Economic Systems and
Decision Making
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Review! What 3 questions must every economy try to answer?
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What goods and services should be produced?
How should these goods and services be produced?
Who consumes these goods and services?
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All economic systems try to answer these Q’s
Cuba: Cosmetic surgery NOT available—government refuses to
allow resources to be used on this service
You don’t have to live like a refugee!
4 Types of 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/command 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. AKA
“Laissez-faire economy” (“allow them to do” or more
simply, leave it alone)
 Mixed economies are systems that combine tradition
and the free market with limited government
intervention.
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Traditional Economy
In a traditional economy, roles and economic
decisions are defined by custom
 Traditional economies rely on habit, custom,
or ritual to decide what to produce, how to
produce it, and to whom to distribute it
 Examples: Canadians living in Nunavut
 Advantages: Everyone knows which role to
play, little certainty about what, how, or for
whom to produce
 Disadvantages: Discourages new ideas, new
ways of thinking. LOW Standard of living
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Command Economy
In a centrally planned economy/command
economy the central government makes all
decisions about the production and
consumption of goods and services
 Found in North Korea, Cuba, China, Vietnam
 Ex: Cosmetic surgery is illegal in Cuba
 Advantages: Can drastically change direction
quickly, little uncertainty
 Disadvantages:Consumer needs are not met,
hard work is not rewarded, decision making is
delayed, has little flexibility, individual initiative
is not rewarded, NO INCENTIVES!!!!!!
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Problems of a Centrally Planned Economy
Centrally planned economies face problems of poorquality goods, shortages, and diminishing production.
The Former Soviet Union
Soviet Agriculture
– In the Soviet Union, the government created large
state-owned farms and collectives for most of the
country’s agricultural production.
Soviet Industry
– Soviet planners favored heavy-industry
production (such as steel and machinery), over the
production of consumer goods.
Soviet Consumers
– Consumer goods in the Soviet Union were scarce
and usually of poor quality.
The USSR Under Lenin & Stalin
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Lenin took large estates from the rich and
gave them to the peasants, while outlawing
private property
Factories were turned over to workers
Workers lacked skill, so New Economic Policy
was instituted (Capitalism)
Stalin’s 5-Year Plans were industrialization at
any cost
Stalin instituted collectivization, particularly
on farms
The USSR after Stalin
The Communist Party and Gosplan, the central
planning authority, ran just about everything without
any local input
 The agricultural sector was a problem—Khrushchev’s
“Virgin Lands” failed and the USSR imported grain
from the U.S.
 Finally, the people demanded better consumer goods,
and more of them
 Gorbachev’s “perestroika” and “glasnost” provided
opportunities to criticize and reform the economic
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Transition in Russia
1. Communism in Russia--The Soviet government reorganized
farmland into state farms and collective farms. Much of the
economy was focused on the growth of heavy industry.
2. Glasnost and Perestroika--In the late 1980s, Soviet Premier
Mikhail Gorbachev introduced new reforms. Glasnost was a
policy of "openness" encouraging open speech. Perestroika
called for a gradual change from a centrally planned
economy to free enterprise.
3. Collapse of Communism--In 1991, Russians voted in their
first democratic election. Soon after, the Soviet republics
declared themselves independent nations. By the end of
1991, the Soviet Union ceased to exist.
4. Transition to a Free Market--Since 1991, the Russian
government has moved Russia towards free enterprise.
However, extensive corruption and government
mismanagement have hindered Russia's progress.
Socialism and Communism
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Socialism is a social and political philosophy based on
the belief that democratic means should be used to
distribute wealth evenly throughout a society. EX:
Sweden
Benefits: Better distribution of benefits
Disadvantages: Lower efficiency, high taxes,
entrenched special interests
Communism is a political system characterized by a
centrally planned economy with all economic and
political power resting in the hands of the government.
EX: Cuba, China (neither a great example)
Advantage: Economy can shift quickly, lack of
uncertainty.
Disadvantage: Poorly meets consumers’ needs
Free Market Capitalism
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Producers and consumers determine how/what/for
whom to produce. Each consumer’s dollar is an
“economic vote.”
Examples: United States, Canada, Western Europe,
Japan, South Korea, Singapore
Advantages: Can adjust to change, gives a high degree
of individual freedom, small degree of government
involvement, consumers have a say in the economy,
leads to a wide variety of goods and services (think of
how many brands of dog food there are), and leads to
high levels of consumer satisfaction (more tattoos than
pocket squares right now)
Disadvantages: More uncertain for individuals.
Unemployment and inflation do happen regularly.
Price Theory
(Important Component of Free
Market)
Output in a free market is decentralized.
 You will work for wages. These wages represent
income--the amount of money a household earns in a
year.
 Wealth is the accumulation of of past income or
inheritances.
 Wage rates determine the rewards for working in
different jobs and professions.
 The basic coordinating mechanism in the economy is
price.
 Individuals will pursue their own self-interest,
motivated by profit, and produce what people want.
 Others will acquire skills and buy, save, or invest the
income they earn. Price is the determinant.
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The Continuum
Parts of the US economy are almost completely
unregulated (Internet), but the Constitution permits
Congress to regulate any interstate commerce—which
since the 1930s has meant practically everything
 During World War II, the government limited
production of goods such as washing machines,
refrigerators, and automobiles so the resources used
to produce those goods could be funneled to different
industries (food, armaments, etc).
 Western Democracies vary widely in their level of
capitalism. Sweden is Socialist, Singapore is almost
unbridled capitalism
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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.
Continuum of Mixed Economies
Centrally planned
Free market
Iran
North Korea
Cuba
South Africa
China
Russia
France
Botswana
Greece
United Kingdom
Canada
Peru
Source: 1999 Index of Economic Freedom, Bryan T. Johnson, Kim R. Holmes, and Melanie Kirkpatrick
Hong Kong
Singapore
United States
Making the Transition
Privatization in Eastern Europe and Russia
has been difficult.
 No Civil Society exists, and distributing
government owned property evenly is difficult
 In addition, there is little understanding by
the populace of free market economy values
 Eastern Germany has probably done the best,
with Poland a close second.
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Critical Thinking Question
In the 1990s, many Eastern European
countries moved from command to
market economies.
 1) HST link: What political
developments made this possible?
 2) What problems did people in these
countries face as the made the change?
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Section 1 Review
1. In a socialist country,
– (a) central planning is unnecessary.
– (b) the government often owns major industries,
such as utilities.
– (c) an authoritarian government controls the
economy.
– (d) economic equality is not important.
2. Which of the following is an advantage of a centrally
planned economy?
– (a) The system’s bureaucracies are small and
flexible.
– (b) The system can work quickly to accomplish
specific goals.
– (c) Innovation is well rewarded.
– (d) Consumers’ needs are well met.
Did You Know?
The Fair Labor Standards Act of 1938
set the nation’s minimum wage at 25¢.
 Debate has raged for years about what
an acceptable minimum wage should
be—should it be a “living wage?”
 The answer to questions like this
depends on a society’s economic goals.
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Economic Goals
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Economic Freedom—Little government intervention in
the production and distribution of goods and services,
allows people to make their own economic decisions
Economic Stability—avoiding wide swings in prices,
wages, unemployment, etc.
Economic Equity—fair distribution of wealth (has not
been achieved in US)
Economic Equality—everyone has equal opportunity to
participate in free market, buying and selling
Economic Security and Predictability--Assurance that
goods and services will be available, payments will be
made on time, and a safety net will protect individuals
in times of economic disaster (Welfare, FDIC)
More Economic Goals
Economic Growth and Innovation--Innovation
leads to economic growth, and economic
growth leads to a higher standard of living.
 Economic Efficiency-Making the most of
resources
 Other goals: Environmental Protection, Using
Economics to reach political/military goals (US
selling grain to USSR in 1970s to coerce USSR
into behaving better)
 Full Employment—providing as many jobs as
possible. (See next slide)
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Unemployment
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It’s impossible for every member of the workforce to
be employed. Bad times often coincide with market
failure-- a situation in which the market, on its own,
does not distribute resources efficiently
Rate is higher among non-whites and males
Frictional and structural unemployment:
Frictional: between jobs
Structural: you don’t have necessary skills
Full employment: ~4.5% unemployment
During World War II, 1% unemployment-overemployment
Group Activity
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In groups of 4, take on the role I assign you and
decide what the US’s economic goals should be.
Roles:
CEO of large company, middle-aged
Single mother on welfare
Teenagers
College Student
Environmental activist
Elderly couple
YUPpy couple
We will discuss these with 15 mins left
Key Concept: Which economic goals conflict?
Competition and Free Enterprise
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Capitalism is a market economy in which private
citizens own the factors of production. In a free
enterprise system, there is limited government
interference and businesses are free to compete,
within reason (NO monopolies though)
During voluntary exchanges, buyers and sellers are
free to decide whether or not to complete
transactions. To complete a transaction, both must
usually agree that the good or service obtained is of
more value than the money or product given up
Private property rights give people the motivation to
succeed because they can keep rewards they earn
The profit motive encourages entrepreneurship
Competition helps lower prices and improve allocative
efficiency
Economic systems have 2 parts:
Public sector
Government spending/investments
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A public good is a shared good or
service for which it would be
impractical to make consumers pay
individually and to exclude
nonpayers.
 EX: Government buys F-22 fighters
 Quasi-Public goods are either
contestable or price-excludable
 EX: Government funds Amtrak; you
may decide not to ride
 EX: Mackinac Bridge toll
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Private
Sector
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Consumer
spending
EX: You buy
any product
or service
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The Free-Rider Problem
A free rider is someone who would not choose to pay
for a certain good or service, but who would get the
benefits of it anyway if it is provided as a public good.
 EX: You don’t want money spent on a new highway,
but when it’s built, you use it during your commute to
work
 Answer: Fee-based system
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The Role of Economic Participants in Capitalism
Entrepreneurs use land, capital, & labor to make profits
 The consumer has much power in a free market
economy. Consumers influence producers through their
buying decisions. Consumers influence the
government’s economic policies through voting and
other techniques. People in 2001 wanted a tax cut, less
spending, elected George W. Bush
 Both consumers and producers are dependent upon
each other.
 EX: Consumer desires size 16.5- 38 dress shirts.
Entrepreneur may decide tall people don’t represent
much of a market, so the entrepreneur won’t make tall
dress shirts. If entrepreneurs want to sell product,
however, they must offer clothing that fits.
 But what is the role of government???????????????
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The Role of Government
What is government’s role in a capitalistic society?
 Answer: Depends on your political orientation
 Liberals: Favor big, all-powerful government, protect
environment and less pro-business
 Conservatives: “the government that governs least governs
best,” preserve initiative, reward success, sink or swim on your
own
 DO NOT confuse with “economic liberal”: favors free trade,
government noninterference, laissez-faire
 Laissez faire is the doctrine that government generally should
not interfere. Americans have traditionally favored economic
freedom over economic regulation
 Governments create laws protecting property rights and
enforcing contracts. They also encourage innovation through
patent and copyright laws.
 Patent=allows you to exclusively produce an invention.
 Copyright=intellectual and artistic work protection
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Japan’s “Role of Government”
Japan is an advanced Western Capitalistic society
 But its government is much more active in the economy that
many capitalist governments
 Japan’s early success was due to management style and
willingness to embrace technology
 The government enacted Protective Tariffs to help these
industries develop, but it never got rid of them. Japan’s
economy is closed by non-tariff barriers as well.
 Protectionism in Japan, however, is hurting consumers and the
Japanese economy
 A 1990s banking crisis has still not been dealt with.
 The Japanese economy has been sick since 1990-91.
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Policy and Technology Review
1. Policymakers encourage all of the following EXCEPT
– (a) stable productivity.
– (b) high employment.
– (c) stable prices.
– (d) steady growth.
2. The government encourages advances in technology
and improvements in productivity by
– (a) maintaining steady price controls.
– (b) funding research and development projects at
many levels.
– (c) hiring more workers to reduce unemployment.
– (d) regulating banks and other financial institutions.
Government’s Role in a Mixed Economy
Market economies, with
all their advantages,
have certain
drawbacks. In a mixed
economy, the
government purchases
goods and services in
the product market,
and purchases land,
labor, and capital from
households in the
factor market.
Product market
Factor market
Protecting Health, Safety, and Well-Being
Many federal
agencies regulate
industries whose
goods and services
affect the wellbeing of the public.
Consumers are also
aided by public
disclosure laws,
which require
companies to give
consumers full
information about
their products.
Major Federal Regulatory Agencies
Agency and Date Created
1906 Food and Drug
Administration (FDA)
Role
Sets and enforces standards for food, drugs,
and cosmetic products
1914 Federal Trade
Commission (FTC)
Enacts and enforces antitrust laws to protect
consumers
1934 Federal Communications
Commission (FCC)
Regulates interstate and international communications
by radio, television, wire, and satellite, and cable
1958 Federal Aviation
Administration (FAA)
Regulates civil aviation, air-traffic and piloting
standards, and air commerce
1964 Equal Employment
Opportunity Commission (EEOC)
Promotes equal job opportunity through enforcement
of civil rights laws, education, and other programs
1970 Environmental Protection
Agency (EPA)
Enacts policies to protect human health and the
natural environment
1970 Occupational Safety and
Health Administration (OSHA)
Enacts policies to save lives, prevent injuries, and
protect the health of workers
1972 Consumer Product Safety
Commission (CPSC)
Enacts policies for reducing risks of harm from
consumer products
1974 Nuclear Regulatory
Commission
Regulates civilian use of nuclear products
Fiscal Redistribution
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Def’n: “Robin hood”: Taking money from the wealthier
members of society and giving it to less well-off members in a
variety of different ways
The poverty threshold is an income level below that which is
needed to support families or households.
The poverty threshold is determined by the federal government
and is adjusted periodically. Currently $20,000 for a family of 4.
US poverty is RELATIVE poverty, much of the world is
ABSOLUTE.
# OF POOR IN WORLD HAS ACTUALLY DECLINED SINCE 1980
Welfare is a general term that refers to government aid to the
poor.
Welfare is funded by taxing the non-poor. Cash redistribution is
usually in the form of transfer payments
Redistribution Programs
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1. Temporary Assistance for Needy Families (TANF)
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This program allows individual states to decide how to
best use federally provided funds.
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2. Social Security
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Social Security provides direct cash transfers of
retirement income to the nation's elderly and living
expenses to the disabled.
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3. Unemployment Insurance
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Unemployment compensation provides money to
eligible workers who have lost their jobs.
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4. Workers' Compensation
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Worker's compensation provides a cash transfer of
state funds to employees injured while on the job.
Other Redistribution Programs
Besides cash transfers, other redistribution programs
include:
• In-kind benefits
In-kind benefits are goods and services provided
by the government for free or at greatly reduced
prices. (Free school lunches)
• Medical benefits
Health insurance is provided by the government
for the elderly and disabled (Medicare) and for
poor people who are unemployed or are not
covered by their employer’s insurance (Medicaid).
• Education benefits
Federal, state, and local governments all provide
educational opportunities for the poor.
Government Involvement Quiz
1. Welfare includes all of the following EXCEPT
– (a) Temporary Assistance to Needy Families.
– (b) Occupational Safety and Health Administration.
– (c) Social Security.
– (d) Medicaid.
2. Education programs make the economy more
productive by
– (a) adding to human capital and labor productivity.
– (b) reducing taxes.
– (c) providing more jobs in manufacturing.
– (d) reducing injuries on the job.
Fiscal and Monetary Policy
Government can affect the performance of the economy
and the allocation of resources. It can:
 Impose TAXES (luxury tax on yachts, gas guzzler tax on
Vipers, “Sin tax” on cigarettes
 Outlaw certain products
 Spend more or less (change FISCAL POLICY)
 Alter the amount of money in the economy (MONETARY
POLICY)
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A business cycle is a period of macroeconomic growth
followed by a period of contraction. Government can
adjust interest rates to stave off recession or inflation
We will revisit all of these concepts later
Externalities
An externality is an economic side effect of a good or service
that generates benefits or costs to someone other than the
person deciding how much to produce or consume. Often the
result of incomplete property rights (Who owns the air?)
 Property rights must be 1) Clearly defined 2) Well-enforced 3)
Transferable
 EX: Chemical company produces DDT, dumps waste into river.
 But externalities can be positive
 EX: “Anchor stores” in malls generate traffic. As a result, they
often pay zero rent!
 EX: Bees benefit more than beekeepers—beekeepers and
orchard owners can work together. Symbiotic relationship is
necessary.
 The goal: Marginal social benefits = Marginal social cost
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Save the Whales Activity
Externalities: An Example
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The building of a new dam/creation of a lake generates:
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Positive Externalities
a possible source of hydroelectric power
swimming
boating
fishing
lakefront views
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Negative Externalities
loss of wildlife habitat due to flooding
disruption of fish migration along the river
overcrowding due to tourism
noise from racing boats and other watercraft
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Critical Thinking Question
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What would be some positive externalities and
negative externalities of a city deciding to permit
Dow Chemical to build a brand new manufacturing
facility?
Positive: Jobs, tax revenue for the city, property
values might increase (due to need for housing
workers—shortage)
Negative: Pollution, health problems, property values
may decrease
Government tries to encourage positive
externalities (subsidies for ethanol) and limit
negative externalities (taxation) to avoid an
underallocation or overallocation of resources
Think about this…
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The market system we have in the United
States is so efficient that…
We make things like Beanie Babies—that we
don’t even use!
 98% of the poor own a color TV
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In a capitalistic system, the only way I can
become wealthy is by improving everyone
else’s standard of living.