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Chapter 2: Economic Systems
1
Section 1: Answering the 3 Economic Questions

different nations & societies have historically been blessed w/ different resources & must find a
way to distribute what they have
Economic System– method used by a society to produce and distribute goods & services
– different systems evolved due to various situations of scarcity and the method chosen to deal
with these problems
● societies must all answer 3 key economic questions.
1. What goods and services should be produced?
– each society decides what needs & goods should be produced to satisfy its own needs & wants
– also important to consider is how much resources should be devoted to different areas, such as
national defense, education, or welfare
2. How should goods and services be produced?
– this question concerns deciding what to use and how to use the factors of production (land,
labor, and capital) (build a big factory or use small-scale production)
– ex: comparing farming done with human labor compared to that done using a tractor
3. Who consumes goods and services?
– addresses the issue of who should get what & how much should a person get for doing his part
– FACTOR PAYMENTS used to distribute goods/services
Factor Payments– the income people receive for supplying factors of production, such as land, labor, or
capital
– more or less how much people get paid for their individual jobs
● 3 economic questions answered based on importance attached to various economic goals.
● Economic Efficiency– providing the goods and services that will be most used
● Economic Freedom– the amount of control the government has over individuals
● Economic Security & Predictability– knowing that things will be there when we need them and
that help likewise will be there if needed
Safety Net– Government programs that protect people experiencing unfavorable economic conditions
● Economic Equity– what people should get paid for doing the work they do
– should same jobs all get paid the same?
● Economic Growth & Innovation– a nation’s economy must grow to increase prosperity
Standard of Living– level of economic prosperity
4 Economic Systems
1. Traditional Economy– economic system that relies on habit, custom, or ritual to decide questions of
production and consumption of goods and services
– tend to remain the same without much change; family central unit; do what parents did
2. Market Economy– Economic system in which decisions of production and consumption of goods and
services are based on voluntary exchange in markets
– also called free markets or capitalism; individuals decide what they make/do and buy
3. Centrally planned economy– Economic system in which the central government makes all decisions
on the production and consumption of goods and services.
– also called command economy; central authority in control of economy
4. Mixed Economy– economic system that combines tradition and the free market with limited
government involvement
Chapter 2: Economic Systems
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Section 2: The Free Market
 any place goods & services are exchanged is a market
Market– an arrangement that allows buyers and sellers to exchange things.
– includes everything from a department store, Wall Street, or even a yard sale.
Specialization– the concentration of the productive efforts of individuals and firms on a limited number
of activities (makes an economy more efficient since people can get really good at one thing)
– the specific jobs/careers that people do that enable them to make money so that they can
purchase the other things that they need but do not make themselves.
● economic systems based on voluntary exchanges are known as free market economies in which
individuals and businesses exchange money and products
● the factors of production are owned privately; not by the government
● the 3 key questions are answered by these people; again not the government
Circular Flow Diagram—way to represent the exchange from businesses to individuals
Household– person or group of people living in the same residence
Firm– organization that uses resources to produce a product, which it then sells
– transform inputs (factors of production) into outputs (products)
Factor market– market in which firms purchase the factors of production from households
– includes purchasing land or resources from people, hiring workers or paying them wages, and
borrowing money for investments
Product market– market in which households purchase the goods and services that firms produce
Profit– financial gain made in a transaction

since the free market is based entirely on voluntary exchanges it is self-regulating in that
everybody only does things that they want to & that will benefit themselves
Self-interest– one’s own personal gain
– used by Adam Smith to explain how buyers and sellers both consider their own best interests
whenever making a transaction
Incentive– an expectation that encourages people to behave in a certain way
– buyers choose the cheaper product and manufacturers make what they have a greater chance of
selling for profit
Competition– the struggle among producers for the dollars of consumers
 self-interest & competition work together to regulate the marketplace
“the invisible hand of the marketplace”– self-interest makes consumers decide to purchase certain
goods; competition among the producers causes them to provide these desirable goods for a lower cost;
with the overall result being consumers get the products they want at costs closely reflecting the costs to
make them
Advantages of the Free Market
1. Economic Efficiency– producers make what consumers want, and at prices they are willing to pay
2. Economic Freedom– highest degree of economic freedom of any system
3. Economic Growth– competition encourages innovation so free markets encourage growth
(entrepreneurs are always looking for new profitable opportunities)
Consumer Sovereignty– the power of consumers to decide what gets produced
– producers are going to make what people will buy so by purchasing only what they want,
consumers ultimately decide what producers make
Chapter 2: Economic Systems
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Section 3: Centrally Planned Economies

in a free market, individuals & businesses make voluntary transactions, but in centrally planned
the gov’t controls everything
● in centrally planned economies, the central government answers the three key economic questions
(not the producers or consumers)
● this central bureaucracy determines what items get produced, how they are produce, and also who
gets them once they are produced.
● Government owns both land and capital, and tells people where they work and what wages they
will be paid
Socialism– a social and political philosophy based on the belief that democratic means should be used to
evenly distribute wealth throughout a society
– argue that real equality can only exist when political equality is coupled with economic
equality, which is only possible if the public controls the centers of economic power
– socialist nations may be democratic, but the government still exercises enormous control
Communism– a political system characterized by a centrally planned economy with all economic and
political power resting in the hands of a central government
– believe that a socialist society can only occur after a violent revolution
– Authoritarian– requiring strict obedience to an authority (ex: dictator)
– Do not allow freedom of judgment or action

Socialist government can still be democratic; communist cannot

in the old Soviet Union, the gov’t controlled everything & owned everything while deciding how
much each individual would receive (nothing voluntary—everything decided by the gov’t)
Collectives– large farm leased from the state to groups of peasant farmers
Heavy Industry– industry that requires a large capital investment and that produces items used in other
industries (ex: chemicals, steel, and heavy machinery manufacturing)



Soviet Union’s biggest problem was that they focused too heavily on heavy industry; wanted to
make a lot of missiles, send someone to space, & make large equipment but stopped growing their
own food
This focused made it difficult for the people to get their basic needs provided for (~10 million
starved to death on 2 different occasions during the 20th century)
Went from being one of the world’s top exporters of grains to one of the world’s leading importers
Problems of Centrally Planned Economies
● in theory, can work effectively and successfully
● no incentive to work hard, since you won’t benefit anyhow
● discourage any change, including innovation
● large expensive bureaucracy lacks flexibility to adjust to consumer demands
● sacrifice individual freedoms to pursue societal goals
Chapter 2: Economic Systems
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Section 4: Modern Economies
● ALL ECONOMIES TODAY ARE MIXED; SOME CONSUMER, SOME GOV’T CONTROL
● Adam Smith and other early free market philosophers believed that the market economy would
provide the greatest benefit for consumers and raise the standard of living
Laissez Faire– the doctrine that states that government generally should not intervene in the marketplace
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even Smith agreed that there was a need for a certain limited degree of government intervention
w/o which we wouldn’t have roads, schools, hospitals, etc.
as time goes on the governments role continues to increase
markets could not operate without some government intervention, usually through laws that
protect people’s rights
● government interacts in all spheres of the economic system (see Circular Flow)

no one system has solved the problem of answering the 3 ?’s perfectly & many vary in their
degree of gov’t control
Free enterprise– an economic system characterized by private or corporate ownership of capital goods;
investments that are determined by private decision rather than by state control; and determined in
a free market

Although all are mixed, nations still vary greatly in whether they are controlled more by
consumers or the gov’t
Continuum– a range with no clear divisions (pg. 43)
● mixed economies vary in the amount of government intervention in the economy
● at the centrally planned end of the continuum, government dominates almost all aspects of the
economy, but there is still some degree of private production
● China currently experiencing transition to become more of a market economy
Transition– period of change in which an economy moves away from a centrally planned economy
toward a market-based system
Privatize– to sell state-run firms to individuals
● at the free market end, private sector controls most everything, but the government still sets some
laws (like wage and price controls on rent & public services)
● US government has free enterprise economy; gov’t provides vital services, but doesn’t play a big
role in the economy