The Three Key
Questions for
Economic
Systems
Why are some countries rich and others poor?
Low, Middle and High Income
Institutions, institutions,
institutions
• The answer to our question seems to lie in the
political and legal institutions of each nation
– Rule of law—what you own depends not on force
or who you know, but is protected by law that treat
all persons equally
– Private property rights—the rights to use and sell
resources are clearly defined, cheaply enforceable,
and fully transferable
– Open markets—people are free to buy and sell
when, where and to or from whom they wish,
including citizens of other nations
Effects of institutions
• Secure property rights, rule of law, and open
markets encourage people to make long term
investments in human and physical capital
– Education, buildings, innovation, land quality,
infrastructure, etc
– These investments raise the capital stock—both
physical and human capital stocks
– This in turn generates income over the long run,
raising living standards and human well being
Key Assumptions in Economics
• People are rationally self-interested
– They seek to maximize their utility
• People generally make decisions at the margin
– They weigh the marginal benefit against the marginal
cost of a decision
• Ceteris Paribus
– Economists hold factors constant, except for what’s being
considered
Three Economic Questions
•
Every society must answer three economic
questions…
1. WHAT?
2. HOW?
3. FOR WHOM?
•
How that society answers the questions
determines which type of economic system
that society employs
WHAT TO PRODUCE?
• WHAT goods and services
will be produced with the
available resources?
Resources a.k.a. The Factors of
Production
•
Economists classify resources into 4 categories
1.
Land
•
•
2.
Natural resources
The payment for Land is RENT
Labor
•
•
3.
Human resources
The payment for Labor is WAGES
Capital (a product of Investment)
•
•
4.
Tools, machines, factories
The payment for Capital is INTEREST
Entrepreneurship
•
•
The special ability of risk-takers to combine land,
labor and capital in new ways in order to make profit
The payment for Entrepreneurship is PROFIT
Check for Understanding
Now that you know these terms, let’s see if we can use them to solve sort
these factors. At the top of a paper write Natural Resources , Human
Resources and Capital Goods . Place these items under the correct
heading.
• Delivery Truck
• Factory
• ATM machine
• River
• Gold
• Teacher
• Tree
• Bushel of corn
• Hair stylist
• Barrel of oil
Do we all agree on the placement of these items?
Factors cont’d
Let’s consider some other questions about
productive resources.
• Are the factors interdependent? (In other words,
do the factors affect one another?)
• Land is considered a “passive” factor. Why?
• How do capital and labor differ from land?
Answer Key
Natural
Resources
Human
Resources
• Tree
• Bushel of
corn
• River
• Gold
• Barrel of oil
•
•
•
•
•
Capital Goods
• Delivery
Teacher
truck
Hair stylist • Factory
Doctor
• ATM
machine
Farmer
• Bulldozer
Factory
worker
• Tractor
HOW TO PRODUCE?
• HOW will the available
resources be combined to
produce goods and services?
FOR WHOM TO PRODUCE?
• WHOM will be the
consumer of the product or
service?
Three Economic Systems
• Command Economies
• Traditional Economies
• Market Economies
MARKET ECONOMIES
• Answer the key questions by a system of supply and
demand. (in other words, it allows buyers and sellers
to voluntarily exchange things)
• The ability of markets to coordinate economic activity
is emphasized by Adam Smith in
“The Wealth of Nations.”
– This is what he referred to as
the Invisible Hand
The Invisible Hand
...every individual necessarily labours to render the annual
revenue of the society as great as he can. He generally,
indeed, neither intends to promote the public interest, nor
knows how much he is promoting it. By preferring the
support of domestic to that of foreign industry, he intends
only his own security; and by directing that industry in such
a manner as its produce may be of the greatest value, 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.
I have never known much good done by those who affected
to trade for the public good.
Invisible Hand
• What is Adam Smith basically saying with
this passage?
– If individuals are allowed to pursue their own selfinterest, then the often times the result will be a
more efficient economy. There is NO PLANNING
• What do you think Adam Smith envisioned as
the role of Government in the economy?
COMMAND ECONOMIES
• Answer the key questions through a central
authority made up of an individual or a
number of individuals who make the decisions
of what to make, how to make it, and for whom
things should be made. (Self-Interest and
Competition are absent)
– Communism
– Socialism
TRADITIONAL ECONOMIES
Answer the key questions by relying on past
customs and practices:
“The Inuit of northern Canada serve as a prime
example of a traditional economy. For thousands of
years, the Inuit parents have taught their children the
survival skills needed to survive in the Arctic Circle's
severe climate. The children are taught to fish, hunt,
and make effective tools. Once learned, these skills
are passed down to the next generation.”
Activity
• Need four volunteers…
– Round 1:
• Part A: when I say go you can try and grab as many
paper clips as possible…for every paper clip that you
grab you will 1 m and m
Activity
– Round 2:
• Part B: when I say go you can try and grab as many
paper clips as possible from your section…for every
paper clip that you grab you will get 1 m and m
Activity
• Discuss what just happened
• On a scale of 1 to 10 (1 being completely
Command Economy & 10 being a Market
Economy); where would you place the United
States?
Economic Spectrum
On a scale of 1 to 10 (1 being completely
Command Economy & 10 being a Market
Economy); where would you place the United
States?
In the United States we have what
is known as a MIXED
ECONOMY…in fact pretty much
every country is a mixed economy
combining aspects of command
and market economies.
1
The United States probably
would lie around 7 and 8
10
Goals of Economic Systems
• Efficiency (maximize what you have)
• Freedom (ability to make choices)
• Security (goods/services will always be
available)
• Equity (Fairness, Opportunity)
• Growth (Economy must grow with population;
innovation)
TANSTAA“F”L
There Ain’t No Such Thing As A
“FREE” Lunch
• NOTHING ON THIS EARTH IS FREE!!!!!
EVERYTHING HAS A PRICE…IN
THE EYES OF AN ECONOMIST!
TANSTAAFL Illustrated: The PPC
• The PPC = The Production Possibilities Curve
• The PPC = a graph showing all of the possible
combinations of output for an economy fully
employing all of its resources in producing 2 goods.
TANSTAAFL Illustrated: The PPC