The Market system Lesson 3

Economic Systems Basic questions Economic systems Planned economy Advantages and disadvantages Market economy Mixed economy

Basic Economic Questions Any economic system must answer the three basic questions (how do we allocate our resources?) 1. What is produced? What goods are services are produced? 2. How are those goods produced? What production methods are used? 3. For whom? Who gets which goods?

Economic Systems Each system answers the three basic questions differently. A market economy uses the price mechanism to allocate resources A planned economy uses the planning mechanism to allocate resources

Countries classified by economic system Market Economy Command Economy Mixed Economy

Economic Systems Some standards used to distinguish among economic systems are: Who owns the resources? What decision-making process is used to allocate resources and products? What types of incentives guide economic decision makers?

Countries classified by economic system Economic system classified by the right mix of ownership and control of the economy Ownership means those who own the resources engaged in economic activity---the public sector, the private sector, or both. Control of economic activity refers to the fact that resources may be allocated and controlled by the public or the private sector.

Economic system Market economy One in which individuals and private firms make the major decisions about production and consumption. The resources are primarily owned and controlled by the private sector, not the public sector. Command economy (centrally planned economy) One in which the government makes all important decisions about production and distribution. The government owns and controls all resources.

Economic system Mixed economy Different degrees of ownership and control best describe most countries. Most market economies have some degree of government ownership and control, whereas most command economies are moving toward a market economy and away from command concepts.

Summary The three fundamental economic questions that all societies have to consider are what to produce, how to produce it and who receives what is produced Economic systems can be classified as planned, market, and mixed In a planned economy the government owns the factors of production and makes the key economic decisions In a market economy there is private ownership of land and capital, consumers decide what is produced and resources are allocated through the price mechanism

Economic Systems A planned economy is also called Command economy Command and control economy Centrally planned economy Collectivist economy Communism In a planned economy the government decides what to produce, how to produce it, and who gets to consume it

Economic Systems Planned economy Who owns the resources? The state What decision-making process is used to allocate resources and products? The state makes all decisions on production and consumption using central planning What types of incentives guide economic decision makers? Central planners are supposed make decisions that benefit society Workers/firms have bad incentives

Economic Systems To coordinate all activities in the economy, the government uses a central planning system Its function was to identify what goods and services were needed by the people, how these goods and services would be produced and how the state output would be distributed Prices are not used to determine resource allocation

Economic Systems What? How? The central planner has to decide which goods to produce and the quantities of each good to produce, based on limited information about individual needs and wants. How? The government decides what it thinks are the best production methods, technologies, etc.

Economic Systems For Whom? In return for the labour expended in producing this output, a wage was given If there was anything in the stores, one could buy it. In reality, most people had to use the black market to get goods, otherwise they would go without When stores did have products, they were not good ones; there was little choice Consumer often experience long queues for consumer goods.

Advantages of the planned economy Wasteful competition is avoided Deal with the externalities Equal distribution of income and wealth Effectively control inflation

Disadvantages of the planned economy Misjudge the preferences of the consume Consumers get low priority and little freedom of choice Reduced incentive to work harder Characterized by poverty and inefficiency partly because of bad incentives Lack of competition between companies Inefficient resource distribution – surplus and shortage

Economic Systems Planned Economies Examples Closely associated with communist regimes in Russia and Eastern Europe that arose from 1917 onwards, finally collapsing in the late 1980s and early 1990s, and China, which has been going through a gradual transition Planned economies still exist in some parts of the world, most notably in Cuba, North Korea, and some states in Africa

Economic Systems In a market economy individual buyers and sellers, as a group, decide what to produce, how to produce it, and who consumes it. The state does not play a role in the allocation of resources

Economic Systems Adam Smith, one of the Founding Fathers of economics famously wrote of the “invisible hand of the price mechanism”. He described how the invisible or hidden hand of the market operated in a competitive market through the pursuit of self-interest to allocate resources in society’s best interest. This remains the central view of all free-market economists, i.e. those who believe in the virtues of a free-market economy with minimal government intervention.

Economic Systems Invisible hand – the idea that self-interest and competition promote economic efficiency without any need for action by government. People working in their own interest creates efficiency and prosperity. To earn money, you must provide a good or service that someone wants to buy. Competition for buyers motivates producers to improve quality and decrease cost.

Economic Systems Market economy Who owns the resources? Private individuals What decision-making process is used to allocate resources and products? The price mechanism (supply and demand) in free, competitive markets What types of incentives guide economic decision makers? Profit incentives: any income derived from selling resources goes exclusively to each resource owner

Economic Systems In a market economy what is produced is determined by consumers This is because producers want to sell their products. They can only sell their products if consumers want to buy them. Therefore, producers must produce what consumers want to buy. This is the idea of consumer sovereignty: consumers decide what is produced.

Economic Systems In a market economy how to produce is determined by firms To earn money, you must provide a good or service that someone wants to buy. Firms a profit incentive. Competition for buyers motivates producers to improve quality and decrease cost. Thus, firms have incentive to produce as efficiently as possible, output can be maximised and waste is minimised Firms have incentive to innovate.

Economic Systems In a market economy who gets to consume ‘it’ is determined by income and wealth This point is the most criticised of market economies. Income is determined by ability – if you have none, you have no income Wealth can be concentrated in the hands of a few people Those with no income or wealth live in poverty

Economic Systems The market system relies on a number of factors to ensure that it works efficiently. The profit motive - the incentive for a reward for enterprise Good levels of information being available to both producers and consumers Price accurately reflecting the costs and benefits of consumption and production The ease with which resources can move to different uses

Economic Systems Advantages of free markets More efficiency Resources are allocated automatically. Competition pushes businesses to be efficient: keeping costs down and production high. Incentives are correct for firms and workers (profit motive for high quality and low cost) The price mechanism transmits information to reallocate resources cheaply and quickly Faster response to changes in consumer wants and real cost of resources

Economic Systems The price system encourages producers and consumers to conserve scarce resources Higher level of wealth than planned economy Economic freedom (choose what you buy, what job to do, where you live, etc.) The market gives producers an incentive to produce goods that consumers want The market provides an incentive to acquire useful skills

Economic Systems Disadvantages of free markets Market failure Lack of information Buying too much of harmful products and not enough of beneficial products Business may simply satisfy the wants they have created through advertising Difficulty enforcing property rights Some people have few resources to sell

Economic Systems Monopolistic industries may restrict output and drive up prices Markets just do not work in some areas (public goods, such as national defense) Prices may give false or inadequate signals to producers and consumers (externalities, like pollution) Market economies tend to produce a skewed distribution of income (large gap between the rich and the poor)

Economic Systems A mixed economy has characteristics of both planned and market economies. Both the government and private citizens make decisions on allocating resources The purpose of a mixed economy is to find a balance between the advantages and disadvantages of a market economy and a planned economy One can think of this as a balance between efficiency and ‘equity’

Economic Systems Mixed economy Who owns the resources? Individuals and the state What decision-making process is used to allocate resources and products? The price mechanism (supply and demand) and the government What types of incentives guide economic decision makers? Profit incentives, ‘equity’ incentives, and some bad incentives

Economic Systems Sometimes we much choose between what is fair (equity) and what is efficient, and it can be difficult to have both. Why?

Economic Systems There are no pure market economies There are few if any pure command economies Most, if not all, economies are mixed economies

Economic Systems The U.S. is considered a mixed economy. Some examples of this include: People can own their own businesses, but political leaders make policies concerning these. The government controls the mail system. The government controls most of the road networks. Waste collection and treatment are usually provided as a service by the local government.

Economic Systems All American airports are government operated but all American airlines are private. The government has created a minimum wage law. The government provides social welfare payments to some citizens. The majority of pre-college education is government-provided and a large part of tertiary education is run by state governments. Some health care is provided by the government