Chapter 2
Economic Systems
WHO ANSWERS THE THREE
ECONOMIC QUESTIONS?
IF YOU KNOW THIS, YOU KNOW
WHAT KIND OF ECONOMIC SYSTEM
YOU ARE LIVING UNDER!
* pay attention to the headings on each slide…don’t
ignore them *
Three Economic Questions
 What goods and services should be produced?
 How should these goods and services be produced?
 Who benefits from these goods and services?
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What Goods and Services Should be Produced?
 WHAT is an item that is over-produced in our
economy? WHAT is an item that is under-produced
in our economy?
underproduced
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overproduced
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What Goods and Services Should be Produced?
 Obviously we all need food and shelter, but there is a
standard of living that is expected--so we have to
decide what to produce to meet that standard.
vs.
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Standard of living = the quality of life based on the ownership of necessities
and luxuries that make life easier.
What Goods and Services Should be Produced?
 Recall Guns vs. Butter. How much is needed with
respect to military spending? How much is wanted?
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How Should Goods and Services Be Produced?
HOW Questions must be answered, such as:
Should we produce energy with oil or solar power?
Should teachers have
classes of 20 or 50?
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Should we have corporate farms
or small family farms?
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For Whom to Produce?
 The answer to the question of distribution
(FOR WHOM to Produce?) is
determined by how societies choose to
distribute income.
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 Who gets the income? …the ones who supply
Land, Labor, Capital, and Entrepreneurship!
Factor Payments
Factor payments are the income people receive for
supplying the factors of production (L,L,C & E).

Land owners receive rent
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Factor Payments?
 Factor payments are the income people receive for
supplying the factors of production (L,L,C & E).
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Land owners receive rent
Laborers receive wages
Factor Payments
 Factor payments are the income people receive for
supplying the factors of production (L,L,C & E).
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Land owners receive rent
Laborers receive wages
money lenders receive interest payments
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Factor Payments
 Factor payments are the income people receive for
supplying the factors of production (L,L,C & E).
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Land owners receive rent
Laborers receive wages
money lenders receive interest payments
Entrepreneurs receive profits
income
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expenses
minus
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= profit
Economic Goals reflect Societal Values
The United States, Saudi Arabia, and Cuba answer the
3 economic questions differently, based on the
importance they attach to various economic goals.
Cuba doesn’t value the same things we do, so their
economy reflects their values, not ours.
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Economic Efficiency
 Since resources are always scarce,
using them always involves
opportunity costs.
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 If a company chooses to produce gas-guzzling SUVs
when society wants Hybrids, the company is
operating inefficiently.
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 If a society can accurately assess what to produce, it
increases economic efficiency!
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Economic Freedom
 Nations have different economic systems.
Each system allows different degrees of
economic freedom.
 Some nations don’t allow the purchase or possession
of particular items.
 Some nations don’t
allow entrepreneurship.
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Economic Security and Predictability
 Security: Most nations believe in providing some
sort of safety net to help citizens in need: examples
would be the elderly, the sick, & those who have lost
jobs through no fault of their own.
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 Predictability: Most people also have the
expectation that there will be food at the grocery
store and fuel at the gas station when they need.
Economic Equity
 Societies have to decide how to divide
the economic pie.
Should everyone get the same portion
or should some people’s piece be bigger?
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 Many people believe in equal pay for equal work.
 Lawyers make more than teachers, doctors make
more than secretaries.
Economic Growth and Innovation
 A nation’s economy must grow for a nation to
improve its standard of living, especially if the
population is growing!
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Economic Growth and Innovation
Innovations in technology foster increases in
efficiency. (More technology = more efficiency in
making goods)
 Nomads
Agriculture Age
Industrial
Revolution
Information Age.
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Additional Goals
 Societies may have more goals than what we have
talked about already, such as:
Environmental Protection
Full Employment
Universal [Everyone Gets] Medical Care
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 Every nation must prioritize its economic goals…they
all come with trade-offs.
Economies and Values
 4 different systems have been developed to address
the 3 economic questions.
 Each system is a reflection of the society’s
values. Try to figure out what each one values
most.
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System 1: Traditional Economies
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 Resources (economic decisions) are
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distributed by inheritance
Social network gives everyone a purpose & function
in society
habit, rituals, & customs dictate decisions
Revolves around family; work is divided by gender
lines.
Hunting & agriculture lie at the heart of lives & laws
Less demand on the earth’s resources; goods are only
produced if they are going to be consumed
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System 1: Traditional Economies
 No over-production or surpluses most of the time;
living at subsistence level (everyone has what they
need, but not a lot more).
 Very few things in place to deal with disaster
 Most have no modern conveniences and have a low
standard of living
 Very resistant to change, because no desire for goods
the rest of the world has--they have no value in this
lifestyle (except possibly for the younger generation!)
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System 1: Traditional Economies
 Goals of a traditional economy are:
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1. Full employment (everyone works)
2. Price stability (no inflation)
3. Satisfactory rate of economic growth
(generally have as much or more than usual)
4. Free trade with other nations (or tribes)
5. Correct (fair) distribution of income
6. Efficient allocation of resources (no wasting time)
 Examples: the Amish in midwestern America, the
Eskimos in Alaska, the Masai tribe in Kenya and
Tanzania…everyone before the Industrial Revolution
System 2: Market Economies
 Economic decisions are made by individuals with no
rules imposed on them by the government.
 Individuals determine what gets made and how and
who profits from it
 Also called “free markets” or “capitalism”
 Examples…?
System 2: Market Economies
 Examples: …guess what! There are no pure market
economies. The government always imposes SOME
rules. The closest thing to free market economies in
the world are:

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the United States
the United Kingdom
Germany
Netherlands
Canada
System 3: Command Economies
 In a centrally planned economy the government
COMMANDS everything.
 The central government owns all the factors of
production (anything productive: land, mines,
buildings, businesses, forests…)
 The central government makes all of the
decisions on how to answer the three questions.
 Examples…?
System 3: Command Economies
 Examples include: the FORMER Soviet Union, and
the CURRENT Cuba, North Korea, and Vietnam.
What do these countries have in common?….
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System 3: Command Economies
 Examples include: the FORMER Soviet Union, and
the CURRENT Cuba, North Korea, and Vietnam.
What do these countries have in common?….

They are communist countries. Under communism, the
government dictates what is made, who is making it, at
what price it will sell, and to whom it is sold.
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System 4: Mixed economy
 Most modern economies fall in this “Mixed”
category: market-based economic systems in which
the government plays a role.
 The government usually “plays a role” by…
System 4: Mixed economy
 Most modern economies fall in this category:
market-based economic systems in which the
government plays a role.
 The government usually “plays a role” by…
 Regulating industries (such as…)
System 4: Mixed economy
 Most modern economies fall in this category:
market-based economic systems in which the
government plays a role.
 The government usually “plays a role” by…
 Regulating industries (such as…)
 Regulating minimum wage
System 4: Mixed economy
 Most modern economies fall in this category:
market-based economic systems in which the
government plays a role.
 The government usually “plays a role” by…
 Regulating industries (such as…)
 Regulating minimum wage
 Imposing taxes (such as…)
System 4: Mixed economy
 Most modern economies fall in this category:
market-based economic systems in which the
government plays a role.
 The government usually “plays a role” by…
 Regulating industries (such as…)
 Regulating minimum wage
 Imposing taxes (such as…)
 Imposing tariffs
System 4: Mixed economy
 Most modern economies fall in this category:
market-based economic systems in which the
government plays a role.
 The government usually “plays a role” by…
 Regulating industries (such as…)
 Regulating minimum wage
 Imposing taxes (such as…)
 Imposing tariffs
 Imposing quotas
System 4: Mixed economy
 Most modern economies fall in this category:
market-based economic systems in which the
government plays a role.
 The government usually “plays a role” by…
 Regulating industries (such as…)
 Regulating minimum wage
 Imposing taxes (such as…)
 Imposing tariffs
 Imposing quotas
 Regulating working conditions
Why Do Markets Exist?
 Markets are a way to exchange what we have for
what we want/need.
 None of us are self sufficient. You did not grow the
cotton to make your shirt.
 You did not grow the wheat to make the bread for
your sandwich.
Specialization Rocks!
 Instead of doing everything ourselves, we specialize
in one or a few products.
 This makes us more efficient.
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 I do not want to calculate my own taxes. I do want to
teach. I specialize in teaching and someone else
specializes in tax law. I pay them to calculate my
taxes, and they pay taxes so I can teach their kids.
Buying and Selling
 The typical person makes what they specialize in,
sells it and then uses those wages to buy what they
want/need.
The Self-Regulating Nature of the Marketplace
 Why is it that firms and households cooperate in
order to get what they need?
Greed is Good
 Why is it that firms and households cooperate in
order to get what they need?
Competition! Self-interest!
… make everything work out.
Adam Smith is brilliant
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 Adam Smith called this “THE INVISIBLE HAND.”
He said…competition is good! Greed is good! Selfinterest is good!
 In The Wealth of Nations, he wrote that in an
economy, there are countless individual transactions.
In each single transaction, the driving force is each
person’s consideration of their own personal gain.
Competition and Self-Interest
 Everyone’s self-interest is the regulating force that
balances an economy:
The circle of life…I mean economics
 Everyone’s self-interest is the regulating force that
balances an economy:

Individuals are trying to get the most for their money,
The circle of life…I mean economics
 Everyone’s self-interest is the regulating force that
balances an economy:


Individuals are trying to get the most for their money,
Firms are trying to make the most profit.
The circle of life…I mean economics
 Everyone’s self-interest is the regulating force that
balances an economy:



Individuals are trying to get the most for their money,
Firms are trying to make the most profit.
Firms will compete with each other for sales.
The circle of life…I mean economics
 Everyone’s self-interest is the regulating force that
balances an economy:




Individuals are trying to get the most for their money,
Firms are trying to make the most profit.
Firms will compete with each other for sales.
This competition drives prices down.
The Invisible Hand
 Adam Smith said that the economy decides on
production and price without any central regulation.
Each individual consumer or individual firm trying
to get the best for itself will set proper production
amounts and prices. [No one will produce what
someone won’t buy! No one will sell at a price
consumers won’t pay!] Adam Smith called this the
INVISIBLE HAND.
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Advantages of the Free Market
 Economic efficiency (no one will waste their own
time or money)
 Economic freedom (no one telling you what to do)
 Economic growth (if I make more profit, I will buy
more goods with it)
 Despite the advantages, it doesn’t exist
anywhere!…on a large scale. No government can
completely stay out of it. Why is that?!?!?!?
How are Command Economies organized?
 Government Control of resources and production
 Government owns both land and capital
 Government decides
What to produce
 How much to produce
 How much to charge

Socialism
 Socialism- The goal is to distribute wealth evenly,
and the decisions are made by the citizens,
democratically.


Can be a democracy, but still centrally planned
Government owns major industries like utilities
Communism
 The goal is to distribute wealth equally, but the

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people are not trusted to do it. Therefore, the
government makes all the decisions of how to
distribute the wealth.
All economic and political power lies in the central
government.
Government is authoritarian in nature
No individual freedom (or very little)
Usually dominated by single political leader
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The Former Soviet Union
 Example of communism: the U.S.S.R. (fell in 1991)
 Allocated best land and capital to the military and
space program
 The Soviet government was responsible for deciding
the process (what, how, for whom) for 24 million
goods
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Soviet agriculture
 Farmers worked for
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daily wage
 Government provided
equipment, seed, fertilizer
 Collectives were formed
 Large farm leased to peasant farmers
 Required to produce what the government told them to
 No incentive to produce better crops (couldn’t keep the profit)
Soviet industry
 Planners favored the defense industry
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(GUNS over BUTTER)
 Consumer goods got the leftover resources
 Jobs were guaranteed…so no incentives given for
good work (you couldn’t get fired; the government
might reassign you but you always had a job)
 Illegal to be an entrepreneur
Soviet Consumers
What was it like for the people?
 Goods scarce and poor quality
 Focus on quantity, not quality
 Vast housing shortages
 Vast food shortages
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Problems with Command Economies
 Since there are no incentives, growth is nearly
impossible
 System can’t meet consumers’ needs or wants
 Discourage change
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 Discourage innovation
 Decisions are over-complicated
Why Mixed Economies?
 Limits of Laissez Faire (hands off)
Why Mixed Economies?
 Limits of Laissez Faire (hands off)
 Market economies are great, but have limitations
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Why Mixed Economies?
 Limits of Laissez Faire (hands off)
 Market economies are great, but have limitations
 If there is no government intervention, where do schools and
roads, police and disaster relief come from?
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Why Mixed Economies?
 Limits of Laissez Faire (hands off)
 Market economies are great, but have limitations
 If there is no government intervention, where do schools and
roads, police and disaster relief come from?
 Laws are created protecting rights and contracts
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Balance of Freedom and Control:
A Mixed Economy
 Some goals are better met by governments:
 Can you think of some examples?
 Some are better met by the free market:
 Can you think of some examples?
Economic Terms
Profit
Loss
Profit
expenses
income
minus
= profit
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Loss
If
income
expenses
minus
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is less
than zero,
then you
have a
LOSS
instead of
a PROFIT
Government Regulation
Minimum Wage
Social Programs
Social Security
being on a “fixed income”
Economic Terms
Inflation
Economic Terms
Private Property Rights
Economic Terms
Competition