FACULTY OF BUSINESS & MANAGEMENT

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PRINCIPLES OF MICROECONOMICS

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Table of Content 1.0 Introduction

Page Number 2 2 2 2 3 3 3 3 4 4 5 5 6 6 6 7 8 9 9 11 11 11 10 11

1.1 Limited resources 1.2 Choice and Opportunities 1.3 Fundamental problems of Economy 1.3.1 What to Produce? 1.3.2 How should it be produced? 1.3.3 For whom should it be produced? 1.4 Economic systems in the world 1.4.1 Traditional Economic System 1.4.2 Free Market or Price System 1.4.3 Centrally-planned Economic System 1.4.4 Mixed Economy System 2.0 Comparison of two Economic systems 2.1 The Centrally-planned Economic of North Korea 2.1.1 How They Solve the Fundamental Problems of Economic 2.1.2 Strengths of Centrally-planned Economic System 2.1.3 The weaknesses of Centrally-planned Economic system. 2.2 The Free Market System of United State of America 2.2.1 How They Solve the Fundamental Problems of Economic 2.2.1.1 What to produce? 2.2.1.2 How should it be produced? 2.2.1.3For whom should it be produced? 2.2.2 Strengths of Free Market System 2.2.3 The weaknesses of Free Market System

3.0 Tables of Comparison 4.0 Conclusion Reference

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1.0

Introduction What is economic?

Economic concerned with the efficient use of a scarce resources to achieve maximum satisfaction of human wants. Therefore, we can summarize that economics is the study of how to satisfy unlimited human wants with limited or scarce resource.

Before we go to the type of economic systems in the world, it is better for us to know some of the concepts in economic. According to http://economicsonline.co.uk, some concepts that we need to know are as below;

1.1

Limited resources

Resources are said to be limited in two ways; one as limited in physical quantity such as land and the other one is limited as in use such as labor and machinery.

1.2

Choice and opportunity

Given that resources are limited, we have to make choices between alternatives we have. All economic decisions involve making choices therefore leads to creating sacrifices. For example, if we have RM10 to spend for, so let say a new shirt will cost us RM10 and magazines are RM5 each, if we buy the new shirt, we will have loss of benefit that we would have been gained from 2 magazines.

1.3

Fundamental problems of Economy

According to Clayton (2008), there are three fundamental problems that we have to answer in order for us to make choices. The three fundamental problems are as shown below;

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Figure 1 : Fundamental Problems in making choices

1.3.1 What to Produce?

The available resources can only produce limited quantity of goods and services. Therefore, the society needs to determine what types of goods and services to be produced with limited resources to maximize their satisfaction.

1.3.2 How should it be produced?

Goods and services must be produced at its optimum level with a minimum input without sacrificing the quality of the goods and products produced. This is the rule of thumb of every economic system.

1.3.3 For whom should it be produced?

After being produced, goods and services have to be distributed. Consumer goods will be disseminated to consumers while capital goods to firms. For this purpose, a mechanism should
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be available. The three basic questions above are used in the economic systems that used in every country.

1.4

Economic systems in the world

The economic systems are classified into four groups, namely as follows;

1.4.1 Traditional Economic System

Traditional Economic system is an economic where people do their things traditionally. Traditional economies are said to be the primitive on undeveloped economic systems where tools and techniques are seen as outdated. This economy system is influenced by human habits, customs and religious belief. This happens because of the people in this economic system live simple where most of the time, they depends on products of nature to meet the needs.

The features of traditional economic system according to Daily Tape;

i.

There is no sharing of work in the community. Everyone has their own part of work to be done.

ii. iii.

The barter system is still used in daily trade in order to cater the need of life. The process of production and distribution system is developed for custom or tradition according to what the community wants and always does.

iv.

Nature is the source of life and prosperity.

1.4.2 Free Market or Price System According to Dictionary.com, a free market system or price system is a system where prices and wages are determined by unrestricted competition between businesses, without government regulation or fear of monopolies. According to Economywatch.com, the features of free market system are as below;

i.

Government does not interfere in the business activities.

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ii.

Producers are free to produce what they want, how much they want and for whom they want to produce.

iii. iv.

Consumers are free to choose. Prices are decided by the Price mechanism.

1.4.3 Centrally-planned Economic System Dictionary.com explained that Centrally-planned economy is an economic system in which economic decisions are made by the state or government rather that by the interaction between consumers and businesses. Therefore, a centrally planned economy pursues to control what is produced and how resources are distributed and used.

The features of Centrally-planned Economic according to Drahokoupil (2010);

i. ii. iii.

All resources are wholly owned by the government. Consumers and producers have no control of what to produce. Government controls the rice of goods and services, the market forces are not allowed to. Profit is not the main concern

1.4.4 Mixed Economy System

This type of economic system is commonly used in most of the countries all over the world nowadays. According to Bradley (2010), this type of economic allows both government and private sector have their roles in directing the economy. Mixed economic are said to overcomes the disadvantages of both free market and centrally-planned economic.

The features of mixed economic according to Shaik (2010) are as below;

i. ii.

Public and private sector are both exist. Government intervenes in regulation and prices, market and also in income distribution.
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iii.

Government and public sector are providing more to social objectives such as public transport, communication, utilities etc.

iv.

Government act as regulator rather that a business entity.

2.0 Comparison of two Economic systems

Above are the four types of economic system used around the world. In order to understand more on centrally-planned economic system and free market system, I would like to compare North Korea and United State of America.

2.1 The Centrally-planned Economic of North Korea

Like most of the countries which used centrally-planned economic system, the role of market allocation in North Korea is very limited. With Gross Domestic Product (GDP) per capita of less than $2,000, North Korea remains as one of the worlds poorest and least developed countries compared to its neighbor South Korea, which is one of the largest economies in Asia.

2.1.1 How They Solve the Fundamental Problems of Economic

This phenomenon of economic status is closely related to how North Korea manages the fundamental problems of economic. The government or the central planning authority decides all the important activities. They choose and the choice is the principle of an economic activity. The government has the Planning Authority to solve the fundamental problems of economic. As discussed earlier, the problems of what, how and for whom to produce are decided by the commission. They decide how much should be produces and which goods and services are to be produced. The problem of how to produce is solved by choosing the method of production to be adopted in the factories owned by the government. The problem of whom to produce solved by deciding the compensation for various skills and compensation for other factors production. The process can be summarized in Figure 2 below.

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Figure 2: How Centrally-planned / Command Economic manages the economy.

2.1.2 Strengths of Centrally-planned Economic System

According to Moynihan & Titley (2000) there are four main strengths of the centrally-planned system. First, the government focuses more on equality. All private property is eliminated and the government will distribute the goods equally. If done correctly, there should be no poverty in North Korea and everyone should be equal in wealth. Second strength is, centrally-planned economic is the emphasizing of social service where there will be equality in provision of health care, education opportunities and food.

The third strength is the government capability of doing rapid change if facing major problems. As government is the sole owner of the companies, if there is any need to be shifted into a different area, there is no difficulty to change it quickly.

The final major strength is that the Centrally-planned economic is very stable. It is great on mobilizing economic resources quickly and effectively even though it has to do in the large scale. Massive projects can be executed easily, create great industrial power and attain to the imperative social goals. Centrally-planned economic system is able to override self interest in individual level and overcome the welfare of general population in order to achieve a superior agreed-upon goal to the bigger society.

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2.1.3 The weaknesses of Centrally-planned Economic system.

Moniyhan & Titley (2000) mentioned that the rapid mobilization means centrally-planned economy cut down other social needs. For example, workers are influenced on what jobs they must do and sometimes the workers are discouraged to move. They dont even given the incentive to work hard and as a result, many people work just hard enough to fill the production quotas set by the central planning authority.

Secondly, the resources in the country will be wasted due to the misallocation. This can happen because the central planning authority does not consider the law of demand and supply. Because they cannot get the updated information of what goods and services need to produce, they go for rationing instead. Furthermore, the prices are set by them, therefore, it cannot be used in gathering information about consumers needs and thus cannot be used to measure or control the demands.

Thirdly, this economic system is not good in promoting innovation. They focus more on following orders and discouraged from making any independent decisions. The rewards for individual initiative are very rare as each person is expected to perform a job according to the economic decisions made by the central planning authority.

Fourth, the centrally-planned economic system requires a very large decision making organization. It requires a lot of administrators to operate the system. Therefore, decisions only made after consulting a number of people and needs a lot amount of paperwork. Thus, these procedures make the decision making slower and increase the production costs.

Finally, the centrally-planned economic system is not flexible when it has to deal with minor day-to-day problems. The government has a difficult time coping with it because the absolute size of the bureaucracy discourages any small adjustment.

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2.2 The Free Market System of United State of America

As we know, in free economic system, individual and private sectors act in their own to answer the fundamental problems of economy. Therefore, the central feature of the United States of America (U.S) is the freedom given to private sector in making majority economic decisions towards the direction and scale of what should U.S produce (Heritage.org on Economic freedom of United States).

According to Anderson (2006), this is boosted by reasonably low levels of government intervention. Nowadays, U.S has 29.6 million of small business, 30% of world millionaires, 40% of world billionaires and 139 largest companies out of 500 companies in the world (As in Forbes, 2011).

2.2.1 How They Solve the Fundamental Problems of Economic

Figure 3: How Free Market system manages the economy.

From the figure 3 above, we can say that the market has the power to make decision. As we have discussed the features of Free Market system in subtopic 1.4.2, we can say that every consumers

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and producers are capable to solve the fundamental problems of economic. Shaik (2010) explained on how free market system solves the fundamental problems of economic as below;

2.2.1.1 What to produce?

In free market system, what to produce would be depends on the needs and wants of the consumer. The consumer would prioritize on goods and services that give the utmost satisfaction and the market will produce according to the consumers preference.

2.2.1.2 How to produce?

This is solved by the producers who seek for profits. Their main objective is to maximize profit. They will look into the needs of the consumers before producing the goods and services needed. In order to maximize profit, producers would use the most efficient production techniques with the minimum of production cost.

2.2.1.3 For whom to produce?

It is depends on purchasing power. Any individual that has purchasing power and willing to buy would have the opportunities to buy the goods and services offered.

2.2.2 Strengths of Free Market System

According to Clayton (2008), the one advantage of free market system is it always can adjust to change. For example in the 70s when the U.S has oil (gasoline) shortage, the consumers reduced their demand for large automobiles and increase in smaller yet more efficient in fuel consumption vehicles. When everything went back to normal, consumers opt for large cars again and so the producers of automobiles began making big cars again.

Secondly, free market system has great degree of individual freedom. Producers may produce whatever they think sellable and decide to produce their products in most efficient manner while
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consumers in the other hand spends on goods and services they most preferred. As individuals, they are free to make their own choice of where and when they want to work, whether they should make further investment on their own education and training.

Thirdly, government has very low degree of interference in the market. Government only intervenes in certain important concerns for example on national defense and protection of the environment.

Lastly according to Clayton (2008), in free market system, the decision making are decentralized unlike the Centrally-planned economic system, therefore everyone has a voice in the economy runs and directs the scarce resources into the uses that consumers favor.

2.2.3 The weaknesses of Free Market System

There are some weaknesses or disadvantages pointed out by Clayton (2008). One is that free economic system does not provide for basic needs for of everyone. Anyone who is not capable to care for themselves would have difficulties in surviving.

Secondly, free market system also does not provide adequate of services that individuals value most for example a system of justice, national defense and comprehensive health care. This is why the government has to intervene in providing these services where individuals pay back with taxes.

Lastly, according to Clayton (2008), there would be high volume of uncertainty that workers and businesses face if there is change done. For example, employees would concern about termination of jobs and in the other hand the employers are worried about business being taken over by another company that provide better and hence lost their customers.

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3.0 Table of comparisons

Advantages Centrally Planned Economic Capable of dramatic change in a short time. Many basic educations, public health, and others public services available at little or no cost. Provide equality to everyone. Disadvantages Centrally Planned Economic Does not meet wants and needs of consumers. Lack effective incentives to get people to work. Requires large bureaucracy, which consumes resources. Little flexibility to deal with minor dayto-day changes. New and different ideas are Free Market System Economic Rewards only productive resources; does not provide for people that not capable to take care themselves to work. Workers and business face uncertainty as a result of competition and change. Does not produce enough public goods such as defense, universal education, or health care. Must guard against market failures. Free Market System Economic Able to adjust to change gradually. Individual freedom for everyone. Lack of government interference. Decentralized decision making Incredible variety of goods and services High degree of consumer satisfaction.

discouraged, no room for individuality.

Table 1: Advantages and disadvantages of Centrally-planned Economy and Free Market System Economy.

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Fundamental of economic

Problems Centrally Planned Economic

Free Market System Economic

What and how much to Decided by central planning Decided by the price determined produce? authority, according to the by the supply and demand.

government decisions in order to maximize the social welfare. How to Produce? On labor incentive in order to Based on profits and techniques fulfill social welfare. are depends on the cost of production. For whom to produce? Equally to everyone Anyone who have the purchasing power. Unfortunately do not

consider poor people.

Table 2: How Centrally-planned Economy and Free Market System Economy solved the fundamental problems of economic.

4.0 Conclusions

In my opinion, between the two, the free market economic system is better and more convincing than the centrally-planned economic system. This is because the Centrally-planned economy seems to be outdated and not suitable for prevailing society as they consider much about freedom, innovation, motivation, satisfaction etc.

Taking former Soviet Union for example; the collapse of it central-planning economy system is caused by the main two problems; one is the coordination problem and the other one is the incentive problem.

The coordination problem was chain related to each production. The outputs of some industries are inputs in others; therefore if there is any problem in any sectors, the other sectors would be
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infected. There was no price mechanism to provide incentives to eliminate the obstacles, as in free market system.

The incentive problem in the other hand, while profit and losses indicate success and failure and incentives is given to increase or decrease production in the free market system, the central planning have no incentive to respond to product insufficiencies or oversupplies.

Furthermore, the centrally planned system also lacked of entrepreneurship. Thus, they cannot make profits to provide for any innovation. What worse, as government owned the system, there is no initiative to improve the product quality or techniques of production and therefore, the workers are lack of motivation to be more innovative. This has brought the collapse of the former Soviet Union where they become 15 separate nations on November 1991.

As for the free market system, actually there is no pure free market system practiced in the worlds nowadays. United States for example, even their economic system is said the closest to the free market system, there is still some intervention from the government in the case of the national defense, public necessities, environment and health issues. In my opinion, as long as there is government, there would be some intervention from them in order to make sure that the economy of the country will always stable and profitable to all.

(2947 words)

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References

Anderson, Jack. ( 2006), "Tax Misery & Reform Index", Forbes, retrieved on 7th February 2013 at http://members.forbes.com/global/2006/0522/032.html

Andrew Jabobs (October 14, 2012). "North Koreans See Few Gains Below Top Tier". The New York Times. Retrieved Februaryr 5th, 2012. At http://www.nytimes.com/2012/10/15/world/asia/north-koreans-say-life-has-not-improved.html

Brown, Betty J., Clow, John E., & Brown, Kenneth W. (1995). Introduction to Business. New York: Glencoe/Mac-Graw Hill.

Clayton G E.2008. Economics Principles and Practices. McGraw-Hill.

Dan Moynihan, Brian Titley.2000. Economic: A Complete Course. Oxford University Press

Myant Martin; Jan Drahokoupil (2010). Transition Economies: Political Economy in Russia, Eastern Europe, and Central Asia. Hoboken, New Jersey: Wiley.

Forbes. March 14, 2011 retrieved online on 7th February 2013 at http://www.forbes.com/billionaires/

Mustapa Mohamed (1993). Kefahaman ekonomi : untuk yang memimpin dan dipimpin.Cahaya Pantai Publisher. Kuala Lumpur

Schiller, Bradley. The Micro Economy Today, McGraw-Hill/Irwin, 2010, p. 15. "Mixed economy - An economy that uses both market signals and government directives to allocate goods and resources." This follows immediately from a discussion on command economies and market mechanism.
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Shaikh, Salman Ahmed.2010. A Comparative Study of the Major Economic Systems in the Aftermath of the Great Recession. Retrieved on 7th February 2013 at http://ssrn.com/abstract=1530392

(n.d.). Dictionary.com Unabridged . Retrieved February 2nd, 2013. at: http://dictionary.reference.com/browse/planned economy

In Dailytape. Retrieved February 1st, 2013 from http://dailytape.com/2011/08/22/traditional-economic-system-the-features-advantages-anddisadvantages/

In Economywatch.com . Retrieved February 2nd, 2013, from http://www.econedlink.org/lessons/index.php?lesson=EM322 mixed economy http://www.economywatch.com/world_economy/world-economic-indicators/mixedeconomy.html http://www.dineshbakshi.com/as-a-level-economics/basic-economic-ideas/117-revisionnotes/1350-market-economic-system

Index of Economic Freedom United States, Heritage.org, retrieved on 7th February 2013 at http://www.heritage.org/research/features/index/country.cfm?ID=Unitedstates http://www.economicsonline.co.uk/Competitive_markets/Economic_systems.html

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