Ch.2sec.1 Economic System & Economic Tools The three questions that all economic systems must answer. What should the economy produce? How should this output be produced? For whom should it be produced?

Economic system Is the set of mechanisms and institutions that resolves the what, how, and for whom questions. Standard questions to distinguish among economic systems Who owns the resource? What decision-making process is used to allocate resources and products? What types of incentives guide economic decision makers?

Pure market economy Private firms account for all production. There is no government at all. Feature-private ownership of all resources and the coordination of economic activity based on the prices generated in free, competitive markets. Any income derived from selling resources goes exclusively to the resource owners.

The Invisible Hand of Markets Resources owners have property rights to the use of their resources and are free to supply those resources to the highest bidder. Producers are free to make and sell whatever they will be profitable. Consumers are free to buy what-ever they can afford. Buying and selling is a competitive market and free from government involvement.

continued Market prices guide resources to their most productive use and channel goods to those consumers who value them the most. What, how, and for whom? Markets transmit information about relative scarcity, provide incentives to producers and consumers, & distribute income among resource owners.

continued No single individual or small group coordinates these activities. Rather, the voluntary choices of many buyers and sellers responding only to their individual incentives direct resources and products to those who value them the most.

Adam Smith Market forces coordinate production as if by an “invisible hand.” Smith argued that although each individual pursues his or her self-interest, the “invisible hand” of market competition promotes the general welfare. Voluntary choices in competitive markets answer questions What, how, and for whom.

question Identify situation in your community that you believe demonstrate problem that have resulted from our market economy. Example Pollution, a lack of public goods, or abuse of monopoly power held by some business. Discuss the situations how they came to existence and steps that could be taken to reduce or eliminate them. Is it possible or even wise to try to eliminate all of the problems that are associated with market economies? Could the effort cause other, even bigger, problems?

Problems w/ Pure Market Economies Market failures 1. Difficulty Enforcing property-Market activity depends on people using their scarce resources to maximize their satisfaction. Private markets would break down if you could not safeguard your private property or if you could not enforce contracts. Ex. thefts

continued Pure market economy, there is no government, so there is no central authority to protect property rights, enforce contracts, and ensure that the rules of the game are followed.

2. Some People Have Few Resources to Sell Poor education, disability, discrimination, the time demands of caring for small children, bad luck few resources to sell to the market economy. Markets don’t guarantee minimum level of income, people have difficulty surviving.

3. Some Firms Try to Monopolize Markets Invisible hand is suppose to promote general welfare. Some try to monopolize the market by either unfairly driving out competitors or by conspiring with competitors to fix prices. W/ less competition, firms can charge a higher price to earn more profit.

4. No Public Goods Private firms do not produce so-called public goods (natural defense) Public goods (once produced are public goods are available to all, regardless who or who does not pay for them. Reduce Terrorism benefits all Firms cannot sell public goods profitably, they are not produced in a pure market economy.

5. Externalities Market prices reflect the benefits to buyers and the cost to sellers. Some production and consumption affect third parties those not directly involved. Ex. A paper mill fouls the air breathed by local residents, but the market price of paper fails to reflect such cost. B/C the pollution costs are outside-or external to-the market transaction, they are called externalities.

Pure centrally planned economy All resources are government owned public, communal, ownership of all resources. *Communism *the government or the state,owns all resources, including labor.

Pure centrally planned economy There is public, or communal, ownership of all resources. The government, or state, owns all resources, including labor. Central planners direct production through state owned enterprises, which usually face no competition. Some goods and services are rationed (each household gets a certain amount.) Use visible hand

Problems w/ Centrally Planned Economies 1. Consumers Get Low Priority Central plans may reflect the preferences of central planners rather than those of consumers. Central planners decide what gets produced and who should consume the goods. Prices are inflexible- shortage of goods.

2. Little Freedom of Choice Central planners are responsible for all production decisions, the variety of products tends to be narrower than in the market economy. Households have less choices about what to consume. Govn’t planners may decide were people live and work.

3. Central Planning Can Be Inefficient Some resources are used inefficiently Growing and distributing farm products Central planners must decide what to grow & resources to employ (ex. Soviet Union reported 1/3 of its harvest was rotten.)

4. Resources Owned by the State Are Sometimes Wasted Resources are owned by the state nobody in particular has an incentive to see that they are employed in their highest-valued use.

5. Environmental Damage The common good Too focused to meet the goals by the central planners.

Mixed Economies An economic system that mixes central planning with competitive markets Market economy-the U.S. is a mixed economy because Government accounts for about one third of all U.S. economic activity.

Govn’t regulates Local zoning boards, lots sizes, home sizes, and types industries, federal bodies regulate workplace safety, environmental quality

Transitional economies An economic system in the process of shifting from central planning to competitive markets.

Traditional economy An economic system shaped largely by custom or religion