determines the unemployment rate (% of the labor force that is unemployed) each period

Getting Everyone To Work!!!!• Economists generally agree that in an economy

that is working properly, an unemployment rate of around 4 to 6 percent is normal.

• Sometimes people are underemployed, that is working a job for which they are over-qualified, or working part-time when they desire full-time work.

• Discouraged workers are people who want a job, but have given up looking for one.

Full employment is the level of employment reached when there is no cyclical unemployment.

Going….UP!!!!!!!!!!

• Inflation is a general increase in prices.

• Inflation limits purchasing power (the ability to purchase goods and services).

To Market, To Market

• The consumer price index (CPI) is computed each month by the Bureau of Labor Statistics.

• This is a measure of the price of a typical consumers “market basket”.

What is in the basket?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

RECREATIONEDUCATION AND COMMUNICATION

OTHER GOODS AND SERVICES

Inflation Theory1. Quantity

Theory2. Demand-Pull3. Cost-Push

What’s the big deal?The three main problems caused by inflation 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

Who does the government provide a safety net for?

ElderlyDisabledChildren Poor

Redistribution ProgramsType of Program Description Example 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