Economic Systems · Yeltsin’s reaction was understandable. By the late 1980s, the state-run Soviet economy was in shambles. Consumer goods were scarce. People had to wait in long

Economic SystemsWho or what decides what you get?

Vocabulary

Glossary VocabularyCards

economic equity

economic system

traditional economy

command economy

market economy

factor payment

mixed economy

free enterprise system

Introduction

E C O N O M I C S Y S T E M S

2020 Teachers' Curriculum Institute Level: A

The U.S. economy offersgrocery store customers anabundance of choices.

It is a Saturday afternoon, and across the United States, supermarketsare hopping and parking lots are full. Inside, brightly lit shelves areneatly stocked with every imaginable foodstuff and household item.Shoppers maneuver their carts through the aisles, deciding whichproducts to buy from a seemingly endless array of choices.

In 1989, Boris Yeltsin, a popular political leader from the Soviet Unionand former chief of the Moscow Communist Party, visited asupermarket in Houston, Texas. It was one of many stops on a two-week tour of the United States.

To Yeltsin, the sight of ordinary people doing their weekly groceryshopping was anything but ordinary. In fact, to someone who had livedhis whole life under communism, it was a revelation. A local newspaperreported that Yeltsin wandered the aisles, shaking his head inamazement. He sampled cheese and produce. He stared at the meatdisplays. He stopped customers to ask about the items in their cartsand how much they cost. He asked the manager whether specialtraining was necessary to run a supermarket.


Level: A 2020 Teachers' Curriculum Institute

Yeltsin’s reaction was understandable. By the late 1980s, the state-runSoviet economy was in shambles. Consumer goods were scarce. Peoplehad to wait in long lines to buy food and other necessities. Storeshelves were frequently empty of all but one or two poorly made goods.Even the privileged Communist Party elite did not enjoy suchabundance as could be found in the average American supermarket.The stark contrast between American and Russian living standards was,as Yeltsin later wrote, “shattering.”

When I saw those shelves crammed with hundreds,thousands of cans, cartons, and goods of every possiblesort, for the first time I felt quite frankly sick with despairfor the Soviet people. That such a potentially super-richcountry as ours has been brought to a state of suchpoverty! It is terrible to think of it.

— Boris Yeltsin, Against the Grain, 1990

The visit confirmed for Yeltsin the painful truth about the Sovieteconomic system: it was a complete failure. In Houston and otherAmerican cities, he saw a very different economic system at work.

In this lesson, you will explore different economic systems. You willlearn how each one functions and who makes the decisions in each typeof economy. You will also learn why some types of economy havesucceeded while others have failed.

1. Who Gets What? How DoSocieties Decide?If resources were unlimited, we all could have whatever we want. Butresources are limited, so people must make choices about what to haveand what to give up. This also forces societies to make choices. Thelarger and more advanced a society is, the more numerous andcomplex these choices may be.

The Three Fundamental Economic Questions: What to Produce,How, and for Whom? In deciding how to allocate limited resources,every society—from a tribe of people living in the Kalahari Desert to amodern industrial nation like the United States—must answer threefundamental economic questions. Each society answers thesequestions differently depending on its priorities. The questions,however, are the same for everybody.



What goods and services are to be produced? Because resourcesare limited, no society can produce everything its people might want.This raises the question: What goods and services are most wanted andneeded? For example, should the United States conserve wildernessareas for recreational purposes or open them up to logging or oilexploration? Should the U.S. steel industry produce more car parts ormore beams for skyscrapers? What do consumers want or need more:sneakers or diapers? Teachers or dentists? Books or video games? Withmillions of possible products and many different interests competing forthe same limited resources, the choices seem endless.

Even the simplest societies face difficult choices. Vanuatu is a nation ofseveral small islands in the South Pacific. Vanuatu’s economy has longdepended on agriculture, but tourism is growing in importance. Thequestion looming over Vanuatu’s people is about what will benefit themmore—putting more resources into growing food or expanding touristservices? As a society, Vanuatuans must decide.

How are goods and services to be produced? The answer to thisquestion is not as simple as it may seem. You know that goods andservices are produced by combining the factors of production: land,labor, and capital. But how exactly is this done and in whatcombination?

Because the people of Vanuatu live on a series of small islands, one oftheir most scarce resources is land. They must make the economicchoice of using their limited land for tourism or agriculture.



Consider wheat production. How should land, labor, and capital be usedto raise this essential grain? Should wheat be grown mainly on giantfactory farms? That is the way an American agribusiness raises wheat.But in a different society, wheat might be grown on smaller familyfarms. Think about another example: hats. Should hats be craftedindividually, by hand, or in factories by machines? Each society has todecide for itself the answer to these questions.

At this point, you are probably wondering why a society as a whole hasto make decisions about hats. Don’t hat manufacturers decide how toproduce headwear? In the United States, they do, but that is becauseour society gives them that choice. Not all societies work this way.

For whom are goods and services to be produced? In otherwords, who gets what? This last question is a difficult one to answerbecause it raises the complicated question of fairness: who deserveswhat? Again, every society finds its own answer.

Goods and services are distributed in a variety of ways. The ability topay is the approach most of us know best. It essentially says thatanyone who can afford to buy a hat can have one.

Another approach is equal distribution. This approach was adopted bythe Soviet Union before its collapse. Unfortunately, goods were in suchshort supply that lines formed for everything. Instead of distributinggoods equally, the system favored those who got in line early and hadtime to wait. As a result, some people got more than their share, whileothers got nothing.

This brings us to yet another form of distribution: first come, firstserved. As in the Soviet Union, this approach often prevails whenquantities are limited. Goods such as concert and theater tickets areusually sold this way.

In addition, there is distribution according to need. A soup kitchen doesthis when it provides meals to the homeless. So, does a public schoolthat provides classroom aides for special education students.



A Society’s Answers Depend on Its Economic Goals The waythat a society answers the three economic questions will depend on itseconomic goals and social values. Most societies try to address some orall of the following six economic goals.



In a society that valueseconomic freedom, peopleare free to own, buy, and sellproperty. Sellers are also freeto decide what price they arewilling to set.

Economic freedom. In our society, we place a high value oneconomic freedom—the ability to make our own economic decisionswithout interference from the government. When you choose to buysomething, whether it is a new game or a used car, you are exercisingthis freedom. If you choose to sell your car or go into business sellingcars or anything else, you are exercising this freedom. A society thatvalues economic freedom gives individuals and businesses the right tomake decisions about how to use their resources, without governmentintervention.

Economic efficiency. An efficient economy makes the most of asociety’s resources. It delivers the goods by allocating resources insuch a way that the greatest number of consumers get what they wantwith the least amount of waste. Because unemployed workers are awasted resource, an efficient economy strives for full employment,which exists when all who want to work can find jobs.

Economic equity. The term equity concerns fairness and justice.Economic equity involves the fair and just distribution of a society’swealth. A society that values economic equity seeks to give everyone afair share of the economic pie. But what constitutes a fair share? Is itfair that corporate executives make millions of dollars while retailworkers earn minimum wage? Is it fair that women, collectively, tend toearn less than men? People often disagree on questions of equity,which makes it a difficult goal to achieve.



Economic growth. An economy is said to grow when it produces moreand better goods and services. Economic growth is desirable becauseover time it leads to an improved standard of living. A century ago,middle-class Americans lived without cars, electricity, kitchenappliances, and indoor plumbing (not to mention antibiotics, frozenfoods, and the internet). A key element of economic growth is scientificand technological innovation. New ideas and inventions bring new andimproved products into the market, creating economic growth andraising living standards.

Economic security. Every society has people who cannot provide forthemselves. They may be too young, too old, too sick, or too poor tomeet all of their basic needs. A society that puts a high value oneconomic security seeks to provide its less fortunate members withthe support they need in terms of food, shelter, and health care inorder to live decently. This is another economic goal in which peopleoften disagree. For example, in the United States, access to affordablehealth insurance, which most people need to pay for healthcare, differsfrom state to state. Even when Americans agree that access to healthcare should be provided to everyone, they do not agree on how thisgoal should be accomplished.

Economic stability. No one likes economic uncertainty. Societiestherefore strive for the opposite: economic stability. Economicstability means that the goods and services we count on—electricityon demand, food and clothing in the stores—are there when we wantthem. Our jobs are there when we go to work each day. Prices arepredictable, allowing us to plan ahead for purchases.

Most societies consider these goals when making economic choices, butsocieties differ in the degree of importance in which they attach to eachgoal. Sometimes progress toward one goal can be achieved only at theexpense of another. For example, when the government taxes ourwages in order to pay unemployment benefits, it is contributing tosociety’s economic security. But it is also encroaching on our economicfreedom to control our own resources. Societies, like individuals, mustweigh the tradeoffs and costs of pursuing any particular set ofeconomic goals.



The Maasai people of EastAfrica are traditional herders.Livestock has been themainstay of the Maasaieconomy for centuries. Cattleare used for food, buildingmaterials, and trade. Likepeople in other traditionaleconomies, the Maasaidecide what, how, and forwhom to produce based onlongstanding customs andtraditions.

2. Who Decides What inDifferent Economic Systems?In the process of answering the three economic questions, everysociety develops an economic system. An economic system is theway a society coordinates the production and consumption of goodsand services. Economic systems are as old as humankind, resulting inmany different models. But if we strip away all of the culturaldifferences that exist between all of the societies that ever existed, wefind that history has produced only three basic types of economicsystems. There are those built on tradition, those based on thecommand of rulers, and those organized by free markets. Each systemanswers the three economic questions differently, and eachemphasizes different economic goals.

Traditional Economies: Decision Making by Custom The firstand oldest economic system is the traditional economy. Traditional



economies have existed since the first clans of hunter-gatherersemerged in Africa. In a traditional economy, custom and traditiondictate what to produce, how to produce it, and for whom.

Most traditional economies that survive today belong to indigenouspeople who live much like their ancestors did hundreds or thousands ofyears ago. The Maasai of East Africa, for example, are a seminomadicherding people. Livestock, primarily cattle, is an important part of theireconomy, and Maasai wealth is measured in cattle and children. Thetraditional Maasai diet consists primarily of meat, blood, and milk fromcattle. The Maasai’s answer to the question of what to produce is cattle,because it is their centuries-old tradition to raise cattle.

As for the question of how to produce, people in traditional economiesengage in farming, herding, fishing, hunting, and the gathering of wildplants. Exactly who does what is determined by social customs, whichcan often divide labor along gender lines. Among the Maasai, forexample, men build enclosures to protect the cattle from lions, boysgraze the cattle, and women and girls milk the cattle. Among the Khoi-San people of the Kalahari Desert in Southern Africa, men hunt andwomen gather.

For whom to produce is another question decided by tradition and inwhich social hierarchies play an important role. A good illustration ofthis is the way meat is distributed among the Khoi-San people of theKalahari. After a hunt, the kill is divided up, with a large share going tothe hunter. The hunter gives some to relatives, and they give part oftheirs to other relatives, all according to the accepted social order. Inthe end, everyone gets enough to eat.

The highest goals of people in a traditional economy are economicstability and security. However, for most traditional societies this goalis increasingly difficult to attain. As modern economies exert an ever-growing influence, traditional societies are struggling to find a path toeconomic survival.

Command Economies: Decision Making by Powerful Rulers Thenext economic system to develop is the command economy. In acommand economy, decisions about what, how, and for whom toproduce are made by a powerful ruler or some other authority.

The earliest command economies originated in Mesopotamia, Egypt,China, and India about 5,000 years ago. As these civilizations becamehighly advanced, centralized governments arose that were headed bypowerful rulers. These rulers then imposed their economic choices on



society. However, at lower levels of society, much of the economicdecisions were still guided by tradition.

Rulers at the top of these early civilizations—kings, pharaohs, emperors— commanded the populace to devote economic resources to buildingprojects or military excursions. Many thousands of people might beconscripted to build a pyramid, defensive wall, irrigation canal, temple,or road. In a preindustrial age, such projects took vast quantities ofhuman labor. Often, many people would be drafted into a ruler’s armyand sent into battle in distant lands.

The primary goal of these ancient command economies was toaccumulate wealth and goods for the ruling class while preservingeconomic stability. The many monuments these societies left behindare a testament to both the productive power of these economies andthe excesses of their rulers.

Market Economies: Decision Making by Individuals The newesteconomic system to emerge in human history is the market economy.A market economy depends on the decisions of individual producersand consumers. Note that when economists speak of “the market,”they are referring to the economic system within which buyers andsellers exchange goods and services. This is distinct from an everydaymarket, which is a place where people buy and sell goods.



The Great Pyramid of Giza was built as a tomb for the Egyptianpharaoh Khufu around 2560 b.c.e. Historians estimate it took 20 yearsand tens of thousands of workers to construct the pyramid. In ancientcommand economies, economic decisions were made by rulers whoused their power to force people to labor on monumental works, manyof which still stand.

In a free market economy, the workings of the market are not plannedor directed. No single person, business, or government agency tellsproducers or consumers what to do. Economic decisions are madevoluntarily by millions of individuals guided by self-interest.

The highest goals of a market economy are economic freedom andefficiency. Individuals and businesses are left at liberty to decide what,how, and for whom to produce. The producers of goods and servicesmake these decisions based largely on consumers’ spending decisions.Because you are free to buy what you want, producers must competefor your money. This competition means that you, the consumer, havemany choices. It also forces producers to use resources efficiently. Ifthey do not, a competitor will find a way to offer the same good orservice at a price that consumers will be more willing to pay.



In a market economy,businesses can decide whothey want to hire. Individualsare also at liberty to choosewhere they want to work. Ifthey believe that they areunderpaid at one place ofemployment, individuals canpursue a position elsewhere.

In a free market, individuals are encouraged to pursue jobs that allowthem to make the most of their human capital. If one employer fails topay an individual what they think they are worth, they can quit andseek employment elsewhere. Or, they can start their own businesses,perhaps even offering new products or services to consumers.

You might expect that the result of this individual decision making andcompetition would be chaos. But, just the opposite is true. Markets arehighly efficient at producing a large variety of goods and services thatpeople find attractive and at prices they are willing to pay. It was thiscoordinating power of markets that Adam Smith famously described as“the invisible hand.” He wrote,

Every individual . . . neither intends to promote the publicinterest, nor knows how much he is promoting it . . . Heintends only his own gain, and he is in this, as in manyother cases, led by an invisible hand to promote an endwhich was no part of his intention . . . By pursuing his owninterest he frequently promotes that of the society moreeffectually than when he really intends to promote it.

— Adam Smith, The Wealth of Nation, 1776

The Flow of Money and Goods in a Market Economy The reason



markets work so well is that one person’s output always becomesanother person’s input. Goods are produced and consumed. Moneycomes in and goes out. This flow is what keeps the economy running.Economists use the circular flow model, like that portrayed in Figure3.2, to illustrate these interactions.

Figure 3.2This economic model shows how money, goods, and resourcescirculate in a market economy. The model assumes that householdsown the factors of production.• The clockwise flow represents the movement of products andresources. Goods and services flow from firms to households. Land,labor, and capital flow from households to firms.• The counterclockwise flow represents the movement of money.Money flows from households to firms in payment for goods andservices. It flows from firms to households as payment for land, labor,and capital.

In the simplified market economy, there are two kinds of participants:households and firms. A household is made up of a person or of agroup of people living together. The model assumes that householdsown the factors of production. A firm is an organization that uses thesefactors to make and sell goods or services.

The model also demonstrates two kinds of markets. One is the productmarket, in which goods and services are sold by firms and purchasedby households. Your local mall or grocery store is part of the product



market. The other is the factor market, in which households sell theirland, labor, and capital to firms. A household, for example, might rentland to a firm. Or, members of a household might sell their labor to afirm for wages. They might loan money to a firm in exchange forinterest payments, or they might buy a firm’s stock in the hopes ofreceiving dividend payments. The funds paid to households— whetherin the form of rent, wages, interest, or dividends—are known as factorpayments.

This model is circular. Households buy products from firms with moneythat they receive in the factor market. Firms acquire land, labor, andcapital from households using money that they receive in the productmarket. For example, you (as part of a household) might buy a pair ofjeans from a firm with money that you earned by working at a local icecream parlor (another firm). The ice cream parlor, in turn, pays you foryour labor with money that it receives from selling ice cream cones toother households.

All these transactions are conducted by people and businesses whowant something for themselves. People work so that they can buythings. Firms employ people so that they can make things to sell. In amarket economy, everybody chooses what is best for themselves. AsAdam Smith observed, “It is not from the benevolence of the butcher,the brewer, or the baker, that we expect our dinner, but from theirregard to their own interest.”



This Soviet-era postagestamp celebrates the heroesof the world’s first socialistcommand economy. KarlMarx and Frederick Engels,authors of The CommunistManifesto, are on the left.Vladimir Lenin, therevolutionary first leader ofthe Soviet Union, is to theirright. Joseph Stalin, whoruled the Soviet Union withan iron fist until his death in1953, is shown at the far rightof the stamp.

Capitalism Gives Rise to Socialism and Communism Marketeconomies emerged in Europe in the 1700s and began to grow rapidlyin the 1800s. This economic growth was a direct result of theIndustrial Revolution. During the Industrial Revolution, newinventions and manufacturing processes spurred the growth ofindustry. Individual investors, called capitalists, grew wealthy byaccumulating capital, such as machinery, factories, and railroads. Theterm capitalism came to be synonymous with the free market



economic system.

The headlong growth of capitalism had profound effects on society. Asmore and better goods became widely available, people’s standard ofliving improved. However, capitalism did not improve the quality of lifefor everybody. The workers who filled the factories and mills laboredunder harsh conditions, often working extremely long hours for meagerwages. Critics of capitalism blamed the capitalists for exploitingworkers and keeping them in poverty.

In 1848, economist Karl Marx and philosopher Friedrich Engelspublished The Communist Manifesto, in which they advocated theoverthrow of capitalism. They proposed an alternative vision of societyknown as socialism. Socialism is a political and economic philosophythat calls for property to be owned by society as a whole, rather than byindividuals, for the equal benefit of all.

To bring about this socialist vision of society, Marx and Engels called onworkers everywhere to revolt against their governments. They arguedthat once the workers had gained power, private property and the freemarket would be replaced with national ownership of industry and amore equal distribution of income.

The final phase of socialism, in the view of Marx and Engels, iscommunism, a political and economic system in which all propertyand wealth are owned by all members of society. In a communistsociety, class differences— and the conflicts they create—disappear.Once that happens, government is no longer needed to keep order.Instead of self-interest, people in a communist society are guided byMarx’s famous slogan: “From each according to his ability, to eachaccording to his needs.”

Modern Command Economies: Decision Making by the StateThe ideas of Marx and Engels spurred the development of politicalmovements dedicated to the creation of a workers’ paradise. But whenthe first successful communist revolution took place in Russia in 1917,it did not lead to the utopian society Marx had envisioned. Instead, therevolutionaries formed an authoritarian government that pursued itssocialist goals with brutal force. The renamed Union of Soviet SocialistRepublics, or Soviet Union for short, became the first modern commandeconomy.

In the Soviet Union, private ownership of property was forbidden andthe state owned the factors of production. Economic planning wasdone by government committees of economists, production experts,



and political officials. These central planning committees attempted toperform the functions of a market. They decided what goods andservices should be produced, as well as decided which farms andfactories should get which resources to produce what was planned.Committees also controlled prices and wages and decided how goodsand services were to be distributed.

In theory, this kind of planning was supposed to ensure economicequity and security—two important goals of a modern commandeconomy—but the reality was very different. The planning committeescould not keep track of the millions of products and prices in the Sovietsystem.

Two Soviet economists, Nikolai Shmelev and Vladmir Popov, describedwhat happened when Goskomsten, the committee in charge of prices,raised the price that the government would pay hunters for moleskins.

State purchases increased, and now all the distributioncenters are filled with these pelts. . . The Ministry of LightIndustry has already requested Goskomsten twice to lowerpurchasing prices, but . . . [they] have no time. . . they haveto keep track of another 24 million prices.

—The Turning Point: Revitalizing the Soviet Economy, 1990

In this planned economy, shortages were common. Long lines wouldform to buy whatever goods suddenly became available, but once acustomer got to the front of that line, choice was limited or nonexistent.

Planners made matters worse by ignoring the incentives-matterprinciple. The wages paid to workers were determined by governmentcommittees, not by a worker’s ability or output. A poor worker could notbe fired for slacking off, nor could a good worker be rewarded forworking hard. Under this system, workers lacked incentive to producehigh-quality goods or to innovate to increase productivity. As a result,production was slow and the goods produced were often far inferior tothose produced in a market economy.

The Soviet Union did succeed in increasing economic equity andsecurity for their people. But what is the benefit to a guaranteedincome if there is nothing to buy? What markets do effortlessly,command economies struggle to do. Central planning was so inefficientthat the Soviet Union economy eventually collapsed. Since then,virtually all modern command economies have either failed or struggledto introduce market-based reforms.



3. How Do Mixed EconomiesDivide the Decision Making?No country in the world today relies on a purely traditional, market, orcommand economic system. These systems represent theoreticalextremes. Nearly all countries have mixed economies that fallsomewhere in between these extremes. In a mixed economy, both thegovernment and individuals play important roles with regard toproduction and consumption. But who decides what varies from onecountry to another.

Government’s Role in a Mixed Economy: Protection, Regulation,and Public Benefits Every nation with a mixed economy forges itsown balance between market freedom and government involvement.At the minimum, governments are needed to establish the institutionsthat enable markets to operate. Such institutions include a legal systemto enforce laws and a stable system of currency. Without theseinstitutions, the market would be unable to function.

In many countries, people expect further government involvement.They want it to step in when the market operates in ways that societyfinds unacceptable. For example, many nations outlaw child labor.



Some governments limit the amount of pollution that industries candischarge. In the United States, the government regulates themanufacture of cosmetics, foods, and drugs because consumers wantto know that products on the market are safe. Not all governmentsregulate the manufacturing of products to the same degree. Eachsociety decides how involved the government will be in curtailing thefreedom of the market.

A public lending library is anexample of a valuable serviceto society that a free marketis not likely to provide. Eachsociety has to decide whatgoods and services it wantsits government to provide.

Finally, government provides certain goods and services that marketsdo not always provide or do not provide enough of. Examples includepublic works, or government-financed projects such as dams,highways, and sewer systems. The market does not provide thesegoods because, as Adam Smith explained, the cost of providing them“could never repay the expence to any individual or small number ofindividuals.”

What a government provides varies from country to country. In Canadaand much of Europe, free health care is provided to every citizen. Somegovernments provide free college education or free day care.Governments that provide a high level of goods and services also taxheavily to pay for those goods and services. Again, these are economicchoices that every nation makes differently.

The Flow of Goods and Money in a Mixed Economy How doesgovernment participation in the economy change the flow of moneyand goods? The answer to this can be seen by adding government to



the circular flow model.

A government enters the flow of money and products through aneconomy in a number of ways. It purchases land, labor, and capitalfrom households in the factor market. In the United States, the federalgovernment employs just under 3 million civilian employees, making itthe nation’s largest employer.

A government also purchases goods and services from firms in theproduct market. As the nation’s largest employer, the federalgovernment is also its largest customer, spending hundreds of billionsof dollars a year on goods and services.

Figure 3.3AThis economic model shows how government affects the flow ofmoney, goods, and resources in a mixed economy.• Households supply taxes and labor to the government.• Firms supply taxes and products to the government.• The government supplies services to households and firms. It alsopays households and firms for their labor and products, as well assending transfer payments to households.

Governments also combine land, labor, and capital to produce anddistribute goods and services. For instance, suppose a town decides itneeds a library. The town government buys land and hires architectsand builders in the factor market. Later, the town buys books, shelves,computers, and furniture in the product market. Finally, it hireslibrarians in the factor market. The end result is a public service that



the entire community can enjoy.

Now, follow the flow of money in a mixed economy. You will see that agovernment collects taxes from both households and firms. It usessome of this money to pay for the goods and services that it buys fromfirms. It may also transfer some money back to households as paymentfor government benefits. Social Security checks, welfare payments, andunemployment benefits are examples of government transferpayments.

The Mixed Economy Continuum: From Free to RepressedAlthough most of today’s economies can be described as mixed, the“mix” of market freedom and government control varies greatly fromone nation to the next. Each year, the Heritage Foundation and the WallStreet Journal publish their annual Index of Economic Freedom. Thisindex is a kind of scorecard that ranks the economic freedom of theworld’s nations. It is a useful tool for understanding the variety ofmixed economies.

In 2018, Australia rated one of the most free economies in the world.Free markets dominate Australia’s mixed economy. All banks areprivately owned. The economy is open to foreign investment and trade.Private property is very secure. Starting a business is easy, taking anaverage of only two and a half days.

At the very bottom of the list is North Korea, which came in last of the180 ranked nations. A communist country since 1948, North Korea stillhas a tightly controlled command economy in which the governmentdirects all industries and businesses. Nearly all foreign trade isforbidden, and private property is severely restricted.

What about countries that fall somewhere in between, such as Japan,South Africa, and France? All three have mixed economies dominatedby the market system. All have relatively high levels of economicfreedom and secure property rights. But they also have high tax rates,which are used to pay for an array of public services, such asgovernment-provided health care. In these nations, people havedecided that achieving economic equity and security for moremembers of society is worth giving up some measure of their individualwealth.

Further down in the rankings is China, which is rated “mostly unfree.”China, which has had a communist government since 1949, is intransition from a command economy to a market-oriented system, butits mixed economy is still dominated by an authoritarian government.



All Chinese banks are owned by the state. Private property is notsecure, and internet use is tightly controlled by the government.

Still, China allows more economic freedom than many countries. Cuba,for example, is rated “repressed” as its economy is dominated by thestate. As in repressed North Korea, foreign investment in Cuba isseverely restricted.

Only five nations in the 2018 Index of Economic Freedom, plus HongKong, were rated “free.” In addition to Australia, these countries areSingapore, New Zealand, Switzerland, and Ireland. What do thesecountries have in common? All have mixed economies dominated byfree markets. Most have democratic forms of government. They arealso all among the wealthiest nations in the world. As Adam Smithmight have predicted, the societies with the most economic freedomare also among the most prosperous.



Figure 3.3BWhereas most countries today have mixed economies, the level ofeconomic freedom their citizens enjoy varies widely. The Index ofEconomic Freedom ranks countries based on 10 indicators, includingthe ease of starting a new business, protection of property rights, andfreedom from corruption. The 2018 rankings – from a high of 90percent to a low of about 6 percent – are displayed on the map.

4. What Are the KeyCharacteristics of the U.S.Economic System?The high ranking of the United States on the Index of EconomicFreedom is not surprising. Americans value their economic freedom, somuch so that our economy is often described as a free enterprisesystem. In a free enterprise system, individuals own the factors ofproduction and make decisions about how to use those factors within



the framework of the law. Seven key characteristics of a free enterprisesystem are explored below.

Economic Freedom As the term free enterprise suggests, theessence of our nation’s economic system is freedom—the ability ofindividuals to act in their own best interest in free markets. In practicalterms, this means that we can buy what we want and from whomeverwe want. If we do not like what one firm is selling, we can take ourbusiness elsewhere. We are free to start businesses or to seek any jobwe choose. Firms are free to make what they want, hire whomever theychoose, and set their own wages and prices.

Because our economic system allows individuals and businesses somuch freedom, it is often referred to as a laissez-faire economy.Economists use the term laissez-faire to describe a market economythat is relatively free of government intervention. (In French, laissez-faire means “let them do.”) But in fact, laws exist that limit whatproducers and consumers can do in the United States. Stores, forexample, are not free to sell alcohol to teenagers. Businesses are notfree to hire child laborers. Economic freedom does not give anyone theright to break the law. However, it does allow us to act in our economicbest interest within the law.

Competition Because virtually anyone can enter the market at anytime, many rival sellers usually vie for customers’ business. Theresulting competition is a hallmark of the free enterprise system.

Competition provides an incentive for businesses to create new andbetter products and ways of serving customers. For consumers, thismeans more goods and services to choose from. Competition alsoencourages producers to use their resources efficiently in order to lowercosts. When lower costs translate into lower prices, consumers winagain.

Equal Opportunity In 1776, the Declaration of Independencedeclared,

We hold these truths to be self-evident, that all men arecreated equal, that they are endowed by their Creator withcertain unalienable Rights, that among these are Life,Liberty and the pursuit of Happiness.

Most Americans today understand these words to mean that we areborn equal in terms of our rights, freedoms, and the opportunity tomake the best of our talents and abilities. Our belief in the United



States as a “land of opportunity” is deeply rooted in our country’shistory as a nation of immigrants.

Nonetheless, our free enterprise system has not always offered equalopportunity to everyone. Women, African Americans, and otherminority groups have had to fight discrimination in education andemployment. Through the efforts of citizens and governmentintervention, these barriers to economic opportunity have begun to fall,providing more equal opportunities for every person to gain aneducation and compete in the marketplace.



This young author is nottaking any chances with herintellectual property. Bycopyrighting her schoolessay, she is protecting herproperty rights in the print,broadcast, and electronicmedia.

Binding Contracts In business, a contract is an agreement betweena buyer and a seller. Contracts are used in all types of economictransactions. Even the receipt that you sign when you use a credit cardis a contract. In our free enterprise system, people are free to decidewhat contracts they want to enter into—but once agreed on, a contractis binding. That means that both sides have to fulfill their ends of thedeal.

Because free enterprise depends on buyers and sellers honoring theiragreements, it is important to have a legal system that upholdscontracts. U.S. courts recognize the binding nature of contracts. Theyalso recognize that people and businesses can run into financialproblems and become unable to pay their debts. Bankruptcy is thelegal process by which such situations can be resolved. Althoughbankruptcy allows people in debt to get a fresh start financially, a majordownside is the negative effect bankruptcy will have on their creditreports, which will make it difficult to obtain loans in the future.Furthermore, not all debts are eliminated during bankruptcy.

Property Rights A necessary element of a free enterprise system is



the right to own property. Property rights are the rights of those whoown land, buildings, or other goods to use or dispose of them as theychoose.

In other countries, past and present, rulers have had the power to seizeanother person’s property for their own use. The U.S. Constitutionprotects against this abuse of power. It guarantees access to the courtsin case of disputes about property. It further guarantees that an ownerwill be paid for property that is taken by the government for public use.These constitutional guarantees are crucial to the free market. Whywould people buy homes or start businesses, unless they were certainthat they would get to keep their property?

The Constitution also protects intellectual property by empoweringCongress to enact patent and copyright laws. Intellectual propertyrefers to creations of the mind that have commercial value. A patentgives an inventor the sole right to make, use, or sell his or her inventionfor 20 years. A copyright similarly gives the creator of a literary orartistic work the sole right to reproduce, distribute, perform, or displaythe copyrighted work. Current copyrights last for 70 years beyond thelife of the author.

Why do we need intellectual property laws? Think about what wouldhappen without them. As soon as a new invention (or book or song)became public, others would copy it and put it on the market. Theinventor (or writer or composer) would therefore receive no reward forhis or her efforts. Without a reward, inventors and creatives would haveno incentive to invent new things or create new works. Patents andcopyrights encourage creativity and innovation by guaranteeing thatinventors and artists can profit from their creations.

Profit Motive If any single force could be said to drive a freeenterprise system, it is the profit motive. Profit is the money earned bya business after subtracting its costs of operation. The desire to make aprofit is known as the profit motive. The profit motive is closely tied tothe incentives-matter principle. Profits are our incentive to work or startbusinesses in the hope of making money for ourselves.

Some people confuse the profit motive with greed or with stealingwealth from others. Most economists, however, see the profit motivepositively as it is the reason most businesses exist. As Adam Smithobserved, people produce goods and services in order to improve theireconomic situation—to make a profit.

Limited Government The final key characteristic of a free enterprise



system is a relatively limited role for government in the economy. Inthe United States, the government does not try to control firms. Nordoes it often compete with firms. Government intervention in theeconomy is generally limited to several different areas.

Protecting property rights and contracts.The government enforceslaws that protect property owners and patent and copyright holders.

Promoting the general welfare.The government funds projects andprograms that benefit society as a whole.

Preserving competition. The government enacts laws that protectand preserve a competitive marketplace.

Protecting consumers, workers, and the environment. Thegovernment requires businesses to ensure that their products do notharm consumers. It also imposes regulations on firms to promoteworkplace safety and to reduce pollution.

Stabilizing the economy. The government works to keep theeconomy growing steadily rather than alternating between periods ofboom and bust.

Let’s return to the question we started with: Who or what decides whatyou get? In our economic system, the answer is both a who and a what.The what is the market, made up of millions of individuals who buy andsell goods every day on a strictly voluntary basis. The who is you, yourfamily, and your friends, all exercising your freedom of choice asconsumers. What are the effects of these choices? Later on, you willlearn more about how the choices you and others make in the markethelp determine what you might get tomorrow.

SummaryBecause resources are always scarce compared to people’s wants, allsocieties must make choices about what to have and what to give up.How those choices are made depends on a society’s economic system.

How do societies decide who gets what? Every society is facedwith three economic questions: What goods and services should beproduced? How should they be produced? Who should get what isproduced? How a society answers those questions depends on itseconomic goals. These goals include economic freedom, efficiency,equity, growth, security, and stability.



Who decides what in different economic systems? Over time,societies have developed three economic systems to answer thesequestions. In a traditional economy, decisions are dictated by customand tradition. In a command economy, a powerful ruler or governmentmakes decisions. In a market economy, decisions are made by theinteractions of individual producers and consumers. Each systememphasizes different economic goals.

How do mixed economies divide the decision making? Mostcountries today have a mixed economy, in which both the governmentand individuals have a voice in economic decisions. Who decides whatvaries greatly. Some countries, including the United States, minimizegovernment regulation of the market. Others, such as China, stillexercise considerable government control over economic activities.

What are the key characteristics of the American economicsystem? Americans describe their economy as a free enterprisesystem. This system has seven key characteristics.

Economic freedom to buy and sell what we want and to workwhere we wantCompetition among firms, which try to attract customers withnew and better productsEqual opportunity to make the best use of our talents, abilities,and educationProperty rights that allow us to buy, own, and sell goods andintellectual propertyBinding contracts, which give us confidence that others will abideby their agreementsThe profit motive, which provides an incentive to work and startnew businessesLimited government that regulates without controllingindividuals, firms, or the market

Five Measures of EconomicWell-BeingWhat says more about the overall economic well-being of a nation: theaverage amount of money each person in the country spends eachyear? The amount of pollution the country emits? Or the average heightof the adult population? The five economic indicators shown here usethese and other criteria to assess the well-being of 10 countries. Four ofthe indicators are indexes, which use a formula to measure well-being.



One—human height—provides comparative data. The United Statesranks high by some measures and low by others. Which indicator doyou think is the most valid?

Nominal GDP

Nominal gross domestic product is the value of all final goods andservices produced during a given year, expressed in current prices. Thefour largest economies in the world, based on estimated 2018 GDPinclude the United States ($20,494), China ($13,407), Japan ($4,971),and Germany ($4,000). This is followed by a sampling of countries withlower GDPs, such as Brazil ($1,868), Canada ($1,711), and Russia($1,630). Note that the dollar figures are given in billions. For example,$20,494 means $20,494,000,000,000, or $20 trillion.

Per Capita GDP

Per capita GDP is calculated by dividing a country's GDP by itspopulation. The result —a country's average economic output perperson—is a better measure than nominal GDP for comparing the livingstandards of two or more countries. The number one country in thisranking is Qatar, whose per capita GDP was $124,100 in 2017. Qatarhas prospered in recent years due to its oil and gas reserves.

Human Development Index (HDI)

The Human Development Index is an economic indicator favored by theUnited Nations. It looks beyond a country's GDP to gain a broaderperspective on well-being. The HDI combines per capita GDP with lifeexpectancy, the adult literacy rate, and school enrollment. Based onthis measure of well-being, the UN ranks countries according to howwell they are doing at promoting human development.

Happy Planet Index (HPI)

The Happy Planet Index does not include any measure of GDP. Insteadit measures the degree to which a country provides well-being to itspeople and the planet. The HPI is based on a combination of lifeexpectancy, life satisfaction, and “ecological footprint”—the fairnessand responsibility with which a country consumes its resources. Thetiny nation of Costa Rica came in first in this ranking, with a value of44.7. Chad came in last.

Human Height

Scientists who study human growth argue that a population's average



height is a better indicator of well-being than GDP or per capita GDP.People grow taller, they say, when they have more healthful diets,greater wealth, better housing, lower levels of pollution, and lessdisease and stress. Height is largely a function of genes—tall parentstend to have tall children. But nutrition and other environmentalfactors, these scientists insist, can explain differences in geneticallysimilar populations. In their view, human height and well-being risetogether.



Economic SystemsIntroduction

1. Who Gets What? How Do Societies Decide?2. Who Decides What in Different Economic Systems?3. How Do Mixed Economies Divide the Decision Making?4. What Are the Key Characteristics of the U.S. Economic System?SummaryFive Measures of Economic Well-Being

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Economic Systems · Yeltsin’s reaction was understandable. By the late 1980s, the state-run Soviet economy was in shambles. Consumer goods were scarce. People had to wait in long