Basic Economic Concepts
5. Economic Systems:
Three Fundamental Questions
1. What should be produced?
2. How should it be produced?
3. For whom should it be produced?
... decisions based on the past
Tied to methods of trial and error
Same products and production methods used as in the past
Jobs passed down through generations
Questions answered by custom, habit, religion or law
Change comes slowly, often with opposition
War, climate, or outside force can cause change
Choices are limited, people do things "the way they were done in the past"
People find it hard to believe other methods exist
Family is important social structure
Examples: (though slowly changing) North American Eskimos, Navajo Indians
... central planners answer the basic questions
Planners have power to make decisions for society as a whole
Decisions are answered by planners' needs and wishes
Planners decide how many workers, who gets what job, and production goals
Wages and distribution system are determined by planners
Poor planning can cause shortages and surpluses; choice is often limited
Punishment and reward are the incentives to workers
Change can be quick without little opposition
Poor worker morale though fear is a motivator
Right to make decisions is based on political power
Examples: North Korea and Cuba
... basic questions answered by the exchanges of buyers and sellers
Interaction of demand and supply determines the three basic questions
No real overall central planning
Self-interest is guiding principle
No single person or group determines what is best for society
"an invisible hand" directs that the best interests of society are met when people compete to achieve individual self-interest
Profit motive determines producer behaviour
Capitalism is a type of market system in which private individuals and firms own the resources
Components are private property, freedom of exchange, competition and profit motive
Example: USA (though it really is a mixed market system)
... Elements of market, command and traditional are used in various economic activities
Government acts as stabilizer of economic activity and provider of goods and services
Large unions and large corporations can manipulate the market
Authoritarian capitalism mixed high government control and private property in Nazi Germany
Market socialism of China mixes extensive government ownership of resources and capital but reliance on free markets for distribution
Sweden's mixed market allows for government redistribution of income through high tax rates
Japanese economy relies on cooperation and coordination between government and businesses
6. The Circular Flow Model:
Economists use the circular flow diagram to show the high degree of economic interdependence in our economy. Money flows in one direction while goods, services, and the factors of production flow in the opposite direction.
Resource (or factor) markets operate as the points of exchange when individuals sell their resources (land, labor, capital, and entrepreneurial ability) to businesses in exchange for money incomes. Businesses will demand these resources to produce goods and services. Price paid for the use of resources are determined in this market, and will create the flow of rent, wages, interest and profit income to the households. Examples are hiring of workers by a business firm, savings and investments in stocks and bonds.
Produce markets operate as the points of exchange between consumers who use money incomes to buy these goods and services produced by businesses.
Households create the demand for goods and services, while businesses can fill the demand with the supply that they produce with the resources sold. The interaction of demand for goods and services with the supply of available products determines the price for the products. The flow of consumer expenditures represent the sales revenues or receipts of the businesses.
Individuals or households function as both providers of resources and as consumers of finished products. Businesses function as buyers of resources and sellers of finished products. Each group of economic units both buyers and sellers.
Scarcity plays a role in this model because households will only possess a limited amounts of resources to supply to businesses, and hence, their money incomes will be limited. This limits their demand for goods and services. Because resources are scarce, the output of finished goods and services is also necessarily limited.
7. Comparative advantage and specialization:
Absolute advantage is the ability to produce something more efficiently. Comparative advantage is the ability to produce something with a lower opportunity cost. People can benefit from voluntary trade because both parties will be specializing in what they do best, and each is doing so at the least opportunity cost. All of the trade in the word takes place because of differing opportunity costs – that is, because of differing comparative advantages.
Because the bakery can produce more pastries than the pizza parlor, the bakery has absolute advantage in pastry production. The pizza parlor has absolute advantage in crust production.
Both producers could produce pastries, but the bakery can produce pastries at lower opportunity cost (0.5 crusts vs. 2 crusts). The bakery is said to have comparative advantage in the production of pastries. Likewise, the table illustrates that the pizza parlor has the comparative advantage in pizza crusts (0.5 pastries vs. 2 pastries).
These producers can, and indeed should, specialize by producing only pastries at the bakery and only crusts at the pizza parlor.