Chapter 3: Economic System

The fundamental economic questions

• “What resources to produce?”-first basic economic question
• “What quantity to produce the resources?”-second basic economic question
• Decided quantity is based on the concept of opportunity cost
• As more of good A is produced, the lesser good B is to be produced
• “Who gets the resources and how much?”-third basic economic question

Economic Systems

• 3 ways to address the economic question

  • Government commands
  • Capitalism
  • A blend of government commands and capitalism

• Command economy: Economy dominated by the government- they decide what gets produced, in what quantity, and who is entitled to it.

• $E.g. communist states such as Cuba rely heavily on the government to decide what goods are produced$

Disadvantages

1. Relies on a quota system and production plans-difficult if millions of products
2. Requires strong coordination of the production of various goods and services.

1. E.g. achieving the production level of crops also needs proper coordination with the quality of land, machinery available, etc.

   3. Extremely tough task to allocate prices for so many goods and decide who is entitled to them

Advantages:

1. Unemployment rates fall
2. Prevent class differences by controlling wage rates
3. Price control of socially desirable and undesirable goods

Capitalism

• The economic system where supply and demand define the prices
• This supply-demand determines how much is produced
• This supply-demand determines the income of people in an economy and how much do they get from the economy
• The government creates an environment where prices can be determined in a free market
• Consumers decide how much of each product would be produced
• $Say if consumers like product A over product B, they would purchase more of A$
• $Due to this, demand increases for product A than B$
• Upon noticing the profit potential, suppliers produce more of product A-hence product B’s quantity is reduced
• The government doesn’t influence prices in capitalist markets-prices and wages are determined in the free market and this helps answer the basic economic question
• The right products are produced in the right quantity-Product A would be produced in a quantity based on only the number of people who demand it-This is known as allocative efficiency

Allocative Efficiency

• Free markets are unaffected by third parties who are uninvolved. E.g. Government

• The more perfectly competitive a market exists in an economy, the closer the economy is to perfect capitalism

• The free market offers 2 main benefits

  • Helps answer the basic economic question
  • Decentralizes the authority-government doesn’t have to interfere to ensure production

• $For E.g. supplier of product A set their price and buyers respond to this profit motive$

• $If the price seems too high, it’s automatically reduced and this signals other sellers$

  $that the profitability of product A is less in the mark$

• $Responds well to changes in market trends.et$

  • $E.g. if product A is no longer popular and product B is taking over the market, sellers$

  $reduce the price of product A and increase that of product B$

• Thus, when all prices are established in a market, optimal allocation is done to ensure the right resources are deployed and in the accurate quantity- this is allocative efficiency
• Government intervention impacts the invisible hand in the economy but they still have an important role to play in the economy

The Mixed Economy

• Government, in a capitalist economy, usually interferes when free markets themselves fail e.g. USA
• The interference is usually for society’s benefit e.g. educational support in the form of student loans, grants, etc after higher education is completed

• All countries in real-world function using both capitalist and command market-just the domination varies on this scale
• The USA is closer to a capitalist economy than a command whereas Cuba is the opposite, being closer to the command economy

The Circular Flow Diagram

• In capitalist economies, most resources are owned by individuals, and households-government owns small shares too
• Resources are transferred from households to firms and in return receive wages and profits
• The resources are sold so that firms may produce goods and services
• This exchange of money for resources is known as the “market for resources.”
• Households spend their wages and profit to purchase the goods and services that the firms supply
• This exchange of income for goods and services is known as the “market for goods and services”
• The diagram represents how institutions are tied up in a capitalist economy
• The diagram can be further expanded to include banks and government