“Introduction to Economic Systems”
Critical Questions
• What key economic questions must
every society answer?
• What basic economic goals do societies
have?
• What types of economic systems exist
today?
What is an economic system?
The method used by a
society to produce and
distribute goods and
services
The Three Questions that Determine
a Societies Economic System
Because ALL economic resources are scarce,
every society must answer three questions:
– What goods and services should be
produced?
• Guns or butter?
– How should these goods and services be
produced?
• What combination of factor resources
should we use?
– Who consumes these goods and
services?
• How will income be distributed?
Four Economic Systems
An economic system is the method used by a society
to produce and distribute goods and services.
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 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.
Mixed economies are
systems that combine the
free market with limited
government intervention.
The Free Market System (a.k.a. Capitalism)
Why do markets exist?
Markets exist because none of us produces
all the goods and services we require to
satisfy our needs and wants.
A market is an arrangement that allows
buyers and sellers to exchange goods and
services.
Specialization is the concentration of the
productive efforts of individuals and firms on a
limited number of activities.
Free Markets
Circular Flow Diagram of a Market Economy
• In a free market
economy, households
and business firms use
markets to exchange
money and
products.
Households
• Households
own the factors
of production
and consume goods and
services.
monetary flow
physical flow
Firms
physical flow
monetary flow
Comparing Economic Systems
Economic System
Who answers the 3 ?’s
•
•
•
•
•
•
•
•
Traditional
Market
Centrally Planned
Mixed
Custom
Individuals
Central Government
Individuals with some
government
involvement
Economic Goals
Societies answer the three economic questions based on their goals
and values.
Economic Goals
Economic Goals
Economic efficiency
Making the most of resources
Economic freedom
Freedom from government intervention in
the production and distribution of goods
and services
Economic security
and predictability
Assurance a safety net will protect
individuals in times of economic disaster
Economic equity
Fair distribution of wealth
Economic growth
and innovation
Other goals
Innovation leads to economic growth, and
economic growth leads to a higher
standard of living.
Environmental protection, variety
Free Markets
 A purely free market can rarely exist, but in theory a
market economy would answer the three economic
questions through a system of exchange and trade.
 In this system, supply and demand determine prices
and prices serve as signals to both producers and
consumers.
 Advantages: Freedom, Efficiency, Growth, Flexibility,
Variety
 The core factors that allow a market system to work
efficiently:
1.
2.
3.
Profit motive
Flow of information
Accurate price levels
“The Father of Economics”
Adam Smith (1723-90)
• Laissez Faire Economic
Theory/Free Enterprise
• Scottish social
philosopher/professor
• “The Wealth of Nations” (1776)
• 10 years to write/5 volumes
• Established Economics as its own
discipline
Core Principles of Adam Smith
On the Division of Labor … the “Assembly Line Model”
Increase in quantity of work
1. Dexterity of workers
2. Saves time: no switch from one activity to the next
3. Machines replace manual labor
Division of physical and mental labor/professional specialization = expertise
Increased productivity = increased wealth for everyone
Motivation for labor
Disposition to barter
Invisible Hand of the Marketplace: highest quality and quantity of goods
produced
Differences in talents are placed in the marketplace
NPR
Adam Smith and the Invisible Hand
• In every transaction, the buyer and seller
consider only their self-interest, or their own
personal gain. Self-interest is the motivating
force in the free market.
• Producers in a free market struggle for the
dollars of consumers. This is known as
competition, and is the regulating force of the
free market.
• The interaction of buyers and sellers, motivated
by self-interest and regulated by competition, all
happens without a central plan. This
phenomenon is called “the invisible hand of the
marketplace.”
Back to
Principles
Potential Problems
in Free Markets
1.
2.
3.
4.
The provision of public goods and services
Income inequalities
Existence of shortages and surpluses
Existence of negative externalities
Centrally Planned Economies
Definition ~The government, or a central authority,
controls the factors of production.
Modern Day Forms of Central Planning:
– Socialism~ a social and political philosophy based
on the belief that democratic means should be used
to distribute wealth evenly throughout a society.
– Communism~ a political system characterized by a
centrally planned economy with all economic and
political power resting in the hands of the
government. Communist governments are
authoritarian in nature.
Communist Theory (Today, Marxism):
Karl Marx (1818-1883)
• German philosopher, political economist and historian
• Developed radical approach to understanding and coping
with the problems that occurred in free market systems,
namely the Industrial Revolution
• Published the Communist Manifesto in 1848 with Engels
• He argued that history is a series of class struggles between
the rich capitalists and the working class.
• He believed that eventually workers needed to unite and
revolt against the capitalists. This revolution would then
breed a classless society.
Advantages and Disadvantages of
Centrally Planned Economies
Advantages
Disadvantages
1. Public goods and services
provided by the state (i.e.
healthcare, education,
housing)
2. Wasteful competition is
avoided
3. Peaceful labor conditions
4. Welfare of citizens is the
primary goal of the state
5. Business cannot act against
the interest of the people
1. Poor-quality goods and
shortages
2. Failure to meet set ideals/
consumer needs
3. Lack of incentive to work
hard
4. Lack of innovation
5. Expensive and inflexible
government
6. Sacrifice of individual
freedoms for society
Mixed Economies
• Most modern economies mix features of both systems
(centrally planned and free market).
• An economic system that permits the conduct of business
with minimal government intervention is called free
enterprise. This is the system that exists in the United
States.
American Free Enterprise (Freedom vs. Protection)
• Americans have favored economic freedom over economic
regulation, but we still expect the government to protect us
from the problems that can exist in free markets.
• All Americans act to decide when the benefits of
government protection outweigh the drawbacks to free
Advantages and Disadvantages of the
American System
Advantages
Disadvantages
1.
2.
3.
4.
5.
6.
7.
1. Unemployment (Types,
Calculation)
2. Inflation (CPI, Causes)
3. Poverty (Determinants,
Programs)
4. Dangerous business
practices See additional
Freedom
Competition
Contracts
Self Interest
Profits
Private Property
Voluntary Exchange
slides for more
detail on #1-3
Types of Unemployment
1.
2.
3.
4.
Frictional Unemployment- Occurs when people change jobs,
get laid off from their current jobs, take some time to find the
right job after they finish their schooling, or take time off from
working for a variety of other reasons
Structural Unemployment- Occurs when workers' skills do not
match the jobs that are available. Technological advances are
one cause of structural unemployment
Seasonal Unemployment- Occurs when industries slow or shut
down for a season or make seasonal shifts in their production
schedules
Cyclical Unemployment- Unemployment that rises during
economic downturns and falls when the economy improves
Unemployment Rates
•A nation’s unemployment rate is an
important indicator of the health of the
economy.
•The Bureau of Labor Statistics polls a sample
of the population to determine how many
people are employed and unemployed.
•The unemployment rate is the percentage of
the nation’s labor force that is unemployed.
Going….UP!!!!!!!!!!
• Inflation is a general increase in
prices.
• Purchasing power, the ability to
purchase goods and services, is
decreased by rising prices.
To Market, To Market
•
•
•
•
A price index is a measurement that shows how the average price of a standard group of
goods changes over time.
The consumer price index (CPI) is computed each month by the Bureau of Labor Statistics.
The CPI is determined by measuring the price of a standard group of goods meant to
represent the typical “market basket” of an urban consumer.
There are over two hundred categories of products that are included in the basket. These
categories fall under 8 major groups:
FOOD AND BEVERAGES
HOUSING
APPAREL
TRANSPORTATION
MEDICAL CARE
RECREATION
EDUCATION AND COMMUNICATION
OTHER GOODS AND SERVICES
Inflation Theory
• Quantity Theory
– Too much $ in the economy
• Demand-Pull
– Demand exceeds supply
• Cost-Push
– Increased input costs for the
supplier
Danger…Prices on the Rise
High inflation is a major economic problem, especially
when inflation rates change greatly from year to year.
The three main problems are:
–Reduced Purchasing Power
–Erosion of Interest Income
–Erosion of Wages/Income
The Poverty Problem
Although the free market is the most
successful economic system at producing
wealth—distribution is HIGHLY uneven.
The poverty threshold is an income level
below what is needed to support families or
households. What is the current
threshold?!?!?!?!?!?!!??
POVERTY...THE FORGOTTEN STATE
What factors contribute to poverty?
Lack of jobs
Lack of educational opportunities
Changes in family structure
Economic shifts
Racial and gender discrimination
Culture of poverty
Who does the government provide
a safety net for?
Elderly
Disabled
Children
Poor
Welfare Programs
Welfare is a general term that refers to
government aid to the poor
1930’s- Under Roosevelt the government
began welfare programs to reduce the
impact of the Great Depression.
1960’s- Lyndon Johnson launched the
“War on Poverty”
1990’s- Clinton transformed welfare
program to Temporary Assistance to Needy
Families (TANF)
Redistribution Programs
Type of Program
Description
Example
Cash Transfers
Direct payment of cash to qualifying Temporary
individuals
Assistance to
Needy
Families
Unemployment
Compensation
In-Kind Benefits
Goods and services for free or
reduced prices
Subsidized
housing
Medical Benefits
Health insurance to those that cannot Medicare
provide it for themselves
Medicaid
Education Benefits
Federal, state, and local government
all provide money for the poor and
disabled to ensure all people receive
educational opportunities.
Head Start
Food Stamps
Pell Grants
Example