The Three Key Questions for Economic Systems. Why are some countries rich and others poor? Low, Middle and High Income.

The Three The Three Key Key

Questions Questions for for

Economic Economic SystemsSystems

Why are some countries rich and others poor?

Low, Middle and High Income

Institutions, institutions, institutions

• The answer to our question seems to lie in the political and legal institutions of each nation– Rule of law—what you own depends not on force

or who you know, but is protected by law that treat all persons equally

– Private property rights—the rights to use and sell resources are clearly defined, cheaply enforceable, and fully transferable

– Open markets—people are free to buy and sell when, where and to or from whom they wish, including citizens of other nations

Effects of institutions• Secure property rights, rule of law, and

open markets encourage people to make long term investments in human and physical capital– Education, buildings, innovation, land quality,

infrastructure, etc– These investments raise the capital stock—

both physical and human capital stocks– This in turn generates income over the long

run, raising living standards and human well being

Key Assumptions in Economics

• People are rationally self-interested– They seek to maximize their utility

• People generally make decisions at the margin– They weigh the marginal benefit against the

marginal cost of a decision

• Ceteris Paribus– Economists hold factors constant, except for

what’s being considered

Three Economic Questions

• Every society must answer three economic questions…

1. WHAT?2. HOW?3. FOR WHOM?

• How that society answers the questions determines which type of economic system that society employs

WHAT TO PRODUCE?

•WHAT goods and services will be produced with the available resources?

Resources a.k.a. The Factors of Production

• Economists classify resources into 4 categories1. Land

• Natural resources• The payment for Land is RENT

2. Labor• Human resources• The payment for Labor is WAGES

3. Capital (a product of Investment)• Tools, machines, factories• The payment for Capital is INTEREST

4. Entrepreneurship• The special ability of risk-takers to combine land, labor and capital in new ways in order to make profit• The payment for Entrepreneurship is PROFIT

Check for UnderstandingNow that you know these terms, let’s see if we can use

them to solve sort these factors. At the top of a paper write Natural Resources , Human Resources and Capital

Goods . Place these items under the correct heading.• Delivery Truck • Teacher• Factory • Tree• ATM machine • Bushel of corn• River • Hair stylist• Gold • Barrel of oilDo we all agree on the placement of these items?

Factors cont’d

Let’s consider some other questions about productive resources.

• Are the factors interdependent? (In other words, do the factors affect one another?)

• Land is considered a “passive” factor. Why?

• How do capital and labor differ from land?

Answer Key

HOW TO PRODUCE?

•HOW will the available resources be combined to produce goods and services?

FOR WHOM TO PRODUCE?

•WHOM will be the consumer of the product or service?

Three Economic Systems

•Command Economies

•Traditional Economies

•Market Economies

MARKET ECONOMIES

• Answer the key questions by a system of supply and demand. (in other words, it allows buyers and sellers to voluntarily exchange things)

• The ability of markets to coordinate economic activity is emphasized by Adam Smith in

“The Wealth of Nations.”

– This is what he referred to as the Invisible Hand

The Invisible Hand...every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good.

Invisible Hand• What is Adam Smith basically saying

with this passage?– If individuals are allowed to pursue their

own self-interest, then the often times the result will be a more efficient economy. There is NO PLANNING

• What do you think Adam Smith envisioned as the role of Government in the economy?

COMMAND ECONOMIES

• Answer the key questions through a central authority made up of an individual or a number of individuals who make the decisions of what to make, how to make it, and for whom things should be made. (Self-Interest and Competition are absent)– Communism– Socialism

TRADITIONAL ECONOMIES

Answer the key questions by relying on past customs and practices:

“The Inuit of northern Canada serve as a prime example of a traditional economy. For thousands of years, the Inuit parents have taught their children the survival skills needed to survive in the Arctic Circle's severe climate. The children are taught to fish, hunt, and make effective tools. Once learned, these skills are passed down to the next generation.”

Activity

• Need four volunteers…– Round 1:

• Part A: when I say go you can try and grab as many paper clips as possible…for every paper clip that you grab you will 1 m and m

Activity

– Round 2:• Part B: when I say go you can try and grab

as many paper clips as possible from your section…for every paper clip that you grab you will get 1 m and m

Activity

• Discuss what just happened

• On a scale of 1 to 10 (1 being completely Command Economy & 10 being a Market Economy); where would you place the United States?

Economic Spectrum

On a scale of 1 to 10 (1 being completely Command Economy & 10

being a Market Economy); where would you place the United States?

1 10

The United States probably would lie around 7 and 8

In the United States we have what In the United States we have what is known as a MIXED ECONOMY…is known as a MIXED ECONOMY…in fact pretty much every country is in fact pretty much every country is

a mixed economy combining a mixed economy combining aspects of command and market aspects of command and market

economies.economies.

Goals of Economic Systems

• Efficiency (maximize what you have)• Freedom (ability to make choices)• Security (goods/services will always

be available)• Equity (Fairness, Opportunity)• Growth (Economy must grow with

population; innovation)

TANSTAA“F”L

There Ain’t No Such Thing As A “FREE” Lunch

• NOTHING ON THIS EARTH IS FREE!!!!!

EVERYTHING HAS A PRICE…IN THE EYES OF AN ECONOMIST!

TANSTAAFL Illustrated: The PPC

• The PPC = The Production Possibilities Curve

• The PPC = a graph showing all of the possible combinations of output for an economy fully employing all of its resources in producing 2 goods.

TANSTAAFL Illustrated: The PPC