The Market system

Lesson 3

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Economic Systems

Basic questions Economic systemsPlanned economy

• Advantages and disadvantages

Market economy

• Advantages and disadvantages

Mixed economy

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Basic Economic Questions Any economic system must answer the three basic questions

(how do we allocate our resources?)

1. What is produced?• What goods are services are produced?

2. How are those goods produced?• What production methods are used?

3. For whom?• Who gets which goods?

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Economic Systems

Each system answers the three basic questions differently.

A market economy uses the price mechanism to allocate resources

A planned economy uses the planning mechanism to allocate resources

Countries classified by economic

system

Market Economy

Command Economy

Mixed Economy

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Economic Systems

Some standards used to distinguish among economic systems are:

Who owns the resources?

What decision-making process is used to allocate resources and products?

What types of incentives guide economic decision makers?

Countries classified by economic system

Economic system classified by the right mix of ownership and control of the economy

Ownership means those who own the resources engaged in economic activity---the public sector, the private sector, or both.

Control of economic activity refers to the fact that resources may be allocated and controlled by the public or the private sector.

Economic system

Market economy

One in which individuals and private firms make the major decisions about production and consumption.The resources are primarily owned and controlled by the private sector, not the public sector.

Command economy (centrally planned economy)

One in which the government makes all important decisions about production and distribution. The government owns and controls all resources.

Economic system

Mixed economy

Different degrees of ownership and control best describe most countries.Most market economies have some degree of government ownership and control, whereas most command economies are moving toward a market economy and away from command concepts.

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Summary

The three fundamental economic questions that all societies have to consider are what to produce, how to produce it and who receives what is produced

Economic systems can be classified as planned, market, and mixed

• In a planned economy the government owns the factors of production and makes the key economic decisions

• In a market economy there is private ownership of land and capital, consumers decide what is produced and resources are allocated through the price mechanism

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Economic Systems

A planned economy is also calledCommand economyCommand and control economyCentrally planned economyCollectivist economyCommunism

In a planned economy the government decides what to produce, how to produce it, and who gets to consume it

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Economic Systems Planned economy

Who owns the resources?• The state

What decision-making process is used to allocate resources and products?• The state makes all decisions on production and

consumption using central planning

What types of incentives guide economic decision makers?• Central planners are supposed make decisions that

benefit society• Workers/firms have bad incentives

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Economic Systems

To coordinate all activities in the economy, the government uses a central planning system

Its function was to identify what goods and services were needed by the people, how these goods and services would be produced and how the state output would be distributed

Prices are not used to determine resource allocation

Advantages of the planned economy

Wasteful competition is avoided

Deal with the externalities

Equal distribution of income and wealth

Effectively control inflation

Disadvantages of the planned economy

Misjudge the preferences of the consume Consumers get low priority and little freedom of

choice Reduced incentive to work harder

Characterized by poverty and inefficiency partly

because of bad incentives

Lack of competition between companies

Inefficient resource distribution – surplus and

shortage

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Economic Systems

In a market economy individual buyers and sellers, as a group, decide what to produce, how to produce it, and who consumes it.

The state does not play a role in the allocation of resources

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Economic Systems

Adam Smith, one of the Founding Fathers of economics famously wrote of the “invisible hand of the price mechanism”.

He described how the invisible or hidden hand of the market operated in a competitive market through the pursuit of self-interest to allocate resources in society’s best interest.

This remains the central view of all free-market economists, i.e. those who believe in the virtues of a free-market economy with minimal government intervention.

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Economic Systems

Invisible hand – the idea that self-interest and competition promote economic efficiency without any need for action by government.

People working in their own interest creates efficiency and prosperity.

To earn money, you must provide a good or service that someone wants to buy.

Competition for buyers motivates producers to improve quality and decrease cost.

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Economic Systems Market economy

Who owns the resources?• Private individuals

What decision-making process is used to allocate resources and products?

• The price mechanism (supply and demand) in free, competitive markets

What types of incentives guide economic decision makers?

• Profit incentives: any income derived from selling resources goes exclusively to each resource owner

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Economic Systems

In a market economy what is produced is determined by consumers

This is because producers want to sell their products. They can only sell their products if consumers want to buy them. Therefore, producers must produce what consumers want to buy.

This is the idea of consumer sovereignty: consumers decide what is produced.

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Economic Systems

In a market economy how to produce is determined by firms

To earn money, you must provide a good or service that someone wants to buy.

Firms a profit incentive. Competition for buyers motivates producers to improve quality and decrease cost. Thus, firms have incentive to produce as efficiently as possible, output can be maximised and waste is minimised

Firms have incentive to innovate.

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Economic Systems

In a market economy who gets to consume ‘it’ is determined by income and wealth

This point is the most criticised of market economies.Income is determined by ability – if you have none, you

have no incomeWealth can be concentrated in the hands of a few

peopleThose with no income or wealth live in poverty

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Economic Systems

Advantages of free marketsMore efficiency

• Resources are allocated automatically.Competition pushes businesses to be efficient: keeping

costs down and production high.Incentives are correct for firms and workers (profit

motive for high quality and low cost)The price mechanism transmits information to

reallocate resources cheaply and quickly• Faster response to changes in consumer wants and real cost of

resources

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Economic Systems

The price system encourages producers and consumers to conserve scarce resources

Higher level of wealth than planned economyEconomic freedom (choose what you buy, what job to do,

where you live, etc.)The market gives producers an incentive to produce goods

that consumers wantThe market provides an incentive to acquire useful skills

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Economic Systems Disadvantages of free marketsMarket failure

Lack of information• Buying too much of harmful products and not

enough of beneficial products• Business may simply satisfy the wants they have

created through advertising

Difficulty enforcing property rights

Some people have few resources to sell

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Economic SystemsMonopolistic industries may restrict output

and drive up prices

Markets just do not work in some areas (public goods, such as national defense)

Prices may give false or inadequate signals to producers and consumers (externalities, like pollution)

Market economies tend to produce a skewed distribution of income (large gap between the rich and the poor)

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Economic Systems A mixed economy has characteristics of

both planned and market economies. Both the government and private citizens make decisions on allocating resources

The purpose of a mixed economy is to find a balance between the advantages and disadvantages of a market economy and a planned economy

One can think of this as a balance between efficiency and ‘equity’

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Economic Systems Mixed economy

Who owns the resources?• Individuals and the state

What decision-making process is used to allocate resources and products?• The price mechanism (supply and demand) and

the government

What types of incentives guide economic decision makers?• Profit incentives, ‘equity’ incentives, and some

bad incentives

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Economic Systems

Sometimes we much choose between what is fair (equity) and what is efficient, and it can be difficult to have both. Why?

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Economic Systems

There are no pure market economies

There are few if any pure command economies

Most, if not all, economies are mixed economies