Economic system - A particular set of institutional arrangements + coordinating mechanism used to respond to the economizing problem

• Determine what goods produced, how goods are produced, who gets them, etc.

Command system - Socialism/communism; gov’t owns most property + economic decision-making occurs through central economic plan

• Central planning board makes all major decisions

• Firms produce according to gov’t directives

• Some private ownership

Market system - Capitalism; private ownership of resources + use of markets/prices to coordinate economic activity

• Acting in own self-interest

• Competition among independently acting buyers + sellers

• Laissez-faire capitalism - Limited gov’t interference w/ economy

• Characteristics

  • Private property - Private individuals + firms own most property resources; encourages investment, innovation, economic growth

  • Freedom of enterprise - Entrepreneurs + businesses can obtain resources to produce + sell goods

  • Freedom of choice - Owners can employ property/money as they see fit; consumers can buy goods and services that best satisfy their wants

  • Self-interest - Each economic unit tries to achieve its own particular goal, usually delivering something of value to others

  • Competition - Between economic units; based on freedom of choice in pursuit of monetary return; spreads economic power between businesses + households

  • Markets - Institution/mechanism that brings buyers + sellers into contact

  • Technology and capital goods

  • Specialization - Use of resources to produce a few goods instead of an entire range

  • Division of labor - Human specialization

  • Medium of exchange - Function of money; makes trade easier

  • Barter - Swapping goods and services for each other; requires coincidence of wants between buyers and sellers

  • Money - Convenient social invention to facilitate exchanges of goods and services

  • Active but limited government

Five fundamental questions

• What goods and services will be produced?

  • Only goods and services produced at continuing profit will be produced

  • Consumer sovereignty - Consumers spend income on goods they are willing + able to buy

  • “Dollar votes” - Consumers using dollars to show what goods + services they want in the market; determine which industries survive and fail

• How will the goods and services be produced?

  • Least-cost production - Most economically efficient techniques of production

• Who will get the goods and services?

  • Products distributed to consumers based on who is willing and able to pay

  • Depends on income, prices, and preferences

• How will the system accommodate change?

  • Changes as consumer preferences, production techniques, and resource supplies change

  • Directs expansion/contraction of industries

• How will the system promote progress?

  • Technological advance

  • Creative destruction - Creation of new products + production methods destroys market positions of firms relying on existing products and older business ways

  • Capital accumulation (dollar votes for capital goods)

“Invisible hand” - As firms seek to further their own self-interest in a market system, they simultaneously promote social interests

• Efficiency - Efficient use of resources by guiding them to production of wanted goods + services

• Incentives - Skill acquisition, hard work, innovation

• Freedom - Economic activity without coercion

Problems with command systems

• Coordination problem

  • Central planners coordinating millions of individual decisions

  • Failure of single industry → Affected several other industries

  • Planning techniques ineffective for large economies

• Incentive problem

  • Persistent shortages + surpluses

  • No incentive to adjust production to fluctuations

Circular flow diagram - Shows repetitive flows of goods, services, resources, and money through the economy

• Resource market - Where resources by households sold to businesses

• Product market - Where goods and services produced by businesses sold to households