The Three Key Questions for Economic Systems

Why are some countries rich and others poor? Low, Middle and High Income

Institutions, institutions, institutions The answer to our question seems to lie in the political and legal institutions of each nation –Rule of law—what you own depends not on force or who you know, but is protected by law that treat all persons equally –Private property rights—the rights to use and sell resources are clearly defined, cheaply enforceable, and fully transferable –Open markets—people are free to buy and sell when, where and to or from whom they wish, including citizens of other nations

Effects of institutions Secure property rights, rule of law, and open markets encourage people to make long term investments in human and physical capital –Education, buildings, innovation, land quality, infrastructure, etc –These investments raise the capital stock—both physical and human capital stocks –This in turn generates income over the long run, raising living standards and human well being

Key Assumptions in Economics People are rationally self-interested – They seek to maximize their utility People generally make decisions at the margin –They weigh the marginal benefit against the marginal cost of a decision Ceteris Paribus –Economists hold factors constant, except for what’s being considered

Three Economic Questions Every society must answer three economic questions… 1.WHAT? 2.HOW? 3.FOR WHOM? How that society answers the questions determines which type of economic system that society employs

WHAT TO PRODUCE? WHAT goods and services will be produced with the available resources?

Resources a.k.a. The Factors of Production Economists classify resources into 4 categories 1.Land Natural resources The payment for Land is RENT 2.Labor Human resources The payment for Labor is WAGES 3.Capital (a product of Investment) Tools, machines, factories The payment for Capital is INTEREST 4.Entrepreneurship The special ability of risk-takers to combine land, labor and capital in new ways in order to make profit The payment for Entrepreneurship is PROFIT

Check for Understanding Now that you know these terms, let’s see if we can use them to solve sort these factors. At the top of a paper write Natural Resources, Human Resources and Capital Goods. Place these items under the correct heading. Delivery Truck Teacher Factory Tree ATM machine Bushel of corn River Hair stylist Gold Barrel of oil Do we all agree on the placement of these items?

Factors cont’d Let’s consider some other questions about productive resources. Are the factors interdependent? (In other words, do the factors affect one another?) Land is considered a “passive” factor. Why? How do capital and labor differ from land?

Answer Key Natural Resources Tree Bushel of corn River Gold Barrel of oil Human Resources Teacher Hair stylist Doctor Farmer Factory worker Capital Goods Delivery truck Factory ATM machine Bulldozer Tractor

HOW TO PRODUCE? HOW will the available resources be combined to produce goods and services?

FOR WHOM TO PRODUCE? WHOM will be the consumer of the product or service?

Three Economic Systems Command Economies Traditional Economies Market Economies

MARKET ECONOMIES Answer the key questions by a system of supply and demand. (in other words, it allows buyers and sellers to voluntarily exchange things) The ability of markets to coordinate economic activity is emphasized by Adam Smith in “The Wealth of Nations.” –This is what he referred to as the Invisible Hand

The Invisible Hand...every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good.

Invisible Hand What is Adam Smith basically saying with this passage? –If individuals are allowed to pursue their own self- interest, then the often times the result will be a more efficient economy. There is NO PLANNING What do you think Adam Smith envisioned as the role of Government in the economy?

COMMAND ECONOMIES Answer the key questions through a central authority made up of an individual or a number of individuals who make the decisions of what to make, how to make it, and for whom things should be made. (Self-Interest and Competition are absent) –Communism –Socialism

TRADITIONAL ECONOMIES Answer the key questions by relying on past customs and practices: “The Inuit of northern Canada serve as a prime example of a traditional economy. For thousands of years, the Inuit parents have taught their children the survival skills needed to survive in the Arctic Circle's severe climate. The children are taught to fish, hunt, and make effective tools. Once learned, these skills are passed down to the next generation.”

Activity Need four volunteers… –Round 1: Part A: when I say go you can try and grab as many paper clips as possible…for every paper clip that you grab you will 1 m and m

Activity –Round 2: Part B: when I say go you can try and grab as many paper clips as possible from your section…for every paper clip that you grab you will get 1 m and m

Activity Discuss what just happened

On a scale of 1 to 10 (1 being completely Command Economy & 10 being a Market Economy); where would you place the United States?

Economic Spectrum On a scale of 1 to 10 (1 being completely Command Economy & 10 being a Market Economy); where would you place the United States? 1 10 The United States probably would lie around 7 and 8 In the United States we have what is known as a MIXED ECONOMY…in fact pretty much every country is a mixed economy combining aspects of command and market economies.

Goals of Economic Systems Efficiency (maximize what you have) Freedom (ability to make choices) Security (goods/services will always be available) Equity (Fairness, Opportunity) Growth (Economy must grow with population; innovation)

TANSTAA“F”L There Ain’t No Such Thing As A “FREE” Lunch NOTHING ON THIS EARTH IS FREE!!!!! EVERYTHING HAS A PRICE…IN THE EYES OF AN ECONOMIST!

TANSTAAFL Illustrated: The PPC The PPC = The Production Possibilities Curve The PPC = a graph showing all of the possible combinations of output for an economy fully employing all of its resources in producing 2 goods.

TANSTAAFL Illustrated: The PPC