Key Point #1. An economic system is the way societies provide goods and services to meet the wants and needs of its citizens.

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1 Lesson 2.1: Three Economic Questions and the Traditional Economy What you will learn! An economic system is the way societies provide goods and services to meet the wants and needs of its citizens. SS.912.E.1.3. There are three economic questions that every economic system must answer: (1) what are we going to make?; (2) how are we going to make it?; (3) for whom are we going to make it? SS.912.E.1.3. A traditional economy is an economic system based on customs, habit and ritual passed down from generation to generation. SS.912.E.1.3. Key Point #1. An economic system is the way societies provide goods and services to meet the wants and needs of its citizens. In the last unit, we learned that economics is about why we make choices about what we want and need. Scarcity limited amount of resources to meet an unlimited about of needs and wants forces us to make decisions about everything. In this unit, we will learn about how we get those needs and wants met. Let s say you have your own little kingdom and it s your task to design an economy to distribute goods and services. How would you want this economy to look? We could make it a smaller economy, based on small communities or families, where everyone could potentially have a say. Everything resources and products could be in the hands of the government, which would make the decisions for everyone. Perhaps you would prefer less control, where everything s in the hands of individuals and businesses, and they make the decisions about what goods and services will be available. There could be some middle ground, perhaps where individuals and businesses control resources, but there s some government intervention where needed. These ideas can form the basis for an economic system. An economic system is a way for a society to provide goods and services to meet the wants and needs of its citizens. It s the way that countries decide how to get goods and services out to the people. In this unit, we will study four economic systems. The first one is a traditional economy, where decisions are made on the basis of habit, custom, and ritual, and are done on a localized level. Second, there is the command economy, where everything is decided by the government. Next, we will look at a market economy. In market economies, decisions are made by individuals and businesses. Finally, the mixed economy provides a combination of private decision-making with some government intervention. Each economic system has its advantages and disadvantages, but the goal is the same: putting goods and services into the hands of the people. But which goods and services? And where are they coming from? This leads us to the three economic questions that every economic system must answer. 1

2 Lesson 2.1: Three Economic Questions and the Traditional Economy Key Point #2. Every economic system must answer these questions to meet everyone s needs and wants: What are we going to make? How are we going to make it? For whom are we making it? What are we going to make? With the PPC, we learned that scarcity forces economies to make decisions about what to make. This is because every country has a certain amount of limited resources. The amount of resources determines not only what we can make, but the amount we can make as well. For example, the United States has an enormous amount of natural and manmade resources and we can produce a large variety of products from those resources. However, the tiny Pacific country of Nauru really only has one resource phosphate which limits the type of products that they can make. Similarly, the U.S. has a population of more than 300 million people, while Nauru only has 9,322 as of That s smaller than the size of Orange City. The amount of people also affects what economies can make because people are the source of labor. In short, economies will make decisions about what to make based on the resources available. How are we going to make it? This question looks at how economies combine what resources they have to make goods and services. For example, let s say an economy is focused on making cars. Should we have people make those cars, or should we use computers and robotics to make them? What about the environment? Should we try to create cars with a process that pollutes less, or should we try to make as many as possible and not worry about it? Economies must look at how to produce the products it has chosen to make. For whom are we going to make it? What this question is asking is who are these products for? And how do we decide that? Remember, we have a limited amount of resources to make these products. That also means that we have a limited amount of products. So who gets what? And how much? Should the economy distribute goods and services according to need, or perhaps equally, or should it give them out according to how much you are willing to pay? Key Point #3. A traditional economy is an economic system based on customs and traditions passed down from generation to generation. Now that we have a working definition of what an economic system is, and what decisions they have to make to meet the needs and wants of its citizens, it s time to take a look at the first economic system: traditional economy. A traditional economy is an economic system based on customs and traditions passed down from generation to generation. Typically, these types of economies are fairly small and close-knit, and are often centered around agriculture and hunting. At the same time, decisions are made on a collective basis, meaning that the local community makes decisions together for the whole society, rather than on an individual or family basis. The biggest advantage of a traditional economy is stability. What has been done in the past, will be done now and in the future. People will participate in the economy according to their own gender sons will follow fathers, daughters will follow mothers. 2

3 Lesson 2.1: Three Economic Questions and the Traditional Economy Unfortunately, this stability also lends itself to several disadvantages. The focus of these economies is on subsistence and survival. That means the focus is on needs: food, water, shelter. Innovation is not typically found in traditional economies. In other words, the iphone is more likely to be produced in a complex economy like the United States, than a traditional one like the Amish. Speaking of the Amish, traditional economies face enormous outside pressures in today s increasingly globalized economies. When we think about the Amish, we think of quiet and quaint Pennsylvanians driving horse and buggies. What we don t typically think about is the city of Philadelphia and its 1.5 million residents about 1 ½ hours away, with its flashy cars, its newfangled ipods, and its rock and roll. How are you going to keep them on the farm when they ve seen Philadelphia? Customs and traditions sounds a little outdated, doesn t it? In most books, tribes, clans, and extended families are often cited as the example to remember. It s fine to think of a Native American tribe in the 1800s or of something more quaint like the Amish. Those examples are limited and locked in time, however, which somehow makes the traditional economy old and antiquated. However, you should recognize that the traditional economy is alive and well, and represented easily in Central Florida and Volusia County. One of our biggest attractions here in Volusia is the Daytona International Speedway. NASCAR dominates the local Daytona Beach economy and has had a history here in some form well over a century when the first racetracks were the sandy beaches of Daytona and New Smyrna. When you think of NASCAR, even if you aren t a fan of 200 mph cars, you probably have heard some of the names that have won the checkered flag: Dale Earnhardt, Sr., Richard Petty, Ned Jarrett. Of course, you re more likely to have heard of their sons, closer to you in age: Dale Earnhardt, Jr., Kyle Petty, Dale Jarrett. Racing, as an industry, has been a family affair. It s no coincidence that some of the drivers on the NASCAR circuit are related to each other. When your Dad s driving a car whose rumble can be felt through a stadium, wouldn t you be attracted to that too? Even outside of driving, NASCAR mechanics often pass their trade down from father to son. Another good modern example of the traditional economy is Pigeon Forge, Tennessee. You may not have heard of the place. In the 1800s, it was a quiet mountain town, a dot on the map as you drive out of the Smoky Mountains on your way 3

4 Lesson 2.1: Three Economic Questions and the Traditional Economy to Knoxville. It remained that way until about the 1970s when a small theme park was built in an attempt to bring tourists in. However, it didn t see any real success until 1985, when the town s most famous resident bought it up and transformed it into what we now know as Dollywood. Dolly Parton s influence in creating this multi-attraction theme park has brought the small town of 5,000 a way of life. Much of what Pigeon Forge s economy is based on is Dollywood, and jobs and businesses related to it. Pigeon Forge s story is really not all that different from Orlando s experience with Disney. Before Walt Disney announced its new theme park in Orange County, Orlando was just another small town that dotted the Florida landscape. Early on, though, Orlando built up its economy with the growth of Walt Disney World, as local citizens went to work at the Happiest Kingdom on Earth, with generations of jobs created. Orlando and Central Florida have long since grown out of that traditional economy dominated by tourism, but you still see signs of it from time to time, literally. Next time you re on I-95, and you see those bright orange billboards advertising oranges, honey and other citrus, you re taking a direct look at Florida s traditional economy. 4

5 Lesson 2.2: Command Economies What You Will Learn! Command economies are controlled entirely by a government and the government decides how to answer the three economic questions. SS.912.E.1.3. Communism is an economic system where both economic and political decisions are made by the government. Socialism is an economic system where economic and political decisions are made by both the government and individuals, but the government allocates resources throughout society to attempt to achieve equality. SS.912.E.1.3, SS.912.E.2.3. Karl Marx is the founding economic philosopher behind communism. SS.912.E.2.3. Key Point #1. A command economy is an economy where the government makes all economic decisions. In the last section, we discussed how an economic system can be set up to decide the three economic questions. In a traditional economy, the three economic questions are decided by the local community, tribes, families, and so on. The reason for this is because the resources are ultimately in the hands of the community and the community decides together for their own survival. In a command economy, we find something quite different. A command economy is an economy where the government makes all economic decisions. Remember, economic systems are trying to answer (1) what are we going to make?, (2) how are we going to make it?, and (3) for whom are we going to make it? In command economies, the central government is going to answer those questions. Why? Well, go back to the resources in a traditional economy we just talked about. In a traditional economy, those resources are in the hands of families, communities, etc. In a command economy, the resources are controlled by the government. Remember, when we say resources, we mean the factors of production land, labor, and capital. If the government owns all the resources, then the government gets to make the decisions about what to make, how to make it, and who will end up buying it. In other words, the government makes decisions about everything in the economy. Okay, so the government controls everything in a command economy, but that seems like an awful big task. And it is. Governments in a command economy control everything from a central authority, and will plan the economy out. This is why sometimes you will see or hear command economies referred to as centrally-planned economies. When we say plan the economy out, we mean just that. How many bananas to produce this year? Who gets a new car over the next five years? Will we make more guns for the military or will we choose more butter for the citizens? Will we be an agricultural society or an industrial one? Should everything be distributed equally among the citizens, or are some citizens more equal than others? 1

6 Lesson 2.2: Command Economies These are just some of the questions that anyone doing any central planning would have to tackle. So what s the process for this? Let s use an economic model called guns or butter to answer this question. Guns or butter refers to the idea of an economy choosing to make more industrial goods (guns) or more consumer goods (butter). You can use the production possibilities curve here on the left as a reference to see how a command economy might choose between them. First, central planners decide that guns are in the best interest of the country which is coincidentally also the best interest of the government and decide to produce at Point B. Central planners will then allocate the factors of production land, labor, and capital to gun makers. Those resources are then used by the manufacturers to make guns. The butter folks farmers will get what resources are left over if the central planners decide to give them those resources. Wait, what if people wanted more butter than guns? The short answer is tough. Decisions are not made for consumers. Decisions are made for what s in the best interests of the government. So what type of government are we talking about here? What kind of government would choose an economic system which benefits the government at the expense of consumers? It should come as no surprise that the type of governments that have command economies are typically not on America s Christmas card list. The perfect example of this would be the Soviet Union and its communist government. When Josef Stalin was in power, he and his central planners enacted a series of what was called 5 year plans, during which the Soviet Union was to transform itself from a country based mainly on farming to one based on heavy industry. In other words, going from butter to guns. The 5 year plans caused massive famines killing hundreds of thousands of people by some estimates. Stalin wasn t exactly a warm and fuzzy individual either, ordering the deaths of anyone who opposed the 5 year plans, or criticized their results. China, under Mao Zedong, also enacted a series of 5 year plans, referred to as the Great Leap Forward. The movement from agriculture to industry also caused massive famines, killing millions. Although both the Soviet Union and China succeeded somewhat in industrializing their economies, the cost of millions of lives is arguably too high a price. The modern example of a command economy is North Korea, where decisions are made by the government for a few elite. Not surprisingly, given the track record of command economies, North Korea suffered a massive famine in the 1990s, with estimates of hundreds of thousands dying from starvation. 2

7 Lesson 2.2: Command Economies Key Point #2. Communism is an economic system where both economic and political decisions are made by the government. Key Point #3. Socialism is an economic system where economic and political decisions are made by both the government and individuals, but the government allocates resources throughout society to attempt to achieve equality. What these countries have in common are authoritarian governments. Authoritarian governments require strict obedience to the government. From history, you might recognize these governments in the form of absolute monarchies from the medieval period, or communist governments during the 20 th Century. Communism is probably a term you ve heard before, but not well defined, at least not by an economist. Communism is an economic system where both economic and political decisions are made solely by the government. There is a high degree of central planning from the government. The only pure modern form of communism today is practiced by North Korea. China still has a communist government, but is moving more and more to a market economy. Contrast communism with socialism, another term you might be familiar with. Socialism is an economic system where economic and political decisions are made by both government and individuals to distribute wealth evenly throughout society. Awesome. What does that mean? The principal ideal behind socialism is to achieve equality, both politically and economically. To do this, some economic power must remain in the hands of the government. In countries with socialism-style economies, the government often owns major industries and resources, like electricity or oil, and to distribute wealth, there is often some central planning. The degree to which the government would participate in the economy this way varies from country to country. Citizens in Sweden, for example, are comfortable with a large role for the government in controlling the economy to help achieve equality. Citizens in the U.S., on the other hand, are not and are divided on the issue. Wait, I hear you ask with baited breath, Sweden and the U.S., aren t they democracies? Why, yes, yes, they are. And that s where the difference between socialism and communism come in. In socialism, policies are chosen by the people mostly by elections or referendum, whereas in communism, policies are chosen by the government. Additionally, communists believed in revolution to achieve their goals, whereas socialists pushed their policies through democratic means, for example, voting. So it s possible to have a democracy that has socialist policies. So does the United States have socialist policies? The short answer is yes. The largest social program we have in the United States is Social Security. Social Security is designed as an income program to people who are retired or disabled. How did we get this program? We voted for Franklin D. Roosevelt in 1932 who ran on establishing this income as part of his platform. Why do we have this policy? We didn t want old people to have to make a choice between food or medicine. In a similar vein, Medicare is another social program designed to provide healthcare for Americans 65 or older. How did we get it? President Lyndon B. Johnson coordinated with Congress to implement the program. Why do we have it? We wanted old people to see doctors when they got ill, instead of avoiding getting healthcare because of cost. SNAP, or the 3

8 Lesson 2.2: Command Economies Supplemental Nutrition Assistance Program, is a program designed to allow people with very little or no income to get food. How did we get it? It was a program established by President Johnson to provide help to the poorest Americans. Why do we have it? Because people should eat, period. So in summary, your grandmother is a socialist. And feel free to go home and call her one. We re sure she won t mind at all. Actually, we re pretty sure she will, and you do too. As a young adult becoming more and more aware of the world around you, you understand that many Americans associate the term socialism with something negative. However, I doubt your grandmother would be willing to give up her socialist Social Security check or Medicare. Politically, politicians have used the term to negatively label their opponents or programs that they do not agree with. Economists, on the other hand, want you to have the information, leaving it up to you to make your decisions about social programs, and whether they re something that belong in American society or not. That s what being a citizen is a democracy is all about. Key Point #4. Command economies suffered from a number of disadvantages, including lack of innovation, severe shortages, and political suffering. There are some advantages to command economies. Command economies can concentrate their production to produce a lot of one thing fairly quickly. They can help guarantee jobs and income for its citizens. However, the disadvantages of command economies render it an inefficient choice as an economic system. First off, as everything is in the hands of the government, there is lack of incentive on behalf of individuals to create new or better products. It didn t matter what you produced, or if you did something very well workers were rewarded the same way no matter what. Movement up the management ladder was practically unheard of without political connections. This lack of incentive and innovation slows the economy down. Since there was no incentive to create more or better goods, workers didn t work all that hard. Second, because central planning allocates resources according to government need not consumer need command economies suffer from serious shortages of what we would consider basic needs. For example, one shortage the Soviet Union was notorious for was toilet paper. It was not readily available except in hotels where foreigners would stay. Soviets would often use newspaper as a substitute. Let s make a comparison to show how bad this is, as if not having toilet 4

9 Lesson 2.2: Command Economies paper wasn t bad enough already. The Soviet Union had more than double the number of nuclear missiles of the United States, but because it had spent so many resources on nuclear weapons, it couldn t regularly produce a basic consumer good like toilet paper. Finally, as we talked about above with the Soviet Union and China, command economies are focused on the benefit of the government at the expense of the population. Individual freedoms come a very distant second to what the government sees as its goals. And if that means the individual has to die so that the government can survive, in a command economy, that life is a small price to pay. Key Point #5. Karl Marx believed that capitalism would collapse and would be overthrown by workers to achieve a more equal society. So where did these ideas come from for command economies? That answer lies with a dead German economist named Karl Marx. His two most important works are The Communist Manifesto, which outlines a class struggle between owners and workers, and Das Kapital, which gives much more detail on his economic philosophy. His works and influence had a profound effect on the 20 th Century, economically and politically. Karl Marx, often cited as the father of Communism, was a German political and economic philosopher who focused on class struggle between owners and workers. He believed that the owners ( capitalists or bourgeoisie who owned the factors of production) exploited workers ( proletariat ) for their own benefit, accumulating mass amounts of wealth. For Marx, this meant that capitalism would collapse in on itself. Owners would eventually fight each other over wealth, and workers would eventually overthrow the owners and government. Marx believed that capitalism would be replaced by first socialism, and then communism, to establish a more equal society. Marx also supported revolution to achieve this. 5

10 Lesson 2.4: Market Economies What You Will Learn! Market economies are controlled by individuals and businesses, and it is they who decide how to answer the three economic questions. SS.912.E.1.3. Specialization is when individuals and businesses concentrate on doing those things they do best. SS.912.E.1.3. A circular flow diagram shows how individuals and businesses interact in the market. SS.912.E Consumers and producers will act in their own rational self-interest when choosing whether to buy or sell a product. SS.912.E.1.3, SS.912.E.2.3. Market economies are considered self-sufficient thanks to specialization, rational self-interest, and competition. Adam Smith referred to this as the invisible hand of the marketplace. SS.912.E.1.3, SS.912.E.2.3. Adam Smith was an economic philosopher who believed in a restricted role for government in an economy, allowing self-interest to guide individuals and businesses. SS.912.E.2.3. Key Point #1. Market economies are controlled by individuals and businesses, and it is they who decide how to answer the three economic questions. In the last section, one of the things we discussed is the ownership of the factors of production. In a traditional economy, the factors, or resources, are in the hands of the community and the community decides together. The community makes the decisions regarding what to make, how to make it, and for whom to make it. In a command economy, all the resources are in the hands of the government, so the government makes all the decisions about the three economic questions. In a market economy, the resources are in the hands of individuals and businesses, and they re the ones who decide how to answer the three economic questions. Okay so what is a market? A market is any particular place where buyers and sellers buy and sell goods and services. In the past, when talking about a physical place for a market, you might have thought of Wal-Mart, Publix, or Macy s. However, it now also includes places such as itunes, Angie s List, or Amazon. That s right when you re buying the new Coldplay album in your bathrobe, you re in the marketplace. Key Point #2. Specialization is when individuals and businesses concentrate on doing those things they do best. But why do you even need a market? Aren t you self-sufficient? Can t you just do it all by yourself? Truth is that as much as we d like to think of ourselves as completely independent, no one actually is. Even if we had all the physical resources available to us to make everything we need and want clothes, Lucky Charms, Ford F- 150 we just simply don t have the time. Not to mention the interest in actually doing so who really wants to make everything themselves? Instead, we specialize. Specialization is when individuals and businesses concentrate on doing those things they do best. What is it that you re good at? And why should we specialize? 1

11 Lesson 2.4: Market Economies The violin is a beautiful delicate instrument. In the most skilled hands, it can raise the roofs of cathedrals and lift souls to the heavens; or with joyous fervor and some irreverence, the violin can make a normally quiet country community dance and celebrate. And it is for these reasons why I should never touch a violin. I am not a person with any musical talent. There are others, however, who can provide that service the great playing of a musical instrument and I m willing to pay for it. Good musicians will specialize in an instrument and use that skill to earn money to buy things they need and want. By trading on their talent, they can focus on the thing they truly love music rather than try to create everything they need and want by themselves. And that focus allows them to improve and get better. Another way of saying this is that by specializing, people get more efficient at the task they specialize in. People use resources more efficiently to make their product. And it s a lot easier to produce one thing well than it is to produce a whole bunch of average things. No one should be a jack of all trades, but master of none. Key Point #3. Market economies are self-regulating, thanks to rational selfinterest and competition. Okay, so individuals and businesses specialize to make stuff we need and want. So what? Well, how does that work exactly? Let s say you want a large cup of blueberry coffee from Do you call down there before you go, and say, Hey, I m going to be there in about 20 minutes. I d like you to make some blueberry coffee for me. Probably not. Does 7-11 call you and say, Hey, we d really like you to buy this blueberry coffee we re making right now. Again, probably not. So how is it you know to buy blueberry coffee from 7-11 and 7-11 knows to make at least enough for you to go buy it? Never thought about it like that, have you? Most people haven t, but that s the real trick behind the market economy. Producers will make and consumers will buy blueberry coffee without there being any communication whatsoever. And it happens all the time, every day, at more than 50, stores throughout the world. How does this happen? Well, there s two forces driving this phenomenon in market economies: rational self-interest and competition. Rational self-interest refers to the personal gain a buyer gets from buying a product and a seller gets from making a product. Competition is where sellers work to earn your dollar, whether by making newer and better products or by making products cheaper. Let s talk about rational self-interest first. When we say something is rational, we usually mean logical or sane. In economics, we say that people and businesses act in their own rational self-interest, that they act logically or sanely to benefit themselves. But we know that is not always true. Raise your hand if you ve ever dated someone you knew was bad for you when you started dating them. We all do it! Raise your hand if you ve ever given to a charity? Other than feeling good, there is no real financial benefit to giving money away. People make bad decisions all the time. However, economists assume that people the majority of the time will act in such a way as to benefit themselves. And remember, economists are trying to predict behavior when it comes to making choices. So we assume that people will act to make themselves better off. 2

12 Lesson 2.4: Market Economies This rational self-interest idea works to make buyers and sellers act appropriately. Case in point, Mattel, the maker of Barbie dolls, has found a new way to make their iconic doll. Instead of the normal plastic to make the body and polyester for the hair, Mattel has decided to make Barbie out of razor blades. They re going to call it Razor Blade Barbie. I m sensing some resistance from you here. What s wrong with making a Barbie doll out of razor blades? Well, we can get several responses to that question. Uh, it s made out of razor blades. Razor blades hurt children. I don t want my kid to play with a doll that s dangerous. And for the consumers of Barbie dolls, those are all valid reasons. So it s a good bet that no one is going to buy Razor Blade Barbie. Why? Because no one is going to knowingly buy a toy for their kid that s going to injure them. In other words, consumers, acting in their own rational self-interest, will not buy the product. That s how rational self-interest works. It also works on the producer end as well. It s a good bet that Mattel will not make Razor Blade Barbie. Why? Well, remember, producers of any product want to make money. Consumers are not going to intentionally buy a product that will likely hurt their kid. If no one is going to buy Razor Blade Barbie, then it is very unlikely that Mattel would make it in the first place. In other words, producers, acting in their own rational self-interest, will not make the product. Granted, I realize this is a ridiculous example, but the point is still valid. Consumers will not buy a product that will not benefit them, nor will producers make a product that no one will buy. That s not to say that people don t make mistakes. Rubberbands in the shape of dinosaurs comes to mind. But so too does Teen Talk Barbie, a version Mattel made back in the 1990s that was able to say a few things here and there. Among other choice phrases were Math class is tough!, I love shopping!, and Will we ever have enough clothes? Considering Barbie is marketed as a toy for girls, this was a poor choice on the part of Mattel, and the company was widely criticized. Parents and women s advocacy groups complained about the stigma for girls, and rightly so. And this is where competition comes in. As a parent, maybe you don t particularly want to buy a toy that could discourage your kid from doing one thing or another. Perhaps instead you d prefer to buy your kid a telescope, or soccer ball, or any other number of toys. Competition ensures that there is a variety of products out there to choose from, but it also helps provide incentives to make better products and provide lower prices. Let s say there are only two competitors out there who make televisions, Sony and Toshiba, and you re in the market to buy one. Assuming for a moment that they were the same price, what would make you pick one TV over another? This is where competition really excels. Sony and Toshiba will work to provide different features, such 3

13 Lesson 2.4: Market Economies as surround sound, picture-in-picture, recording your favorite television shows and more. They may provide different screen sizes and widths, along with plasma and LCD. Sony might figure out a way to automatically order and deliver hot chicken wings when I m watching football in the fall. For me, I m pretty sure that would be the deciding factor. The point is that the companies will find a way to one up each other in terms of features and quality to win your money. But what s to stop them from charging whatever they want? The answer, again, is competition. Sony and Toshiba, along with many other companies, make a variety of televisions. If Sony set the price of a 60-inch plasma television at $10,000, Toshiba could come along and make a similar or better product and charge less, say $2,000. As could many other TV makers. If Sony wanted to keep selling that product, they probably will end up dropping their price, or risk having lots of televisions sitting on store shelves. Key Point #4. The invisible hand of the marketplace refers to the selfregulating nature of market economies. Key Point #5. Laissez-faire is an economic principle that states that government should not intervene, or have limited intervention, in the economy. To sum up, rational self-interest provides the motivations for consumers and producers. Consumers are going to buy only those things that benefit them, and producers will make only those things that will sell. Competition among producers helps regulate the market so that prices don t get too high and products continually get better over time. Rational self-interest and competition are the cornerstones behind why a market economy is self-regulating. Adam Smith, a Scottish economist, called this the invisible hand of the marketplace. When we talk about the invisible hand, economists are referring to this self-regulation of the market. Thanks to individuals and businesses acting in their own self-interest, and competition among producers, buyers buy the product they want to buy at the price they want to buy it for, and sellers sell the product they want to sell at the price they want to sell it for. And they do this without direction. Direction from whom? Well, go back to the traditional and command economies. In a traditional economy, the products would be focused on necessities: food, water, and shelter. Since the community runs things in a traditional economy, consumers and producers would be focused on these things. In a command economy, the products would be focused on whatever the government wants. Since the government runs things in a command economy, products would only be created at the government s direction, and not to consumer need. In a market economy, goods and services are produced according to what you, the consumer, want. There is a market out there for televisions that order chicken wings for you, just as assuredly there is one for Barbie and blueberry coffee. Ultimately, decisions about what to make and buy are in the hands of the consumer and producer, with limited to no government intervention. This lack of direction from the government, allowing consumers and producers to act in their own self-interest and compete against one another is referred to as laissez-faire. Laissez-faire is an economic principle that 4

14 Lesson 2.4: Market Economies states that government should not intervene, or have limited intervention, in the economy. Laissez-faire is French for leave them be, or let them do. Key Point #6. A circular flow diagram shows how individuals and businesses interact in the market. Now let s put this together in a visual called the circular flow diagram. A circular flow diagram shows how individuals and businesses interact in the market. Remember, a market is any place where buyers and sellers can buy or sell goods and services. We can further divide up the market between the product market and the factor market. In the product market, buyers and sellers exchange goods and services. In the factor market, buyers and sellers exchange the resources to make those products land, labor, and capital (factors). There are two actors in these markets: households and firms. Households are typically the consumers. Firms are typically the producers. Take a look at this diagram, the circular flow diagram for a market economy. The top half is the product market, and notice the two arrows between firms and households. Remember, in the product market, we sell goods and services. On the money end, households buy the goods and services from the firms. In exchange for the money, the firms will provide the households with goods and services. In the factor market, we re looking at resources. Firms need the resources to make the products, so they will buy the factors of production land, labor, capital from the households. In exchange for the money, households will provide firms with the resources to make goods and services. Another way to look at the circular flow diagram is as a whole. On the money end, households buy goods and services from firms in the product market, and firms buy the factors of production from the households in the factor market. In exchange, firms provide goods and services to the households, and households provide firms will land, labor, and capital. 5

15 Lesson 2.4: Market Economies Key Point #7. Market economies have a great deal of economic and political freedom, and provide financial incentives for work and innovation. Key Point #8. Pure market economies suffer from providing public goods and services and income inequality. There are quite a few advantages in a market economy. Because of the lack of central planning from the government, people in a market economy tend to have a great deal of economic and political freedom to choose what they want to do and what they would like to have. Instead of being told to do a particular job, people can specialize in what they re good at and make money off their skills. Because they can trade on their specialization, people don t have to produce everything by themselves and can focus on what they enjoy. Similarly, earning money for work and creating new products provides a financial incentive that doesn t really exist in a command or traditional economy. That being said, market economies in their pure form with limited to no government intervention in the economy have several disadvantages. First off, market economies generally do not provide what we call public goods. A public good is a good or service that has no profit, and is usually provided by the government. Examples of public goods include schools, highways, and national defense. We ll talk a little more on public goods in the next lesson, but for now, understand that what we re saying is that producers in the market will not provide these goods because there is no incentive to do so there is no profit, despite the fact that consumers can greatly benefit from these goods. Another issue is that pure market economies tend to have income inequality, either from lack of opportunity in a community or the inability to work, particularly an issue for the elderly and disabled. Key Point #9. Adam Smith believed competition and self-interest guided economies without the need for government intervention, calling this the invisible hand of the marketplace. So how did we get to market economies? Well, there s another dead economist you should be aware of named Adam Smith. Smith s most important work was The Wealth of Nations, in which he outlined the basic concepts of specialization, laissez-faire, competition, and self-interest. He is largely considered the father of classical economic study. Smith believed that specialization 6

16 Lesson 2.4: Market Economies increased productivity, since workers could focus on one or a couple of tasks, and do them very well. With the increase in production, that means more goods and services available, which means the economy would grow. At the same time, Smith believed that this was something that could happen without the need for absolute government control. For him, if people were free to make choices about buying and selling, the market would provide the goods that people needed and wanted or demanded. This is the foundation for the principle of laissez-faire, that government should avoid interfering in the economy. Smith s point though, more importantly, is that the government didn t have to. Self-interest on behalf of consumers and producers would ensure a smooth marketplace, and competition would help provide better products and cheaper prices. Smith called this the invisible hand of the marketplace. 7

17 Lesson 2.4: Mixed Economies What You Will Learn! Mixed economies are economic systems where individuals and businesses make decisions about how to answer the three economic questions, with some government intervention. SS.912.E.1.3. A public good is a good or service that has no profit, and is usually provided by the government. SS.912.E.2.11, SS.912.E.3.4, SS.912.FL.6.8. An externality is a good or service that creates a benefit or cost to an individual who is not consuming the product. SS.912.E.2.11, SS.912.E.3.4, SS.912.FL.2.2. A circular flow diagram can be used to show how a mixed economy works. SS.912.E Other countries with mixed economies can be compared to the United States. SS.912.E.3.5. Key Point #1. Mixed economies are economic systems where individuals and businesses make decisions about how to answer the three economic questions, with some government intervention. In previous sections, we explored traditional economies where communities make decisions, command economies where governments make decisions, and market economies where individuals and businesses make decisions. Looking at command and market economies as polar opposites of each other, what if there was a middle ground? What if there was an economy which combines private decisionmaking with government intervention? Welcome to mixed economies. Mixed economies are economic systems where individuals and businesses make decisions about how to answer the three economic questions, with some government intervention. Most economies in the world today are mixed economies, including the United States. Accurately, the United States is a mixed economy based on free market principles, with limited government intervention. As we talked about in previous sections, the amount of government intervention in a mixed economy will be different from country to country. Why do we need a mixed economy? Can t market economies provide everything we need without government intervention? Isn t that the basis for laissez-faire? Doesn t self-interest and competition help ensure self-regulation of the economy? For the most part, the answer to these questions is yes, but not everything can be supplied by the market. Remember, producers want to make money, that s the overriding incentive. Even if consumers want a product, or it s in the best interest of the country to make a product, if producers don t have an incentive to make the product, or provide enough of it, then producers won t make it. This is where government steps in. Key Point #2. A public good is a good or service that has no profit, and is usually provided by the government. What kind of goods would the market not produce that we would need or want? Well, a good example is actually a public school. It is in America s best interests that we have an educated population, people with knowledge to be plumbers, doctors, 1

18 Lesson 2.4: Mixed Economies mechanics, and lawyers. We also need our citizens to have a basic working knowledge of our society, its history, and yes, its economy. The American government set up public schools very early on after the Revolution to give its citizens the working knowledge to succeed in our country. A public school is an example of a public good. A public good is a good or service that has no profit, and is usually provided by the government. We use public goods all the time, from highways to public transportation, and yes, even dreaded schools. Public goods are products that producers are just not going to be willing to make because they have no incentive to do so. Even if there was a financial incentive for the producer to make a public good, the good might suffer from a free rider. A free rider is an individual who benefits from a good or service, but doesn t pay for it. For example, you and some of your friends watch the next Justin Bieber concert on pay-perview. You pay for it, but your friends do not. Everyone enjoys the concert, but your friends got a free ride, they didn t pay for the benefit. You could charge them, but then you wouldn t have any friends. Public parks, highways, public schools are all examples of public goods, as is the social safety net of Social Security and Medicare. Without government setting aside funds or land to build these public goods, they would not be available to the public. When the market fails to provide a product, we call this market failure. Key Point #3. An externality is a good or service that creates a benefit or cost to an individual who is not consuming the product. Another reason for mixed economies has to do with externalities. An externality is a good or service that creates a benefit or cost to an individual who is not consuming or producing the product. That s a mouthful. It s best to think of externalities as positive and negative. A positive externality is a good or service that creates a benefit to an individual who is not consuming the product. That doesn t sound so bad, and indeed, it is not. A good example of this that you might use every day is Twitter. If you had one person using Twitter, then that person let s call him a twit would be awful lonely, and Twitter wouldn t have any value. If you have millions using Twitter, then suddenly millions of twits can communicate ideas, and Twitter suddenly becomes incredibly important in everybody s lives. Rotten Tomatoes, a movie review site, expands its influence within the movie industry, and will let you know in 140 characters whether Hunger Games: World Cup Edition is fresh or rotten. Your teacher can tweet tonight s homework to you, and you can retweet it to your classmates. Twitter can also apparently let you know where the revolution is taking place. And I m not kidding. In recent uprisings and revolutions in Egypt and Libya, Twitter was used to great effect in organizing protests and fights. So what does that have to do with a mixed economy? Well, sometimes we want our citizens to have a benefit beyond what an individual might have alone. Case in point, the polio vaccine. Polio is a devastating 2

19 Lesson 2.4: Mixed Economies contagious illness, and a deadly one as well, especially to children. Polio knows no limits, affecting everybody in its wake, rich and poor, famous and obscure, in strong countries and weak. If you survived it, paralysis in the legs was a likely result, as one of our own presidents, Franklin D. Roosevelt, can attest to. In 1952, Jonas Salk developed a vaccine to cure polio, a simple vaccine that can be administered now with a drop on the tongue. Given the deadly nature of the disease, countries around the world, including our own, wanted to make sure that its citizens got it, and governments helped provide the vaccine at a reduced cost or even free. If one citizen gets the vaccine, certainly he benefits from not getting polio. However, his family and friends all the people around him also get a benefit by not being exposed to polio. This is the positive externality. Multiply that by millions of people, and the positive externality expands to the rest of the world, a world without polio. A negative externality is a good or service that creates a cost to an individual who is not consuming the product. Compare that to the positive, and that doesn t seem so good, and indeed, it is not. A classic example of a negative externality is pollution. All kinds of pollution air, water, noise, even light. The Griffith Observatory in Los Angeles was built almost 100 years ago, and has served as a home for many astronomers and physicists. Since astronomers do their work by looking up at the night sky, darkness is a necessity. 100 years ago, not a light came from the city of Los Angeles. Now, the City of Angels is the second largest city in the United States, with almost 4 million people. The light from Hollywood alone would make it difficult for any stargazer. Volusia County is home to some terrific natural springs, including Blue Springs and DeLeon Springs, not to mention some fairly clean beaches. These are not only places to do some great swimming, but are also home to one of Florida s unique and silly creatures, the manatee. Manatees may be ridiculous looking animals, but they serve a great purpose in Florida s ecology. Manatees eat enormous amounts of plants that would otherwise clog up our waterways. They help keep our rivers and lakes clean. Seriously though, they re silly animals. So again, how does this work with a mixed economy? Air pollution is one of the biggest areas in climate change research and pollution control. Air is important. If air is dirty, we can t breathe. If we can t breathe, we die. Death is bad. Thing is power companies, one of the largest producers of air pollution, do not have an incentive by themselves to reduce air pollution, whether by making cleaner energy or switching to different fuels, or other ways. Governments step in with regulations, subsidies, and taxes to encourage polluters to find cleaner ways of producing energy, including solar and wind. Without intervention, ultimately, the air becomes unbreathable and causes great health 3

20 Lesson 2.4: Mixed Economies problems. Los Angeles has struggled with air pollution for quite some time now, with one of the biggest effects of energy pollution and car emissions being smog, and the city and the state of California have passed laws to help clean up the air. In China s capital, Beijing, air pollution has gotten so bad, that citizens there have to wear masks on heavy smog days, and there are smartphone apps that track the pollution. And that pollution doesn t just stay in China, it travels throughout our atmosphere. To summarize, the biggest advantage of a mixed economy is allowing the government to provide for public goods and respond to externalities when the market fails to provide solution. To be clear, this isn t a criticism of market economies. Rather, it s a recognition that the market economy provides most products well, but requires an incentive to do so. In public goods and externalities, there is no incentive. That s where the government tends to come in. Key Point #4. A circular flow diagram shows how individuals and businesses interact in the market. 4 Let s go back to the circular flow diagram again, except this time, we re going to add a new actor to the economy, in addition to households and firms: government. We still have the product and factor market, and the interactions between households and firms, that hasn t changed. Remember, in the product market, we sell goods and services. On the money end, households buy the goods and services from the firms. In exchange for the money, the firms will provide the households with goods and services. In the factor market, we re looking at resources. Firms need the resources to make the products, so