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Chapter 2:
Economic Systems
Chapter 2: Economic Systems
• Scarcity and Decision Making
– How societies have developed different
economic systems to make choices about
resource allocation
Chapter 2: Economic Systems
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Answering the Three Economic Questions
The Free Market
Centrally Planned Economies
Modern Economies
Section 1: Answering Three Economic Questions
• Scarcity forces societies and nations to answer
key economic questions
• Different economic systems have evolved in
response to the problem of scarcity
• Economic system
– The method used by a society to produce and
distribute goods and services
Section 1: Answering Three Economic Questions
• Because economic resources are limited, every
society and nation must answer
three key economic questions
1) What goods and services should be produced?
2) How should these goods and services be produced?
3) Who consumes these goods and services?
Section 1: Answering Three Economic Questions
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What goods and services should be produced?
– How much resources will be devoted to:
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National defense
Education
Public health and welfare
Consumer goods
Section 1: Answering Three Economic Questions
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How should goods and services be produced?
– How should resources be used?
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Land
Labor
Capital
Section 1: Answering Three Economic Questions
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Who consumes goods and services?
– Societies must decide how to distribute the
available goods and services
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Determined by how societies choose to distribute
income
– based on social values and goals
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Factor payments
– The income people receive for supplying
factors of production
» land, labor, capital
» entrepreneurship
Section 1: Answering Three Economic Questions
Societies answer the three economic questions based on their values.
Economic Goals
Economic efficiency
Economic freedom
Economic security
and predictability
Making the most of resources
Freedom from government intervention
in the production and distribution of
goods and services
Assurance that goods and services will
be available, payments will be made on
time, and a safety net will protect
individuals in times of economic disaster
Economic equity
Fair distribution of wealth
Economic growth
and innovation
Innovation leads to economic growth,
and economic growth leads to a higher
standard of living
Other goals
Societies pursue additional goals, such
as environmental protection
Section 1: Answering Three Economic Questions
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Safety net
– Government programs that protect people
experiencing unfavorable economic
conditions
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Injuries
Layoffs and unemployed
Natural disasters
Severe shortages
Retirement
Poor
Section 1: Answering Three Economic Questions
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Standard of living
– Level of economic prosperity
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A nation’s economy must grow to improve its
standard of living
– Especially if its population is growing
» New jobs and income need to be provided
– Innovation plays huge role
Section 1: Answering Three Economic Questions
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Four main kinds of economic systems
based on:
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Prioritization of economic goals
Values of the society or nation
Section 1: Answering Three Economic Questions
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Four main kinds of economic systems
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Traditional Economy
Market Economy
Command Economy
Mixed Economy
Section 1: Answering Three Economic Questions
Four Economic Systems
An economic system is the method used by a society to
produce and distribute goods and services.
1) Traditional economies
rely on habit, custom, or ritual to
decide what to produce, how to
produce it, and to whom to
distribute it (consumption).
3) In a centrally planned
economy the central
government makes all decisions
about the production and
consumption of goods and
services. Sometimes called
Command economies
2) In a Market economy
economic decisions (production
and consumption) are made by
individuals and are based on
voluntary exchange, or trade.
Also called free markets, or
capitalism.
4) Mixed economies
are systems that combine
tradition and the free market with
limited government intervention.
Chapter 2: Economic Systems
• Section 1 Review
– Answering Three Economic Questions
Chapter 2, Section 1 Review:
1. Each society determines who will
consume what is produced based on
(a) its unique combination of social values and
goals.
(b) the amount of factor payments.
(c) its needs and wants.
(d) economic equity.
Chapter 2, Section 1 Review:
2. To improve its standard of living, a
nation’s economy must
(a) remain stable.
(b) grow through innovation.
(c) reach economic equity.
(d) allow the central government to make
economic decisions.
Chapter 2: Economic Systems
• Section 1 Review
– Answering Three Economic Questions
• Assignments
– Textbook pg. 24, Figure 2.1
• Identify the opportunity costs of each method of
farming
– Chapter 2, Section 1 - Review
Chapter 2: Economic Systems
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Answering the Three Economic Questions
The Free Market
Centrally Planned Economies
Modern Economies
Section 2: The Free Market
• Market
– An arrangement that allows buyers and
sellers to exchange things
• Markets exist because none of us produces all
we require to satisfy our needs and wants
• Markets allow us to exchange the things we
have for the things we want
Section 2: The Free Market
• Specialization
– The concentration of the productive efforts of
individuals and firms on a limited number of
activities
• Specialization leads to efficient use of resources
Free Market Economy (voluntary exchanges)
Circular Flow Diagram of a Market Economy
In a free market
economy,
households and
business firms
use markets to
exchange money
and products.
Households
pay firms for
goods and
services.
Product market
monetary flow
physical flow
Firms supply
households with
goods and
services.
Households
Households own
the factors of
production and
consume goods
and services.
Firms
Households
supply firms with
land, labor, and
capital
physical flow
monetary flow
Factor market
Firms pay
households
for land,
labor, and
capital.
Section 2: The Free Market
• Household
– A person or group of people living in the same
residence
– Households own factors of production
(land, labor, capital)
– Households are the consumers of goods and services
Section 2: The Free Market
• Firm (or business)
– An organization that uses resources to
produce a product, which it then sells
– Firms transform “inputs” (factors of production) into
“outputs” (products)
Section 2: The Free Market
• Factor market
– Market in which firms purchase the factors of
production from households
• Product market
– Market in which households purchase goods
and services that firms produce
• Profit
– The financial gain made in a transaction
Section 2: The Free Market
• Our society is competitive
– Competition and self-interest keep the marketplace
functioning
• Competition
– The struggle among producers for the dollars of
consumers
• Regulating force in the free market
• Self-interest
– One’s own personal gain
• Motivating force in the free market
Section 2: The Free Market
• Incentive
– An expectation that encourages people to
behave in a certain way
• The hope of reward or the fear of punishment
• Consumers have incentive to look for lower prices
• Firms have incentive to make greater profits by
increasing sales
Section 2: The Free Market
• Two forms of incentives
– Monetary
• Rewards (profits or savings) in the form of money
– Nonmonetary
• Rewards in forms other than money
– Gifts, services, other goods
Section 2: The Free Market
• Invisible hand
– Term economists use to describe the
self-regulating nature of the marketplace.
– Competition causes more production and moderates
prices
– Consumers get products they want at prices that
closely reflect the cost of producing them
Section 2: The Free Market
• Advantages of the free market
– 1. Economic efficiency
– Because it is self-regulating, a free market responds
efficiently to rapidly changing conditions
– 2. Economic freedom
– Highest degree of economic freedom of any system
» Workers free to work where they want
» Firms free to produce what they want
» Individuals free to consume what they want
Section 2: The Free Market
• Advantages of the free market
– 3. Economic growth
– Competition encourages innovation
– Entrepreneurs always seeking profitable opportunities,
contributing new ideas and innovations
– 4. Additional goals
– Free markets offer wider variety of goods and services
than any other system, because producers have
incentives to meet consumers’ desires; this is called
consumer sovereignty
Section 2: The Free Market
• Consumer sovereignty
– The power of consumers to decide what gets
produced
Chapter 2: Economic Systems
• Section 2 Review
– The Free Market
Chapter 2, Section 2 Review:
1. Why do people need to buy and sell
goods or services?
(a) People need to buy and sell goods to make
a profit.
(b) People buy and sell to maintain a
competitive society.
(c) No one is self-sufficient.
(d) People need to provide the market with
goods and services.
Chapter 2, Section 2 Review:
2. What factors create the phenomenon of
the “invisible hand”?
(a) incentives and efficiency
(b) specialization and efficiency
(c) competition between firms
(d) competition and self-interest
Chapter 2, Section 2 Review:
3. Which of the following is an accurate
definition of competition?
(a) the hope of reward that encourages a
person to behave in a certain way
(b) the struggle among producers for the dollars
of consumers
(c) the financial gain made in a transaction
(d) an organization that uses resources to
produce a product
Chapter 2: Economic Systems
• Section 2 Review
– The Free Market
• Assignments
– Chapter 2, Section 2 - Review
Chapter 2: Economic Systems
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Answering the Three Economic Questions
The Free Market
Centrally Planned Economies
Modern Economies
Section 3: Centrally Planned Economies
• In a centrally planned economy the central
government makes all decisions about the
production and consumption of goods and
services.
• Sometimes called Command economies
Section 3: Centrally Planned Economies
• Operate in direct contrast to free market systems
• Oppose private property, free market pricing,
competition, and consumer choice
• A central bureaucracy makes all decisions about
what goods to produce, how to produce them,
and who gets them (consumes)
Section 3: Centrally Planned Economies
Organization of Centrally Planned Economies
In a centrally planned economy, the government
owns both land and capital. The government
decides what to produce, how much to produce,
and how much to charge.
Government controls where individuals work
and what wages they are paid.
Section 3: Centrally Planned Economies
(Command Economies)
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 central
government.
Section 3: Centrally Planned Economies
(Command Economies)
• Socialist economies can be democracies
• Communist governments are authoritarian
• Require strict obedience to an authority, such
as a dictator
• Do not allow individuals freedom of judgment or
action
The Former Soviet Union (case study)
• Communist nation arose out of two revolutions in 1917.
• Soviet planners were most concerned with building
national power and prestige in the international
community
• Best land, labor, and capital was allocated to the armed
forces, space program, and production of capital goods
such as farm equipment and factories.
The Former Soviet Union (case study)
• Soviet Agriculture
– In the Soviet Union, the government created large
state-owned farms and collectives for most of the
country’s agricultural production.
• Soviet Industry
– Soviet planners favored heavy-industry production
(such as chemical, steel, and machinery), over the
production of consumer goods.
• Soviet Consumers
– Consumer goods in the Soviet Union were scarce and
usually of poor quality.
Section 3: Centrally Planned Economies
(Command Economies)
• Collective
– Large farm leased from the state to groups of
peasant farmers
• Farmers managed operation, but were told by
government what to produce
• Farmers received either a share of what they
produced or income from its sale
Section 3: Centrally Planned Economies
(Command Economies)
• Heavy industry
– Industry that requires a large capital
investment and that produces items used in
other industries
• Chemical, steel, heavy machinery manufacturing
The Former Soviet Union (case study)
Soviet industry
• Lack of incentives
– Jobs were guaranteed & wages were set by government
– Once a production quota was met, no reason to produce more
– Little incentive to work hard or to innovate
• Illegal for workers to exhibit entrepreneurial behavior and
start their own businesses
Problems of a Centrally Planned Economy
Centrally planned economies face problems
of poor-quality goods, shortages,
and diminishing production.
Section 3: Centrally Planned Economies
• Advantages
– Work quickly to accomplish specific goals
• Can be used to jumpstart selected industries
– Guarantee jobs and income
Section 3: Centrally Planned Economies
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Poor quality of goods
Serious shortages of non-priority goods and services
Diminishing production
Large, expensive bureaucracy
– Decisions overly complicated
– Lacks flexibility to adjust to consumer demands
• Individual freedoms sacrificed to pursue societal goals
• Most planned economies have failed
Chapter 2: Economic Systems
• Section 3 Review
– Centrally Planned Economies
(Command Economies)
Chapter 2, Section 2 Review:
1. In a socialist country,
(a) central planning is unnecessary.
(b) the government often owns major industries,
such as utilities.
(c) an authoritarian government controls the
economy.
(d) economic equality is not important.
Chapter 2, Section 2 Review:
2. Which of the following is an advantage of
a centrally planned economy?
(a) the system’s bureaucracies are small and
flexible
(b) the system can work quickly to accomplish
specific goals
(c) innovation is well rewarded
(d) consumers’ needs are well met
Chapter 2, Section 2 Review:
3. Which of the following is NOT a reason
why Soviet workers lacked incentives?
(a) Job were guaranteed.
(b) Wages were set by the government.
(c) There were no production quotas.
(d) Entrepreneurial behavior was illegal.
Chapter 2: Economic Systems
• Section 3 Review
– Centrally Planned Economies
(Command Economies)
• Assignments
– Pg. 17 of Unit 1 book, Soviet Union
Chapter 2: Economic Systems
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Answering the Three Economic Questions
The Free Market
Centrally Planned Economies
Modern Economies
Section 4: Modern Economies
• Limits of laissez faire
• The doctrine that states that government
generally should not intervene in the
marketplace
• Adam Smith
• Wrote The Wealth of Nations
• Published in 1776
• Called for restricting the role of the government in the
economy
Section 4: Modern Economies
• As market economies have evolved, government
intervention has increased
• Most modern economics are a mixture of
economic systems
– Blending the market with government involvement (or
intervention)
• Rise of Mixed economies
• Systems that combine tradition and the free market
with limited government intervention
Section 4: Modern Economies
• Some government interventions
• National defense
• Roads, highway systems, & mass transit
• Conservation
• Environmental protection
• Job safety guidelines
• Consumer protection
Section 4: Modern Economies
• Some government interventions
• Social Security
• Minimum wage
• Unemployment benefits
• Education
• Health care
Section 4: Modern Economies
• More government interventions
• Laws:
• Protecting property rights
• Patent laws give the inventor of a new product
the exclusive right to sell it for a certain time
period
• Private property
• Property owned by individuals or
companies, not by the government or the
people as a whole
Section 4: Modern Economies
• More government interventions
• Laws:
• Enforcing contracts
• Insisting on competition
• Monopolies & trusts are illegal
Section 4: Modern Economies
• Mixed economies balance economic control and
freedom in the market
– Prioritize economic goals (based on society’s values)
• Some goals are better met by open market
• Some goals are better met by government action
– Evaluate opportunity cost of pursuing each goal
• What are you willing to give up?
Section 4: The Rise of Mixed Economies
Market economies, with all their advantages, have certain drawbacks.
Limits of Laissez Faire
Laissez faire is the doctrine
that government generally
should not interfere in the
marketplace.
Governments create laws
protecting property rights
and enforcing contracts.
They also encourage
innovation through patent
laws.
Section 4: Modern Economies
• Example: Sweden
• See textbook p. 41 Global Connections:
Sweden’s Mixed Economy
• Swedish government redistributes more than half of
the nation’s wealth through social benefit programs
• Swedes pay around 56% of their GDP in taxes,
compared to Americans paying 32%
• Gross Domestic Product (GDP)
• Dollar value of all goods and services produced within a
country’s borders within a given year
Government’s Role in a Mixed Economy
In a mixed economy,
Circular Flow Diagram of a Mixed Economy
Product market
monetary flow
• The government
purchases land,
labor, and capital
from households in
the factor market
• The government
purchases goods
and services in the
product market.
physical flow
Households
expenditures
Government
physical flow
monetary flow
Factor market
expenditures
Firms
Section 4: Comparing Mixed Economies
• Foundation of the U.S. economy is the
free market
• Free enterprise
– An economic system characterized by private
or corporate ownership of capital goods
– Investments are determined in a free market
by private decision rather than by state control
Section 4: Comparing Mixed Economies
• An economic system that permits the conduct of
business with minimal government intervention is called
free enterprise. The degree of government involvement
in the economy varies among nations.
Continuum of Mixed Economies
Centrally planned
Free market
Iran
North Korea
Cuba
South Africa
China
Russia
France
Botswana
Greece
United Kingdom
Canada
Peru
Source: 1999 Index of Economic Freedom, Bryan T. Johnson, Kim R. Holmes, and Melanie Kirkpatrick
• Continuum
– A range with no clear divisions
Hong Kong
Singapore
United States
Section 4: Comparing Mixed Economies
• In free enterprises, the degree of government involvement in the
economy varies among nations.
Continuum of Mixed Economies
Centrally planned
Free market
Iran
North Korea
Cuba
South Africa
China
Russia
France
Botswana
Greece
United Kingdom
Canada
Peru
Source: 1999 Index of Economic Freedom, Bryan T. Johnson, Kim R. Holmes, and Melanie Kirkpatrick
• Continuum
– A range with no clear divisions
Hong Kong
Singapore
United States
Section 4: Comparing Mixed Economies
• Mixed economies where government
intervention dominates
– North Korea
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economy is almost totally dominated by the government
government owns all property & economic output
state-owned industries produce 95% of nation’s goods
almost all imports are banned
production of goods & services by foreign companies is
forbidden
Section 4: Comparing Mixed Economies
• Mixed economies where government
intervention dominates
– China
• economy is dominated by government, but 25% of all
enterprises are at least partly owned by individuals
• has relied heavily on central planning in the past, but is now
in transition
Section 4: Comparing Mixed Economies
• Transition
– A period of change in which an economy
moves away from a centrally planned
economy toward a market-based system
– To make the transition, state firms must be
privatized
Section 4: Comparing Mixed Economies
• Privatize
– To sell state-run firms to individuals
– These firms then compete with one another in
the marketplace
Section 4: Comparing Mixed Economies
• Mixed economies where the market system
dominates
– Hong Kong
• private sector rules
• government protects private property
• government rarely interferes with free market
– Government does set wage and price controls on rent and
some public services
• highly receptive to foreign investment
• virtually no barriers on foreign trade
• banks operate independently of government
– foreign-owned banks have nearly same rights as domestic
ones
Section 4: Comparing Mixed Economies
• United States economy
– free enterprise
– foreign investment encouraged
– free trade
• government does protect some domestic industries &
retaliates against trade restrictions imposed by other nations
– few restrictions on banking industry
– high level of economic freedom
– low level of government regulation
Section 4: Comparing Mixed Economies
• United States economy
– Government interventions
• keep order
• provide vital services
• promote general welfare
Chapter 2, Section 4 Review:
1. The United States economy is a mixed
economy
(a) based on the principle of a traditional economy, but
allows some government intervention.
(b) based on the principles of a centrally planned
economy, with limited government intervention.
(c) based on the principles of the free market, and
allows no government intervention.
(d) based on the principles of the free market, but
allows some government intervention.
Chapter 2, Section 4 Review:
2. Government intervention in a modern economy
is useful because
(a) the needs and wants of modern society are always
met by the marketplace.
(b) the marketplace has many incentives to create
public goods such as parks and libraries.
(c) governments are able to provide some goods and
services that the marketplace has no incentive to
produce.
(d) the marketplace provides all of its own laws.
Chapter 2: Economic Systems
• Section 4 Review
– Modern Economies
• Assignments (handouts)
– Vocabulary Practice
– Economic Cartoons
– Building Flowcharts