Economic Systems

Unit 2

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? Examples

How should these goods and services be produced?

Examples

Who consumes these goods and services?Examples

Economic Goals

Economic Goals

Making the most of resourcesEconomic efficiency

Freedom from government intervention in the production and distribution of goods and services

Economic freedom

Assurance a safety net will protect individuals in times of economic disaster

Economic security and predictability

Fair distribution of wealthEconomic equity

Innovation leads to economic growth, and economic growth leads to a higher standard of living.

Economic growth and innovation

Environmental protection, varietyOther goals

Societies answer the three economic questions based on their goals and values.

Economic Goals

An economic system is the method used by a society to produce and distribute goods and services.

4Economic 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 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.

Comparing Economic SystemsEconomic System

Traditional Market Centrally Planned Mixed

Who answers the 3 ?’s

Custom Individuals Central Government Individuals with

some government involvement

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.

The Free Market System (a.k.a. Capitalism)

Free Markets In a free

market economy, households and business firms use markets to exchange money and products.

Households own the factors of production and consume goods and services.

monetary flow

physical flow

monetary flow

physical flow

Circular Flow Diagram of a Market Economy

Households Firms

“The Father of Economics” Adam Smith (1723-90)

Laissez FaireScottish social

philosopher/professor “The Wealth of Nations”

(1776) 10 years to write/5

volumesEstablished Economics as

its own discipline

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

Advantages of the Free Market

1. Freedom2. Efficiency3. Growth and Innovation4. Variety of Goods and Services

Centrally Planned Economies

Definition ~The government, or a central authority, controls the factors of production.

Organization of Centrally Planned SocietiesModern 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

historianDeveloped 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.

Philosophy Becomes Reality: The Soviet Union

In 1917, the ideas proposed by Marx would become a “reality”.

The Bolshevik Revolution, led by communist Vladimir Lenin, would result in a centrally planned society.

The Soviet Experiment Factors of production were all controlled by

the state. The best resources were allocated to the

armed forces, space program, and production of capital goods.

Government committees decided the quantity, process and distribution of all products.

The government created large state-owned farms and collectives to produce all agricultural products.

There was little incentive to produce, and the Soviet Union saw a decline in the production of agricultural goods.

Advantages and Disadvantages of Centrally Planned EconomiesAdvantages 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 innovation5.Expensive and

inflexible government6.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 and most industrialized nations throughout the world.

How do mixed economies differ? For example consider the United States and France.

American Free Enterprise (Freedom vs. Protection)Tradition of Free Enterprise

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 enterprise.

The Role of the American Consumer

Constitutional Protections Property RightsContracts Taxation

RolesConsumerVoter

The Role of Government1. Protect the Public Interest 2. Provide Information 3. Promote Growth and Stability

PovertyKey Indicators of Economic Health

Inflation

Employment

Gross Domestic Product

Gross Domestic Product The main indicator used to determine

overall health of the economy is gross domestic product (GDP) which is the dollar value of all final goods and services produced within a country’s borders in a given year.

This will allow them to better determine upcoming business cycles to determine prosperity, recession or depression.

Limitation of GDP1. Non-market activities2. Underground economy3. Quality of life

GDP vs. GNPAnnual income earned by

US owned firms and citizens.

Types of Unemployment• 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.

Getting Everyone To Work!!!!Economists generally agree that in an

economy that is working properly, an unemployment rate of around 4 to 6 percent is normal.

Sometimes people are underemployed, that is working a job for which they are over-qualified, or working part-time when they desire full-time work.

Discouraged workers are people who want a job, but have given up looking for one.

Full employment is the level of employment reached when there is no cyclical unemployment.

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.

What is in the basket?There are over two hundred categories of products that are

included in the basket. These categories fall under 8 major groups:

1. FOOD AND BEVERAGES

2. HOUSING

3. APPAREL

4. TRANSPORTATION

5. MEDICAL CARE

6. RECREATION

7. EDUCATION AND COMMUNICATION

8. OTHER GOODS AND SERVICES

Inflation TheoryQuantity Theory

• Too much $ in the economy

Demand-Pull• Demand exceeds supply

Cost-Push• Increased input costs for the supplier

Impact of InflationHigh inflation is a major economic problem,

especially when inflation rates change greatly from year to year. The three main problems are:

1. Reduced Purchasing Power2. Erosion of Interest Income 3. Erosion of Wages/Income

The Poverty ProblemAlthough 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

Who does the government provide a safety net for?

ElderlyDisabledChildren Poor

Welfare Programso Welfare is a general term that refers

to government aid to the pooro 1930’s- Under Roosevelt the

government began welfare programs to reduce the impact of the Great Depression.

o 1960’s- Lyndon Johnson launched the “War on Poverty”

o 1990’s- Clinton transformed welfare program to Temporary Assistance to Needy Families (TANF)

Redistribution ProgramsType of Program

Description Example Example

Cash Transfers Direct payment of cash to qualifying individuals

Temporary Assistance to Needy Families

Unemployment Compensation

In-Kind Benefits Goods and services for free or reduced prices

Food Stamps Subsidized housing

Medical Benefits Health insurance to those that cannot provide it for themselves

Medicare Medicaid

Education Benefits

Federal, state, and local government all provide money for the poor and disabled to ensure all people receive educational opportunities.

Pell Grants Head Start