G1 ECONOMICS

Economic Systems
Economic Systems

■ Every country has an economic system or economy involving decisions

about the production, consumption, and exchange of goods and
services.
■ Economies can be of any size, with any number of people and firms
involved.
– Smaller economies, such as a village or town, are most likely parts of a
much larger regional or national economy.
Economic Systems & Scarcity

■ Some economies have access to more resources that others, but all
economies have far fewer resources than they require to satisfy all the
needs and wants of their populations (i.e. scarcity).
3 Fundamental Economic Questions

■ The basic economic problem of scarcity has led

economists and governments to ask 3
fundamental economic questions in order to
effectively allocate their resources:
– What to Produce?
– How to Produce?
– For Whom to Produce?
What to Produce?
■ This decision is a matter for both the public sector (i.e.
government) and the private sector.
– The government has to decide what goods and services
to provide and how much of each to provide.
■ For example, a government may have to decide
between building more nuclear weapons or building
more hospitals.
– The private sector also has to decide what to produce,
but this will tend to be decided by the market.
■ Firms will examine demand and try to produce goods where there
is the greatest level of demand. This question is then answered
by the market forces of demand and supply.
How to Produce?
■ This involves questions like: What tools are needed?
How many workers? How much land?
■ Typically, firms will decide how to produce on the basis
of cost because their aim is to make a profit.
■ To help them do this, they need to produce as
efficiently as possible.
– The more efficiently they produce, the lower the cost of
production.
■ If labour is cheap, and nearly as productive as more
expensive machinery, then the firm may choose labour
intensive production.
■ If, however, machines are more productive per dollar
spent, then they may choose capital intensive
production.
For Whom to Produce?
■ This question is looking at the distribution of the goods and
services we produce.
■ FoP earn incomes and these incomes can be used to purchase
goods and services.
– The higher the level of income, the more goods and
services can be demanded.
– Effective Demand – the desire, willingness, and ability to
buy a good/service.
■ Note: Governments approach these questions in different ways
and employ various economic systems which attempt to most
effectively allocate the resources of land, labour, and capital, and
then distribute the output produced.
Economic Systems
■ An economic system is the set of mechanisms and
institutions that resolve the what, how and for
whom questions for a country.
– Some standards used to distinguish between economic
systems are:
1. Who owns the resources?
2. What decision-making process is used to allocate
the resources?
3. What types of incentives guide economic decision
makers?
■ There are 3 main economic systems:
 1. Free/Pure Market Economic System

■ An economic system with no government involvement so that private

firms account for all decisions and all production.
■ This is also known as capitalism.
■ There is private ownership of all resources.
■ There is no role for government or a public sector and therefore there
are no taxes or public spending.
 Free/Pure Market Economic System

■ All income (rent, wages, interest) generated from selling resources

goes exclusively to the resource owners.
■ Every firm will aim to make as much profit as possible.
– Defined: Profit is the amount of money a firm makes from selling goods and
services less the money it costs to buy the resources required to make them.
Free/Pure Market Economic System

■ Firms will produce what consumers want, signaled by

prices, in the cheapest possible way so as to maximize
their profits.
– Example: Sales of Savita’s shoes are rising quickly.
Savita decides to increase her selling price by 10%.
This will accomplish 2 things: 1) cover the costs of
buying more materials and using more electricity 2)
increase her profit on each pair of shoes sold.
■ The increase in price will be noticed by other firms. This is how
market prices act as a signal.
■ Competitors will be encouraged to reallocate resources
towards producing more shoes.
■ Summary: The price mechanism guides decisions taken by
different producers and consumers about how scarce
resources should be allocated between competing uses.
Advantages of the Free Market System
■ A wide variety of goods and services will be produced.
– Firms are competing to satisfy wants and generate profit.
■ Firms will respond quickly to changes in consumer
wants and spending patterns.
– If people want a good and can afford it, then it is profitable
to make and resources are quickly (re)allocated to produce
it.
■ The profit motive of firms encourages them to develop
new products (i.e. innovation) and more efficient
production methods.
– Profits incentivize firms to develop new products and more
efficient production methods.
■ There are no taxes on incomes or on goods and
services.
– Because there is no public sector, there is no need for
taxes.
Disadvantages of the Free Market System

■ Difficulty enforcing property rights as no central

authority exists to enforce laws.
■ Not all people have adequate resources to sell or
money to buy (inequality).
■ Public goods such as sidewalks, streetlights, and
national defense are not produced as they offer no
profit.
■ Externalities (e.g. pollution) that impact third parties
are ignored by the private firms.
Centrally Planned/Command
Economic System
■ An economic system where all factors/resources are
government-owned (public sector).
■ Production is coordinated by the central plans of the
government, who also set all the prices.
■ This is also known as communism.
 Mixed Economic System
■ An economic system that mixes central planning with competitive
markets.
■ Almost all economies in the world are mixed economies with
some being more free market based (e.g. U.S.) and others relying
more on government (e.g. China).
■ In a mixed economy, ownership of scarce resources and
decisions about how to use them is split between the private
sector and the public sector.