2.1 Economic Systems

• Economic system - A particular set of institutional arrangements and a coordinating mechanism for solving the economizing problem.

• There is the laissez-faire capitalism and the command systems.

Laissez-Faire Capitalism

• Laissez-faire capitalism - A hypothetical economic system in which the government’s economic role is limited to protecting private property and establishing a legal environment in which contracts are enforced and people interact by buying and selling goods, services, and resources.

• Laissez-faire means let it be.

• One of its beliefs is that any interference in the economy by the government reduces human welfare.

• No society has a pure laissez-faire system

The Command System

• The command system - A system in which the government owns most property resources, and economic decision making is set by a central economic plan created and enforced by the government.

• It is used in communist countries.

• A central planning board determines production goals for each enterprise and specifies the amount of resources allocated to each enterprise so that it reaches its production goals.

The Market System

• Market system - An economic system in which individuals own most economic resources and in which price serve as the major determinant used to allocate those resources.

• It is also known as capitalism, the mixed economy, or the market economy.

• Characterized by a mixture of centralized government economic initiatives and decentralized actions

• Markets - Places where buyers and sellers come together to buy and sell goods, services, and resources.

• The market system offers high potential monetary rewards that create powerful incentives for existing firms to innovate and for entrepreneurs to come up with new products and processes.

• The government is not the dominant economic force in deciding what to produce, how to produce it, and who will get it.

2.2 Characteristics of the Market System

Private Property

• The market system is characterized by the private ownership of most property resources, including capital.

• The legal right to private property enables individuals and businesses to obtain, use, and dispose of property resources as they see fit.

• Property rights facilitate exchange.

Property rights

• Encourage investment, innovation, and economic growth.

• Encourage owners to maintain or improve their property so as to preserve or increase its value.

• Enable people to spend time and resources increasing the production of goods and services.

• Protect intellectual property through patents, copyrights, and trademarks.

Freedom of Enterprise and Choice

• Freedom of enterprise - Ensured that entrepreneurs and private businesses are free to obtain and use economic resources to produce their choice of goods and services and to sell them in chosen markets.

• Freedom of choice - Allows owners to employ or dispose of their property and money as they see fit. Also allows workers to try to enter any line of work for which they are qualified.

  • These choices are free under legal limitation.

Self-Interest

• In the market system, self-interest is the motivating force.

• Each economic unit tries to achieve its own particular goal.

• It provides direction and consistency to what might otherwise be a chaotic economy.

Competition

• The market system depends on competition between economic units.

• Competition requires:

  • Two or more buyers and two or more sellers acting independently in a particular product or resource market.

  • Freedom of sellers and buyers to enter or leave markets based on their economic self-interest.

• Competition diffuses economic power throughout the economy.

• Freedom of entry and exit enables the economy to adjust to changes in consumer tastes, technology and resource availability.

• The diffusion of economic power inherent in competition limits the potential abuse of that power.

Markets and Prices

• Competition is the regulatory mechanism of the market system.

• The coordinating mechanism of the market system is a system of markets and prices.

  • It is an elaborate communication network through which innumerable individual choices are recorded, summarized, and balanced.

Technology and Capital Goods

• In the market system, the monetary rewards go to the innovator.

• The market system encourages extensive use and rapid development of complex capital goods.

• Advanced technology and capital goods are important because the most direct methods of production are often the least efficient.

• More efficient production = more output.

Specialization

• Specialization - Using the resources of an individual, firm, region, or nation to produce one or a few goods or services rather than the entire range of desired goods and services.

Division of Labor

• Human specialization (division of labor)

• Division of labor - The separation of the work required to produce a product into a number of different tasks that are performed by different workers.

• Human specialization makes use of differences in ability. It enables individuals to take advantage of the differences in their abilities and skills.

• Human specialization fosters learning by doing.

• Human specialization saves time.

• Human specialization increases the total output society derives from limited resources.

• Specialization also works on a regional and international basis.

Use of Money

• Money performs several functions, but it is primarily a medium of exchange.

• Specialization requires exchange.

• The use of money in market systems facilitates the exchange of goods and services that specialization requires.

• Barter - The direct exchange of one good or service for another good or service.

• Barter requires a coincidence of wants between the buyer and the seller.

Active, but Limited, Government

• An active but limited government is the final characteristic of modern market systems.

• Market failures - Shortcomings within a market system.

• Governments have their own set of shortcomings that can cause substantial misallocations of resources.

2.3 Five Fundamental Questions

What Will Be Produced?

• Profits and losses are the difference between the total revenue a firm receives from the sale of its products and the total cost of producing those products.

• Continuing economic profit (TR > TC) results in expanded production and the movement of resources toward that industry and it expands.

• Continuing losses (TC > TR) lead to reduced production and the exit of resources from that industry.

  • TC - Total cost

  • TR - Total revenue

• Consumer sovereignty - The determination by consumers of the types and quantities of goods and services that will be produced with the scarce resources of the economy.

• Dollar votes - The votes that consumers cast for the production of preferred products when they purchase those products.

• If dollar votes for a product is great enough to create a profit, businesses will produce and sell that product.

• If the dollar votes don’t create sufficient revenues to cover costs, the product won’t be produced.

How Will the Goods and Services Be Produced?

• Inefficiency drives up costs and lower profits.

• Any firm wishing to maximize its profits will make great efforts to minimize production costs.

• These efforts include using the right mix of labor and capital and will be intensified if the firm faces competitions.

• Competition eliminates high-cost producers.

• Goods and services will be produced in the least-costly way.

Who Will Get the Output?

• A good or service is distributed to consumers on the basis of their ability and willingness to pay the market price.

• The more income a consumer can generate from selling resources, the more output they will be able to purchase and consume.

How Will the System Accommodate Change?

• Market systems are dynamic.

• If consumer tastes change, the prices of the products they like the most will rise and the price of the ones they don’t like as much will drop.

• This directing or guiding function of prices and profits is a core element of the market system.

How Will the System Promote Technological Progress?

Technological Advance

• The market system provides a strong incentive for technological advance.

• Technological advance includes new and improved methods that reduce production or distribution costs.

• The market system promotes the rapid spread of technological advance throughout an industry.

• Creative destruction - The belief that the creation of new products and production methods destroys the market power of firms committed to existing products and older ways of doing business.

Capital Accumulation

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