Economics Chapter 2 (1)

Economics Chapter 2Free Enterprise and Other Economic Systems

Section 1: 3 Basic Economic Questions

• What goods and services should be produced?

• How should these goods and services be produced?

• Who consumes these goods and services?


• Economic system- structure of methods and principles a society uses to produce and distribute goods and services

• Society must decide what to produce in order to satisfy society’s needs and wants– Because resources are limited, each decision

comes with an opportunity cost

• Society must decide how to produce goods and services– All require land, labor, and capital


• Societies must also make decisions that determine how goods and services are consumed– Largely determined by how societies

distribute income


• Factor payments- income people receive in return for supplying factors of production– Land, labor, and capital

• Landowners- collect rent• Workers- collect wages• Money lenders- collect interest• Includes profits that entrepreneurs earn if their

enterprises succeed


• Profit- the amount of money a business receives in excess of its expenses

• Questions answered by society based on their priorities of economic goals– Efficiency– Freedom– Security– Equity– Growth


• Efficiency– Societies want to maximize what they produce– If society can accurately assess what its people need and

want, it increases its economic efficiency– Reducing waste also involve answering other economic

questions– An economy that cannot deliver the right goods in the right

quantity to the right people at the right price is not efficient


• Freedom– Own property, work where we want, choice

of what we buy, etc.– Are costs that come with freedom

• Possible failure


• Security– Economic systems seek to reassure people that

goods and services will be available when needed and that expected payments will arrive on time

– Safety net- set of programs to protect people who face unfavorable economic conditions

– Many economies also provide basic income for retired people


• Equity or Fairness– Should everyone get the same share of

goods and services a nation produces


• Growth– Standard of living- level of economic

prosperity• Comes with economic growth


• Innovation– Process of bringing new methods,

products, or ideas into use• Plays large roll in economic growth


• Other possible goals– Environmental protection– Full employment– National industry

• Sometimes goals conflict with one another– Must prioritize economic goals


• There are 4 different economic systems to address these basic questions– Reflect different prioritization


• Traditional economy- relies on habit custom, or ritual to answer 3 economic questions– Little room for innovation or change– Revolves around family unit– Work divided along gender lines– May lack modern conveniences and have a low

standard of living


• Market- any arrangement that allows buyers and sellers to exchange things– Allows us to exchange the things we have

for the things we want

Section 2: Free Markets

• Specialization- the concentration of the productive efforts of individuals and businesses on a limited number of activities– Leads to efficiency in the use of capital, land, and

labor– Benefits the business to allow them to use their

factors of production more efficiently


• In a modern market-based economy people earn income by specializing in particular jobs- they then use his income to buy the products that they want to consume

• Free market economy- 3 economic questions are answered by voluntary exchange in markets– “capitalist economies”– “free enterprise”


• Participants in a free market are households and firms– Household- a person or group living in a single residence

• own the factors of production• Consumers of goods and services

– Firm (business)- an organization that uses resources to produce a product or service, which it then sells

• Transforms inputs (factors of production) into outputs (goods or services)


• Can represent exchanges in a diagram called a circular flow model


• Factor market- firms purchase factors of production from households

• Product market- households buy the goods and services that firms produce


• According to Adam Smith- competition and our own self-interest actually help to keep the market functioning– The Wealth of Nations- 1776– How markets function

• Self-interest is the motivation force in the free market- the push that leads people to act


• Incentive- the hope of reward or fear of penalty that encourages a person to behave in a certain way– Adam Smith observed that people respond

in a predictable way to both positive and negative incentives


• Competition- struggle among producers for the dollar of consumers– While self-interest is the motivating force

behind the market, competition is its regulating force


• Under ideal conditions, the free market meets many goals– Economic efficiency- because its self-regulating

• Can respond to rapidly changing conditions– Economic freedom- highest degree of economic

freedom of any system– Economic Growth- competition encourages

innovation


• Other positives: wide variety of goods, consumer sovereignty- consumers have the power to decide what gets produced- consumer is king


Section 3: Centrally Planned Economies

• Centrally planned economy- government rather than individual producers and consumers answer the 3 basic economic questions– A central bureaucracy decides what to produce,

how to produce, and for whom to produce– Government owns both land and capital– Controls where people work and what they get

paid

• Command economies- oppose private property, free market pricing, competition, and consumer choice– No consumer sovereignty


• Socialism: not a single economic system– Range of economic and political systems

based on belief that wealth should be evenly distributed throughout society


• Socialism can co-exist with free market practices– Example: Sweden

• Use of heavy taxes

• Or can have government ownership of the means of production– Socialism is considered by some the intermediate

stage between capitalism and communism


• Communism: central government owns and controls all resources and means of production and makes economic decisions– Karl Marx

• Stressed conflict between labor and capital• Believed labor was the sources of all value• The inevitable result of capitalism was the exploitation of

workers and an unfair distribution of wealth


• Communist governments have always been authoritarian– Limit individual freedoms and require strict

obedience– Book examples of the USSR and China


• Disadvantages:– Economic efficiency

• Lack of worker incentive to work faster or produce more• Lack of flexibility

– Economic freedom• Takes almost all economic choices away from producers and

consumers– Economic growth

• Doesn’t tend to reward innovation• No profit motive

– Economic equity• Tends to be only in theory


Section 4: Mixed Economies• Most economies are a form of a mixed

economy• Adam Smith believed in laissez faire-

idea that government should not intervene in the marketplace– Some limited degree of government

involvement

• Examples of Government involvement:– National defense– Highways– Public schools– Private property rights

Section 4: Mixed Economies

• Private Property- property owned by individuals or companies and not by the government or the people as a whole

• Also have laws protecting intellectual property– Private property is a fundamental element

of the American economy


• Governments look to make sure exchanges are fair– Honest– Keep competition


• Government also collects taxes and has some redistribution of wealth– Social Security– Disability Payments

• No nation today is a complete free market


• Mixed Economy- an economic system that has some market- based elements and some government involvement– Degree of government involvement varies from nation to

nation• Some goals are solved by open market, some are

better met with government involvement– Must evaluate the opportunity cost with each goal


• Must Add government into the circular flow diagram


• Governments can purchase land, labor, and capital from households in the factor market– US Government pays nearly 3 million

employees over $150 billion a year for their labor


• Governments also purchase goods and services from firms in the product market– Governments can also provide certain

goods and services by combining the factor resources they have purchased


• Governments collect taxes from both households and businesses – Transfer some of this money to businesses

and individuals


• Most modern economies are mixed economies are mixed economies

• Economic transition- period in which a nation moves one economic system to another

• Privatization- selling enterprises operated by government to individual and then allowing them to complete in the marketplace


• US Economy– Mixed economy with its foundation of the free

market– Government plays a substantial role in American

economy• Keeps order• Provides vital services• Promotes general welfare


• Federal and state laws protect private property• Marketplace operates with a limited degree of

government regulation• High level of economic freedom• Economy is open• Foreign investment is encouraged

– Does protect some domestic industries– Does retaliate against trade restrictions imposed by other

nations


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Economics Chapter 2 (1)