Economic Systems
1
 Economic Systems are a particular set of
institutional arrangements and coordinating
mechanism – to respond to the economizing
problem
 Has to be able to determine what goods are
produced, how they are produced, who gets
them, how to accommodate change, and how
to promote technological progress
2
Economic Systems differ as to:
 who owns the factors of production
 the method used to motivate,
coordinate, and direct economic activity
 Two polar extremes:
command system and market system
3
Command System
4
Command System
 Known as communism or socialism
 Central authority making decisions about
production and consumption
 Soviet Union 1917-1991
5
 Why didn’t it work?
1. Producers in the Soviet Union routinely found
themselves unable to produce because
2. did not have crucial raw materials
3. or they succeeded in producing but no one
wanted their products
4. consumers were unable to find necessary
items
6
Market System
7
Market System
 Market Economy is an economy in which decisions about
production and consumption are made by individual
producers and consumers
 System allows for private ownership of capital, communicates
through prices, and coordinates economic activity through
markets
 No central authority telling people what to produce or where
to ship it
 Each individual producer makes what he or she thinks will be
most profitable
 Each consumer buys what he or she chooses
 Participants in this type of system act in their own selfinterest
8
 Market economies are able to coordinate even
highly complex activities and to reliably
provide consumers with goods and services
they want
 “Invisible Hand” – economy manages to
harness the power of self-interest for the good
of society
9
“Pure Capitalism”
 Known as “laissez-faire” capitalism
 Government’s role is limited to protect private
property
 The force behind capitalism in the US and
other countries is “the market”
10
Why do Market Economies work?

1.
2.
3.
4.
5.
6.
7.
8.
9.
Reasons:
Private Property
Freedom of enterprise and choice
Self-Interest
Competition
Markets and Prices
Technology and Capital Goods
Specialization
Money
Limited Government
11
1. Property Rights
 Private individuals and firms, not the
government, own most of the property
resources
 Right of private property (5th Amendment)
 Encourages investment, innovation, exchange,
maintenance of property, and economic growth
 Includes patents, copyrights, and trademarks
12
2. Freedom of Enterprise and Choice
 Freedom of Enterprise
 Entrepreneurs and private businesses can obtain and use
economic resources needed to produce and sell their
goods
 Freedom of Choice
 Owners can or tell people how to dispose their property
and money as they see fit
13
3. Self-Interest
 Each economic unit tries to achieve its
own particular goal, which requires
delivering something of value to others
14
4. Competition
 The basis is the freedom of choice exercised in
pursuit of a monetary return
 Requires:
 Two or more buyers/sellers acting independently in a
certain product or resource market
 Freedom of sellers/buyers to enter or leave markets on the
basis of their own self-interest
15
5. Market and Prices
 Markets are an institution or mechanism that
brings buyers (demand) and sellers (supply)
into contact
16
6. Technology and Capital Goods
 Technology facilities production so that it
is done in the most efficient way possible
 It is not wise for someone to use their
bare hands to harvest corn instead of
using a corn picker.
 Only way to avoid inefficiency is to rely
on capital goods
17
7. Specialization
 Use of resources by an individual, firm, region, or
nation to produce one or a few goods or services
rather than the entire range of goods and services
 Human Specialization
 Ability – one person can sing, one can be a great quarterback, one can
produce beautiful jewelry
 Single Tasks – learning and improving techniques in one area is more
efficient than doing more than one thing – lawyers, heart surgeons
 Saves Time – doing one thing is more efficient than stopping and
starting a new task
 Geographic Specialization
 Regional and International Specializations
18
8. Money
 Medium of exchange
 Barter is a way to swap goods for goods but
can not be used in all situations
 Money is a convenient way to facilitate the
exchange of goods and services – creates
trade
19
9. Limited Government
 Market systems operate fine on their
own but at times, there are market
failures that the government has to
address
20
Fundamental Questions of a Market Economy
1. What goods and services will be produced
2. How will the goods and services be produced?
3. Who will get the goods and services?
4. How will the system accommodate change?
5. How will the system promote progress?
21
The Circular-Flow Diagram
Money
Households
Goods
and
services
Money
Factors
Factor Markets
Goods
and
services
Money
Factors
Firms
Money
Property Rights and
Role of Incentives
23
Property Rights
 This means a system in which valuable items in the
economy have specific owners who can dispose of
them as they choose
 In a system of property rights – by purchasing a good
you receive “ownership rights”
 These are rights to use and dispose of the good as
you see fit
 Property rights are what make the mutually
beneficial transactions in any market
24
Role of Incentives
 Incentives are anything that offers rewards to people who
change their behavior
 People will usually exploit opportunities to make themselves
better off
 Parking in Manhattan rises, those who can find alternative
ways to get into their jobs will save money by doing so – and
that means fewer people will be driving to work
 Although, incentives can be bad
 Command Economies face problems – central planners determined the output.
When they misjudged the output amount at the government-determined
prices, shortages and surpluses arose. BUT….as long as the mangers were
rewarded for meeting their assigned production goals, they had no incentive to
adjust production
25
Economic Signals
 This is any piece of information that helps
people make better economic decisions
 There are thousands of signals that businesses
watch in the real world
 Prices are the most important signal in a
market economy – they convey essential
information about other people’s costs and
their willingness to pay
26
 This shows that the market price “signals” to
consumers with a willingness to pay equal to or more
that the market price that they should buy the good,
just as it signal to producers with a cost equal to or
less that the market price that they should sell the
good
 Since, in equilibrium, the quantity demanded equals
the quantity supplied, all willing consumers will find
willing sellers
27
 Although, prices can sometimes fail as economic
signals
 Sometimes a price is not an accurate indicator of
how desirable a good is—when there is uncertainty
about the quality o f a good, price alone may not be
an accurate indicator of the value of the good
 Example: you can’t infer from the price alone
whether a used car is good or a “lemon”
 Markets are a great way to organize economic
activity BUT markets can sometimes get it wrong!
28
 Markets can be inefficient—where there are missed
opportunities in the ways in which production or
consumption can be rearranged that would make
some people better off without making other people
worse off
 When a market or markets are inefficient, the
economy is inefficient.
29
 Two reasons for a market to be inefficient:
1. lack of property rights
2. inaccuracy of prices as economic signals
 When a market is inefficient it is known as
market failure
30
 Three ways for a market to become a market failure:
1. in an attempt to capture more surplus, one party
prevents mutually beneficial trades from occurring –
happens when there is one single seller of a good
(monopolist)
2. actions of individuals sometimes has side effects on
the welfare of others that markets don’t take into
account – example is pollution
3. markets for some goods fail because these goods, by
their very nature, are unsuited for efficient
management by markets
31
Economic Systems Notes
32
Economic Systems
 Economic Systems are a particular set of institutional
arrangements and coordinating mechanism – to
respond to the economizing problem
 Has to be able to determine:





what goods are produced
how they are produced
who gets them
how to accommodate change
how to promote technological progress
33
Economic Systems
Economic Systems differ as to:
 who owns the factors of production
 the method used to motivate,
coordinate, and direct economic activity
34
Command System
35
Command System
 Known as communism or socialism
 Central authority making decisions about
production and consumption
 Soviet Union 1917-1991
36
Command System
 Why didn’t it work?
1. Producers in the Soviet Union routinely found
themselves unable to produce because
2. did not have crucial raw materials
3. or they succeeded in producing but no one
wanted their products
4. consumers were unable to find necessary
items
37
Market System
38
Market System
 Market Economy is an economy in which decisions
about production and consumption are made by
individual producers and consumers
 System allows for private ownership of capital,
communicates through prices, and coordinates
economic activity through markets
 Participants in this type of system act in their own
self-interest
39
Market System
 Market economies are able to coordinate even
highly complex activities and to reliably
provide consumers with goods and services
they want
 “Invisible Hand”
40
Market System
 “Pure Capitalism”
 Known as “laissez-faire” capitalism
 Government’s role is limited to protect private
property
41
Why do Market Economies work?

1.
2.
3.
4.
5.
6.
7.
8.
9.
Reasons:
Private Property
Freedom of enterprise and choice
Self-Interest
Competition
Markets and Prices
Technology and Capital Goods
Specialization
Money
Limited Government
42
1. Property Rights
 Private individuals and firms, not the
government, own most of the property
resources
 Right of private property (5th Amendment)
43
2. Freedom of Enterprise and Choice
 Freedom of Enterprise
 Freedom of Choice
44
3. Self-Interest
 Each economic unit tries to achieve its
own particular goal, which requires
delivering something of value to others
45
4. Competition
 The basis is the freedom of choice exercised in
pursuit of a monetary return
 Requires:
46
5. Market and Prices
 Markets are an institution or mechanism that
brings buyers (demand) and sellers (supply)
into contact
47
6. Technology and Capital Goods
 Technology facilities production so that it is
done in the most efficient way possible
 Only way to avoid inefficiency is to rely on
capital goods
48
7. Specialization
 Use of resources by an individual, firm, region, or nation to
produce one or a few goods or services rather than the entire
range of goods and services
 Human Specialization
 Ability – one person can sing, one can be a great quarterback, one can produce
beautiful jewelry
 Single Tasks – learning and improving techniques in one area is more efficient
than doing more than one thing – lawyers, heart surgeons
 Saves Time – doing one thing is more efficient than stopping and starting a
new task
 Geographic Specialization
49
8. Money
 Medium of exchange
 Barter is a way to swap goods for goods but can not be
used in all situations
 Money is a convenient way to facilitate the exchange of
goods and services – creates trade
50
9. Limited Government
 Market systems operate fine on their own but
at times, there are market failures that the
government has to address
51
Fundamental Questions of a Market Economy
1. What goods and services will be produced
2. How will the goods and services be produced?
3. Who will get the goods and services?
4. How will the system accommodate change?
5. How will the system promote progress?
52
The Circular-Flow Diagram
Money
Households
Goods
and
services
Money
Factors
Factor Markets
Goods
and
services
Money
Factors
Firms
Money
Property Rights and
Role of Incentives
54
Property Rights
 This means a system in which valuable items in the
economy have specific owners who can dispose of
them as they choose
 In a system of property rights – by purchasing a good
you receive “ownership rights”
55
Role of Incentives
 Incentives are anything that offers rewards to people
who change their behavior
 People will usually exploit opportunities to make
themselves better off
 Although, incentives can be bad
56
Economic Signals
 This is any piece of information that helps
people make better economic decisions
 Prices are the most important signal in a
market economy – they convey essential
information about other people’s costs and
their willingness to pay
57
Economic Signals
 The market price “signals” to consumers with a
willingness to pay equal to or more that the market
price that they should buy the good, just as it signal
to producers with a cost equal to or less that the
market price that they should sell the good
 Since, in equilibrium, the quantity demanded equals
the quantity supplied, all willing consumers will find
willing sellers
58
Economic Signals
 Prices can fail as economic signals
 Sometimes a price is not an accurate indicator of
how desirable a good is—when there is uncertainty
about the quality of a good, price alone may not be
an accurate indicator of the value of the good
59
Economic Signals
 Markets can be inefficient—where there are missed
opportunities in the ways in which production or
consumption can be rearranged that would make
some people better off without making other people
worse off
 When a market or markets are inefficient, the
economy is inefficient.
60
Economic Signals
 Two reasons for a market to be inefficient:
1. lack of property rights
2. inaccuracy of prices as economic signals
 When a market is inefficient it is known as
market failure
61
Market Failure
 Three ways for a market to become a market failure:
1. Monopolist -- an attempt to capture more surplus, one
party prevents mutually beneficial trades from occurring
– happens when there is one single seller of a good
2. actions of individuals sometimes has side effects on the
welfare of others that markets don’t take into account –
example is pollution
3. markets for some goods fail because these goods, by
their very nature, are unsuited for efficient management
by markets
62