Important concepts, issues and relationships
Different economic systems
Each society must provide answers to three central economic questions…
1. What goods and services will be produced and in what quantities?
 These are output questions.
2. How will each of the goods and services be produced?
 These are input questions.
3. For whom will the various goods and services be produced?
 These are distribution questions.
There are four types of economic systems that attempt to answer these questions…
a. the traditional system
b. the command system
c. the market system
d. mixed system
a. The traditional system
Traditional system: the same goods are produced and distributed in the same way by each
successive generation.
People use the same techniques of production as their parents did and production is distributed
according to long-established traditions.
A traditional economic system provides clear and easy answers to the three central questions. It is,
however, a rigid system, which is slow to adapt to changing conditions and stubbornly resists
innovation.
They tend to be limited to isolated and largely self-sufficient communities, for example in the
Canadian Arctic, certain remote parts of Latin America, island communities in the Pacific, and
various parts of Africa.
b. The command system
Command system: participants are instructed what to produce and how to produce it by a
central authority which also determines how the output is distributed.
Command systems are also called centrally planned systems.
Central planning is obviously a tremendous task. Decisions have to be taken on how, where and
for what purpose every natural resource, every labourer and every capital good is to be applied.
The planners have to determine what consumer goods should be produced, how to produce them
and how to divide them between consumers; how many resources should be allocated to the
production of capital goods and how many to consumer goods; and what types of capital good
should be produced. This is an extremely difficult task, particularly in a changing environment.
Nevertheless, in the 1970s and early 1980s more than a third of the world’s population lived in
countries that relied heavily on central planning. These countries included Russia, China, Poland,
Romania, North Korea and East Germany. Since then, however, central planning has become
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almost obsolete. At the time of writing, North Korea was generally regarded as the best remaining
example of a country in which the economy was still largely based on central planning.
The government plays an important role in every country. All government activity has to be
planned and coordinated by some central body or bodies. In other words, even in market or
capitalist systems, the command mechanism is still alive and well.
c. The market system
Market system: economic system in which there is free competition and prices are determined
by the interaction of supply and demand.
A market is any contact or communication between potential buyers and potential sellers of a
good or service.
For a market to exist, the following conditions have to be met…
 There must be at least one potential buyer and one potential seller of the good or service.
 The seller must have something to sell.
 The buyer must have the means with which to purchase it.
 An exchange ratio – the market price – must be determined.
A market system is one in which individual decisions and preferences are communicated and
coordinated through the market mechanism. The most important elements of this mechanism are
market prices.
 Market prices are signals or indices of scarcity which indicate to consumers what they have
to sacrifice to obtain the goods or services concerned.
 At the same time, market prices also indicate to the owners of the various factors of
production how these factors can best be employed.
Market systems or capitalism are characterised by…
 Individualism
 private freedom
 private property
 property rights
 decentralised decision making and limited government intervention
 factors of production are owned by individuals who take decisions based on their selfinterest.
 private property rights exist
Two centuries ago, Adam Smith, the Scottish professor who is generally regarded as the father of
the capitalist market system, dealt with precisely this issue as follows:
“Every individual … generally, indeed, neither intends to promote the public interest, nor knows
how much he is promoting it … he intends only his own gain, and he is in this, as in many other
cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it
always the worse for the society that it was no part of it. By pursuing his own interest he frequently
promotes that of the society more effectually than when he really intends to promote it.” (Adam
Smith, 1776, The wealth of nations, 423.)
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In other words, Smith claimed that the market mechanism works like an invisible hand which
coordinates the selfish actions of individuals to ensure that everyone is better off.
Let us take a closer look at how this is achieved.
What will be produced in a market system?
 The answer is those goods and services that consumers are willing to spend their income
on and which can be supplied profitably.
 Goods that consumers do not want will not be produced.
 Only those goods which can be produced and sold profitably will continue to be produced.
How will it be produced?
 Decisions on the combination of factors of production are governed by the prices of the
various factors and their productivity.
For whom will the goods and services be produced?
 In a market system the goods and services go to those who have the means to purchase
them.
It is almost inconceivable that a complicated economic system can function quite smoothly
without some agency to coordinate the millions of decisions taken by the various participants
every day.
The functions of prices in a market economy
Prices serve two important functions in a market economy…
a) a rationing function
b) an allocative function.
a) The rationing function
Prices serve to ration the scarce supplies of goods and services to those who place the highest
value on them (and can afford to pay for them). This is the rationing function of prices.
b) The allocative function
Prices also serve as signals which direct the factors of production between different uses in the
economy. In markets where there is excess demand, prices increase. Higher prices mean
increased profit opportunities, ceteris paribus. The possibility of increased profits attracts
additional factors of production (labour, capital, etc) towards the activities concerned. This is
the allocative function of prices, which may be regarded as the driving force behind Adam
Smith’s “invisible hand”, which we referred to earlier.
Always bear in mind, however, that markets reflect only the plans of those who are able to
participate as consumers or suppliers. Those who lack purchasing power or command over factors
of production are not able to signal their wants or plans via the market. In markets only money
votes count. Advocates of free markets claim that markets produce the most efficient allocation of
resources and that the problem of income distribution is not an economic issue.
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Production, income and spending
As we have seen, economics is essentially concerned with what to produce, how to produce it and
how to distribute the products between the various participants. Note that the focus is on
production. It stands to reason, therefore, that the total production of goods and services is of
major concern to economists.
The ultimate aim is to use or consume the products to satisfy human wants. The logical sequence
is therefore as follows: production creates income (earned in the production process by the
various factors of production), this income is then spent to purchase the products.
The sequence contains three major elements: production, income and spending. In practice, of
course, everything is happening at the same time: production occurs, income is earned, and all or
part of the income is spent on buying the goods and services that are available. In other words,
there is a continuous circular flow of production, income and spending in the economy as shown
in the diagram below.
Production
In the production process each factor of production earns income…
 natural resources (land) earn rent
 labour earns wages and salaries
 capital earns interest
 entrepreneurship earns profit
Income
The four main categories of income are rent, wages and salaries, interest and profit.
Spending
This income is then spent on buying the goods and services that have been produced.
In the mixed economy, the spending is done by the four main sectors that participate in the
economy: households, firms, the government and the foreign sector.
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Apart from production, income and spending, an important economic activity that links the
various sectors in an economy is exchange.
In a mixed economy exchange usually occurs in two sets of markets.
1. Goods market: the market where goods and services are exchnaged.
2. Factor market: the markets for the various factors of production (land, labour, capital).
The interdependence between households and firms
Households: people who live together and who make joint economic decisions or who are
subjected to others who make such decisions for them.
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Every person in the economy belongs to a household.
Members of households consume goods and services to satisfy their wants. They are
therefore called consumers.
The total spending of all households on consumer goods and services is called total or
aggregate consumption expenditure, or simply total consumption (C).
Because households are the basic units in the economy, we often use the term
“households” when we refer to individuals or consumers.
In a market economy it is households or consumers who largely determine what should be
produced.
In a mixed economy most of the factors of production are owned by households. Labour is owned
by the members of households. Many of the other means of production, such as capital goods, are
also owned by individuals. Even large businesses like Anglo American, Sanlam and Pick ‘n Pay are
owned by their shareholders.
Households sell their factors of production (labour, capital, etc) to firms that combine these
factors and convert them into goods and services. In return for the factors of production that they
supply, the households receive income in the form of salaries and wages, rent, interest and profit.
This income is then used to purchase consumer goods and services which satisfy their wants.
Summary…
 Every individual is a member of a household.
 Households are the basic units in an economic system.
 They own the factors of production and sell these factors on the factor markets to firms.
 In exchange for the services of their factors of production, households receive an income
(salaries and wages, rent, interest and profit)
 Income is used to purchase consumer goods and services in the goods markets.
 These goods and services are then consumed to satisfy human wants.
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Firms: units that employs factors of production to produce goods and services that are sold in
the goods markets.
Firms are the basic productive units in the economy. Firms convert factors of production into the
goods and services that households desire. Firms are therefore the buyers in the factor markets
and the sellers in the goods markets.
In a market economy it is firms which largely decide how goods and services will be produced.
One of the factors of production purchased by firms is capital.
Capital goods: manufactured factors of production, such as machinery and equipment, which
are used to produce goods and services.
The act of purchasing capital goods is called investment or capital formation, which is denoted by
the symbol I.
Summary…
 Firms purchase factors of production in the factor markets.
 They transform the factors into goods and services.
 These are then sold in the goods markets.
The circular flow of goods and services
The interaction between households and firms can be illustrated by the circular flow of goods and
services diagram.
The diagram below shows the following…
 Households offer their factors of production for sale on the factor market
 These factors are purchased by the firms.
 The firms combine the factors of production and produce consumer goods and services.
 These goods and services are offered for sale on the goods market where they are
purchased by the households.
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The circular flow of income and spending
In the diagram above, we show how goods and services flow between households and firms. The
interaction between households and firms can also be illustrated by showing the flow of income
and spending.
The flow of income and spending is usually a monetary flow (i.e. a flow of money). Its direction is
opposite to the flow of goods and services.
The diagram below shows the following…
 Firms purchase factors of production in the factor market.
 This spending by firms represents the income (wages, salaries, rent, interest and profit) of
the households.
 The households, in turn, spend their income by purchasing goods and services in the goods
market.
 The spending by the households represents the income of the firms.
We can now combine the circular flow of goods and services with the circular flow of income and
spending and we get a diagram that looks like the one below…
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Adding the government
Government spending (G) constitutes an addition or injection into the flow of spending and
income, while taxes (T) constitute a leakage or withdrawal from the circular flow of income
between households and firms.
The various links between government, on the one hand, and households and firms, on the other,
are illustrated in the diagram below…
Adding the foreign sector
The fourth major sector to consider is the rest of the world, which we call the foreign sector. The
foreign sector consists of all countries and institutions outside the country’s borders. The flows of
goods and services between the domestic economy and the foreign sector are export (X), and
imports (Z).
South African exports consist mainly of minerals and other commodities, while the country’s
imports are mainly capital and intermediate goods that are used in the production process.
Exports constitute an addition or injection into the circular flow of income and spending in the
domestic economy. Imports constitute a leakage or withdrawal from the circular flow of income
and spending in the domestic economy.
To keep things simple, we concentrate on the flows of income and spending between the
domestic economy and the foreign sector rather than on the flows of goods and services. The
diagram on the following page summarises the flows of income and spending between all four
sectors.
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Specialisation, division of labour and exchange
Production is characterised by specialisation. Each person specialises in the production of certain
goods and services. In the modern economy production processes are usually broken up into
different stages or parts, each of which is performed by an individual worker or group of workers.
This is called the division of labour.
Specialisation creates wealth, but the gains from specialisation can be achieved only if there is
exchange or trade between the different participants. Individuals, businesses and countries trade
the goods and services in which they specialise for goods and services produced by others.
Without exchange, specialised producers cannot satisfy their consumption wants from their own
production.
The cartoon above shows the benefits of specialising in one production activity, creating a surplus and then
finding someone to trade that surplus with. This leads to an improved standard of living.
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