CHAPTER 2: ECONOMIC SYSTEMS how each society answers the three fundamental questions of what, how, and for whom to produce

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1 CHAPTER 2: ECONOMIC SYSTEMS how each society answers the three fundamental questions of what, how, and for whom to produce Note that there are as many real-world economic systems as there are nations, but we will look at the two extremes: pure capitalism and pure command socialism. As we go through these economies, consider: 1. Who owns the means of production? 2. Who makes the economic decisions? Means of Production: the raw materials, factories, farms and other economic resources used to produce g/s The Model of Pure Capitalism an economic system in which the means of production are privately owned and fundamental economic choices are made by individual buyers and sellers interacting in markets Basic Elements of Pure Capitalism: 1. Private Property and Freedom of Choice Private individuals and groups own the means of production Businesses are free to produce what they wish and to purchase resources from whomever they choose Individuals may also spend their resources as they choose 2. Self-Interest The driving force of capitalism (via the invisible hand) The Invisible Hand: as individuals pursue their own best interests, they promote the good of society as a whole (Adam Smith) i.e. business is driven by profits: make g/s consumer want most workers driven by wages: take jobs in higher paying sectors consumers driven by prices/quality: buy valued products Thus, each person, acting in their own best interest would be led by this invisible hand to produce the g/s desired by the society.

2 3. Markets and Prices Capitalism is the market system Market: actual or potential buyers and sellers of a particular item Does not need to be a physical location May be regional, national, international Market prices are determined by the interaction of buyers and sellers and serve the following purposes: Ration societies limited g/s to those who want/need it most Motivate businesses to produce the most desired g/s 4. Competition Pure capitalism requires pure competition to work Pure Competition: a market where many buyers and sellers, who are small in size, interact to determine prices Thus, prices are determined by the market mechanism and not a few powerful buyers and sellers 5. Limited Government Intervention The market answers the three fundamental economic questions, not the government The only role of the government is to ensure an environment where the market economy can function Laissez-faire economy: one where the government will let the people do as they choose

3 HOW CAPITALISM ANSWERS THE THREE FUNDAMENTAL QUESTIONS 1. What to Produce Producers are motivated by profits The most profitable products are the ones the consumers desire most Thus, producers are forced to be responsive to consumer s wants and needs Consumer sovereignty: consumers dictate which g/s businesses will produce 2. How to Produce Capitalists choose the least-cost approach because lower costs=higher profits e.g. in the US and Japan, skilled labor is very expensive, so often mechanized techniques (such as robots in the auto industry) are used 3. For Whom to Produce Output is given to those who desire and can afford the g/s price STRENGTHS AND WEAKNESSES OF CAPITALISM Strengths: economic efficiency ; businesses produce the g/s that consumers want most and use the least amount (cost-wise) of economic resources economic freedom political freedom ; economic and political power is separate Weaknesses: unequal distribution of wealth that is perpetuated unequal treatment of the wealthy vs. poor environmental concerns; externalities health and safety externality: costs or benefits that spill-over to a third party

4 THE MODEL OF PURE COMMAND SOCIALISM an economic system where the means of production are publicly owned and the fundamental economic choices are made by the central authority Basic Elements of Pure Command Socialism 1. Public Ownership of all Means of Production 2. Centralized Decision Making Makes all production and distribution decisions Follows-through to ensure that decisions are carried out 3. Economic Planning Central planning board must gather information about existing production capabilities devises a master plan with production outputs for industries industries give production outputs to each producing unit 4. Allocation by Command Producing units are told what and how much to produce as well as resources to use Individuals are told where to work and how much of a g/s they can consume HOW COMMAND SOCIALISM ANSWERS THE THREE FUNDAMENTAL QUESTIONS What to produce, how to produce, and for whom to produce are all determined by the central planning board. They must further ensure that their directives are carried out Must produce within their production possibilities Cannot produce efficiently or even realistically without a clear understanding of their resources Allocation methods may vary: equality, service, loyalty

5 STRENGTHS AND WEAKNESSES OF PURE COMMAND SOCIALISM Strengths: Greater equality in the distribution of wealth and g/s Potential for greater growth and other goals in targeted sectors Weaknesses: Central planning board s goals may not be those of the society Unrealistic amount of information must be acquired and dissimilated in a short period of time REAL-WOLD ECONOMIES Mixed economy: an economy which is a blend of capitalism and command socialism e.g. The U.S. Economic System: Capitalist Aspects High degree of private ownership Coordinated by the market mechanism Buyers and sellers are guided by self-interest Profit seeking and competition are evident Command Socialism Aspects Public ownership e.g. municipal power, public schools and universities, USPS, public transportation, etc. Rules and regulations established, maintained and enforced by the government o anti-trust laws to maintain competition o laws, taxes, subsidies to correct externalities o g/s which would not or could not be produced privately such as national defense o the progressive federal income tax redistributes the nation s wealth o government agencies and policies are designed to watch and stabilize the economy o regulating health and safety by banning or restricting some g/s while mandating others

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