Chapter 2 Economic Systems Section 1: Answering the Three Economic Questions
Economic System: the method used by a society to produce and distribute goods and services
Three Key Economic Questions (must be asked because of scarcity)
o What goods and services should be produced?
In our world’s complexity, it is often difficult to distinguish between needs and
Each production decision comes at an opportunity cost
o How should goods and services be produced?
Factors of production can be combined in different ways. Examine Fig 2.1
o Who consumes goods and services?
Need to ask how does abundance get divided; society must decide how to distribute
the goods and services
Factor payments: the income people receive for supplying factors of production, such
as land, labor, capital or entrepreneurship
How do we decide how much each person gets paid?
Each society answers the question of distribution based on its unique combination of
social values and goals
Economic Goals and Societal Values
Keep in mind that each society pursues these goals, to some degree =, at the expense of the
o Economic Efficiency
o Because resources are always scarce and always involve an opportunity cost, most
societies try to maximize what they can get from their resources
o An economy that can’t deliver goods is inefficient.
o Ex. Economy that still produces record albums when people want CDs and MP3
o Economic Freedom
o Ability to make choices with regard to how you handle your economic decisions.
o Discuss: What limits do we have on our economic freedom? Why do you think so?
o Patriotism: the love of one’s country; the passion that inspires a person to serve his or
o Discuss: Does patriotism have opportunity costs and trade-offs?
o Economic Security and Predictability
o Ideally, economic systems reassure people that goods and services will be available
when they need them and that people can count on receiving expected payments on
o Safety Net: government programs that protect people unfavorable economic conditions
o Discuss: Why would safety nets be important for the economy? Can we identify any
safety nets in our country?
o Economic Equity
o Each society must divide the best way to divide the economic pie.
o Activity: Create a list of ten jobs in the order of how much you believe they should
receive in income. How did you come to your decision?
o Economic Growth and Innovation
o A nation’s economy must grow for to improve its standard of living
o Innovation plays a huge role in economic growth; it increases efficiency of
production and ushers in new goods and services
o Social Goals
o Societies may also value goals like environmental protection, full employment, and
universal health care.
o Discuss: What trade-offs would you make if you created an economic system?
o Economies and Values- each system reflects a different priority of economic goals
o Tradition Economy: economic system that relies on habit, custom, or ritual to decide
questions of production and consumption of goods and services
o Qualities: revolve around the family, little room for innovation and change, gender
roles, usually small communities, communal support, agricultural focus, have
difficulty dealing with environmental disaster, lack modern conveniences
o Market Economy: economic system in which decisions on production and consumption of
goods and services are based on voluntary exchange in markets
o Command Economies: economic system in which a central authority is in command of the
economy; a centrally-planned economy
o Centrally planned economy: economic system in which the central government makes
al decisions on the production and consumption of goods and services
o Mixed Economies: market based economic system with limited government involvement
o Most modern economies are mixed
Chapter 2 Economic Systems Section 2: The Free Market
Market: an arrangement that allows buyers and sellers to exchange things
o Why Markets Exist
o Markets exist because people are not self-sufficient; markets allow us to exchange the
things we have for the things we need
o Specialization- Instead of being self-sufficient, each one of us produces one or a few
Specialization: the concentration of the productive efforts of individuals and firms
on a limited number of activities
Discuss: What are the benefits and opportunity costs of specialization?
o Buying and Selling
Markets help people sell what they have and buy what they want.
People specialize at their job, earn an income, and use what they earn to consume
o Free Market Economy
o In a free-market economy, individuals and privately owned businesses own the factors
of production, make what they want, and buy what they want
o Individuals answer the three key economic questions of what to produce, how to
produce it, and who consumes that which is produced.
o Discuss: The book states, “As you might guess, a free-market economy functions best in
an environment of de-centralized decision-making such as enjoyed in the United States.”
Do you agree or disagree with this statement? Are there times when the U.S.
government makes decisions that impact one of the three key economic questions?
o Households: a person or group of people living in the same residence.
Households own the factors of production-land, labor, and capital
o Firm: an organization that uses resources to produce a product which it then sells
Firms transform “inputs” or factors of production, into “outputs” or products
o Factor Markets: Markets in which firms purchase the factors of production from
Firms purchase land or rent land (natural resources), hire workers, and borrow
money from households to purchase capital and paying households interest or
profits in return
Profit: The financial gain made in a transaction
o Product Markets: Markets in which households purchase the goods and services that firms
o The Self-Regulating Nature of the Marketplace
According to Adam Smith, it is competition and our own self-interest that keep the
o Self-Interest: one’s own personal gain; a motivating factor in the free-market.
o Competition: the struggle among producers for the dollars of consumers
Households have the incentive to look for lower prices out of self-interest.
Incentive: an expectation that encourages people to behave in a certain way
Firms seek to make greater profits by increasing sales and to make the most
profit in selling their goods
While self-interest is the motivating force behind the free-market, competition is
the regulating force
Incentives come in two forms-monetary in the form of money or nonmonetary in
the form of gifts, services, and other goods
o The Invisible Hand: term economists use to describe the self-regulating nature of the
P.32 Fast fact- The book states, “self-interest and the free-market will provide
social services- if there’s a profit to be gained.” Do you agree or disagree with this
statement? What could be the potential opportunity costs with this fact.
o Advantages of the Free Market
o Using P.32, create a chart of the advantages and disadvantages of the free market. Make
sure to list points that may not be mentioned in the book.
o Adam Smith: One of the first people to offer an explanation of how a market economy works;
wrote The Wealth of Nations
o Answer question #1 and 2 on P. 33 and answer the caption questions on P.30 and P.31
Chapter 2 Economic Systems Section 3: Centrally Planned Economies
In a centrally planned economy, the central government rather than individual producers and consumers
in markets, answer the three key economic questions of production and consumption
How is a Centrally Planned Economy Organized
o Government control of Factor Resources and Production
Government owns both land and capital.
Government decides what to produce, how much to produce, and how much to
charge. Ex. Sweaters P35
o Socialism and Communism
They are two distinct terms
Socialism: a social and political philosophy based on the belief that democratic means
should be used to evenly distribute wealth throughout society
Socialism exists in varying degrees around the world
Socialists argue that real equality can only exist when political equality is
coupled with economic equality
In some socialist countries, the government owns industries such as utilities or
Communism: a political system characterized by a centrally planned economy with all
economic and political power resting in the hands of the central government
o Former Soviet Union
Bolshevik revolution of 1917, led by socialist Vladimir Lenin
The Soviet Union allocated the best land, labor, and capital to the armed forces,
space program, and production of capital goods such as farm equipment and
Central government set up large state-owned farms and collectives where
farmers were supplied the equipment and worked for a daily wage set by
Collective: large farm leased by the state to groups of peasant farmers
Farmers were guaranteed employment and income, but had few incentives to
produce crops more efficiently
Planners favored military industry, the space program and heavy industry.
Heavy Industry: industry that requires a large capital investment and that
produces items used in other industries
Like agriculture, workers in heavy industry had few incentives to work
harder or to innovate
Consumers and workers experienced opportunity costs of planners
Worker’s wages were not worth much because consumer goods were scarce
and usually of poor quality.
Manufacturers had to focus on quantity over quality.
o Problems of Centrally Planned Economies
Benefits: Centrally planned economies can be used to jumpstart certain
industries and guarantee jobs and income
Problems: Poor quality or goods, shortages, diminishing production, difficulty
meeting wants and needs of the society, lack of incentives for workers
Most countries have moved to mixed economies
Discuss: Why do think the Soviet Union transitioned into a mixed economy? The
book only mentions a few benefits of centrally planned economies; can you think
of any other benefits and problems? What countries do you think moved to more
of a mixed economy? And why?
o Russia In Crisis: Read and Answer the two questions on Applying Economic Ideas
Chapter 2 Economic Systems Section 4: Modern Economies
You cannot find today any economic system that relies exclusively on central planning or the individual
initiative of the free market. Most blend the market with government intervention, or involvement in the
The Rise of Mixed Economies
o The Limits of Laissez Faire
Adam Smith and other free market philosophers believed that, left to its own
devices, the free market system would provide the greatest benefit for consumers and
raise the standard of living.
Laissez faire: the doctrine that states that the government generally should not
intervene in the marketplace
They are needs and wants that could not be met in the marketplace. For example:
roads, health care, mass transit, military, education.
Governments also create laws that protect private property
Private Property: property owned by individuals or companies, not by the government
or the people as a whole
Property rights and patent rights provide incentive to develop new products.
Laws insisting on competition prevent any firm from dominating the market and
o Balancing Control and Freedom\
A society must assess its values and prioritize its economic goals
P.41 Analyze Sweden’s Mixed Economy
o A Circular Flow Model of a Mixed Economy
Discuss: What has changed about the flow chart on P42 compared to the flow chart
Just like business, the government purchases land, labor, and capital from
households in the factor market. For example, U.S. government pays 2.8 million
employees $9.7 billion for their labor
Government purchases goods and services in the product market. For example, it
buys building supplies and office supplies.
Government also provides certain goods and services like 4 million miles of roads.
Government collects taxes from both households and firms.
Government also transfers this money to households and firms for a wide
variety of reasons
o Discuss: What are specific ways the government transfers money to
both households and firms?
o Comparing Mixed Economies
Free enterprise: an economic system characterized by private or corporate ownership of
capital goods; investments that are determined by private decision rather than by state
control; and determined in a free market
Continuum: a range with no clear divisions
Activity: Comparing the “continuum of mixed economies” with the “matrix of
ownership of wealth versus control of wealth”
What information does the matrix include that is not included in the
Activity: Comparing the “continuum of mixed economies” with the Human
What is the HDI?
What counties are in the top 10?
Why do you think they are there? How many of them are mixed economies?
Transition: period in which an economy moves between a centrally planned economy
and a market-based economy
China is in transition as it begins to privatize (sell state-run firms to individuals)
Discuss: the United States Economy P. 45