Economic Systems

Every society needs to develop an economic system—a particular set of institutional arrangements and a
coordinating mechanism—to respond to the economizing problem.
The economic system has to determine what goods are produced, how they are produced, who gets them,
how to accommodate change, and how to promote technological progress.
Economic systems differ as to
(1) who owns the factors of production
(2) the method used to motivate, coordinate, and direct economic activity.
Economic systems have two polar extremes:
1) the command system
2) the market system

Economic Systems: The Command System

The command system is also known as socialism or communism.
In that system, government owns most property resources and economic decision making occurs through a
central economic plan.
A central planning board appointed by the government makes nearly all the major decisions concerning the
use of resources, the composition and distribution of output, and the organization of production.
The government owns most of the business firms, which produce according to government directives.
The central planning board determines production goals for each enterprise and specifies the amount of
resources to be allocated to each enterprise so that it can reach its production goals.
The division of output between capital and consumer goods is centrally decided, and capital goods are
allocated among industries on the basis of the central planning board’s long-term priorities.

Economic Systems: The Market System

The polar alternative to the command system is the market system, or capitalism.
The system is characterized by the private ownership of resources and the use of markets and prices to
coordinate and direct economic activity.
Participants act in their own self-interest.
Individuals and businesses seek to achieve their economic goals through their own decisions regarding
work, consumption, or production.
The system allows for the private ownership of capital, communicates through prices, and coordinates
economic activity through markets—places where buyers and sellers come together.
Goods and services are produced and resources are supplied by whoever is willing and able to do so. The
result is competition among independently acting buyers and sellers of each product and resource.
Thus, economic decision making is widely dispersed. Also, the high potential monetary rewards create
powerful incentives for existing firms to innovate and entrepreneurs to pioneer new products and
processes.
In pure capitalism—or laissez-faire capitalism— government’s role would be limited to protecting private
property and establishing an environment appropriate to the operation of the market system.
The term “laissez-faire” means “let it be,” that is, keep government from interfering with the economy. The
idea is that such interference will disturb the efficient working of the market system.
But in the capitalism practiced in the United States and most other countries, government plays a
substantial role in the economy. It not only provides the rules for economic activity but also promotes
economic stability and growth, provides certain goods and services that would otherwise be underproduced
or not produced at all, and modifies the distribution of income.
The government, however, is not the dominant economic force in deciding what to produce, how to produce
it, and who will get it. That force is the market.
Characteristics of the Market System

Private Property
In a market system, private individuals and firms, not the government, own most of the property resources
(land and capital). It is this extensive private ownership of capital that gives capitalism its name. This right
of private property, coupled with the freedom to negotiate binding legal contracts, enables individuals and
businesses to obtain, use, and dispose of property resources as they see fit.
The right of property owners to designate who will receive their property when they die helps sustain the
institution of private property.
Property rights encourage investment, innovation, exchange, maintenance of property, and economic
growth.
Property rights also extend to intellectual property through patents, copyrights, and trademarks. Such long-
term protection encourages people to write books, music, and computer programs and to invent new
products and production processes without fear that others will steal them and the rewards they may bring.
Moreover, property rights facilitate exchange. The title to an automobile or the deed to a cattle
ranch assures the buyer that the seller is the legitimate owner.
Finally, property rights enable people to use their time and resources to produce more goods and services.

Freedom of Enterprise and Choice

The market system requires that various economic units make certain choices, which are expressed and
implemented in the economy’s markets:
Freedom of enterprise ensures that entrepreneurs and private businesses are free to obtain and use
economic resources to produce their choice of goods and services and to sell them in their chosen
markets.
Freedom of choice enables owners to employ or dispose of their property and money as they see fit. It also
allows workers to try to enter any line of work for which they are qualified. Finally, it ensures that
consumers are free to buy the goods and services that best satisfy their wants and that their budgets allow.
These choices are free only within broad legal limitations, of course. Illegal choices such as selling human
organs or buying illicit drugs are punished through fines and imprisonment.
Global Perspective 2.1 reveals that the degree of economic freedom varies greatly from economy to
economy (2008):
Free - Hong Kong, Ireland. US
Mostly free - Belgium, Spain, France
Mostly unfree - Brazil, China, Russia
Repressed - Venezuela, Cuba, North Korea

Self-Interest
In the market system, self-interest is the motivating force of the various economic units as they express
their free choices.
Self-interest simply means that each economic unit tries to achieve its own particular goal, which usually
requires delivering something of value to others.
Entrepreneurs try to maximize profit or minimize loss.
Property owners try to get the highest price for the sale or rent of their resources.
Workers try to maximize their utility (satisfaction) by finding jobs that offer the best combination of wages,
hours, fringe benefits, and working conditions.
Consumers try to obtain the products they want at the lowest possible price and apportion their
expenditures to maximize their utility.
Competition
The market system depends on competition among economic units. The basis of this competition is
freedom of choice exercised in pursuit of a monetary return.
Very broadly defined, competition requires two or more buyers and two or more sellers acting
independently in a particular product or resource market. Freedom of sellers and buyers to enter or leave
markets, on the basis of their economic self-interest.
Competition among buyers and sellers diffuses economic power within the businesses and households that
make up the economy.
When there are many buyers and sellers acting independently in a market, no single buyer or seller can
dictate the price of the product or resource because others can undercut that price.
Competition also implies that producers can enter or leave an industry.
Freedom of entry and exit enables the economy to adjust to changes in consumer tastes, technology, and
resource availability.
Competition is the basic regulatory force in the market system:
A producer that charges more than the competitive market price will lose sales to other producers.
An employer who pays less than the competitive market wage rate will lose workers to other employers.
A firm that fails to exploit new technology will lose profits to firms that do.

Markets and Prices

We may wonder why an economy based on self-interest does not collapse in chaos. If consumers want
breakfast cereal but businesses choose to produce running shoes and resource suppliers decide to make
computer software, production would seem to be deadlocked by the apparent inconsistencies of free
choices.
In reality, the millions of decisions made by households and businesses are highly coordinated with one
another by markets and prices, which are key components of the market system. They give the system its
ability to coordinate millions of daily economic decisions.
A market is an institution or mechanism that brings buyers (“demanders”) and sellers (“suppliers”) into
contact. A market system conveys the decisions made by buyers and sellers of products and resources.
The decisions made on each side of the market determine a set of product and resource prices that guide
resource owners, entrepreneurs, and consumers as they make and revise their choices and pursue their
self-interest.
Just as competition is the regulatory mechanism of the market system, the market system itself is the
organizing and coordinating mechanism. It is an elaborate communication network through which
innumerable individual free choices are recorded, summarized, and balanced.
Those who respond to market signals and heed market dictates are rewarded with greater profit and
income; those who do not respond to those signals and choose to ignore market dictates are penalized.
Through this mechanism society decides what the economy should produce, how production can be
organized efficiently, and how the fruits of production are to be distributed among the various units that
make up the economy.

Technology and Capital Goods

In the market system, competition, freedom of choice, self- interest, and personal reward provide the
opportunity and motivation for technological advance.
The monetary rewards for new products or production techniques accrue directly to the innovator.
The market system therefore encourages extensive use and rapid development of complex capital goods:
tools, machinery, large-scale factories, and facilities for storage, communication, transportation, and
marketing.
Specialization
Specialization is the use of resources of an individual, firm, region, or nation to produce one or a few goods
or services rather than the entire range of goods and services.
Those goods and services are then exchanged for a full range of desired products.
The majority of consumers produce virtually none of the goods and services they consume, and they
consume little or nothing of the items they produce.
The person working nine to five installing windows in commercial aircraft may rarely fly. Many farmers sell
their milk to the local dairy and then buy margarine at the local grocery store.
Society learned long ago that self-sufficiency breeds inefficiency. The jack-of-all-trades may be a very
colorful individual but is certainly not an efficient producer.

Division of Labor
Human specialization—called the division of labor—contributes to a society’s output in several ways:
Specialization makes use of differences in ability. Specialization enables individuals to take advantage of
existing differences in their abilities and skills.
E.g. Peyton is strong, athletic, and good at throwing a football and Beyonce is beautiful, agile, and can sing,
their distribution of talents can be most efficiently used if Peyton plays professional football and Beyonce
records songs and gives concerts.
Specialization fosters learning by doing. Even if the abilities of two people are identical, specialization may
still be advantageous. By devoting time to a single task, a person is more likely to develop the skills
required and to improve techniques than by working at a number of different tasks. You learn to be a good
lawyer by studying and practicing law.
Specialization saves time. By devoting time to a single task, a person avoids the loss of time incurred in
shifting from one job to another.
For all these reasons, specialization increases the total output society derives from limited resources.

Geographic Specialization
Specialization also works on a regional and international basis. It is conceivable that oranges could be
grown in Nebraska, but because of the unsuitability of the land, rainfall, and temperature, the costs would
be very high. And it is conceivable that wheat could be grown in Florida, but such production would be
costly for similar geographical reasons. So Nebraskans produce products—wheat in particular—for which
their resources are best suited, and Floridians do the same, producing oranges and other citrus fruits. By
specializing, both economies produce more than is needed locally. Then, very sensibly, Nebraskans and
Floridians exchange some of their surpluses—wheat for oranges, oranges for wheat.
Similarly, on an international scale, the United States specializes in producing such items as commercial
aircraft and computers, which it sells abroad in exchange for video recorders from Japan, bananas from
Honduras, and woven baskets from Thailand. Both human specialization and geographic specialization are
needed to achieve efficiency in the use of limited resources.
Use of Money
A rather obvious characteristic of any economic system is the extensive use of money. Money performs
several functions, but first and foremost it is a medium of exchange. It makes trade easier.
Specialization requires exchange. Exchange can, and sometimes does, occur through barter—swapping
goods for goods, say, wheat for oranges. But barter poses serious problems because it requires a
coincidence of wants between the buyer and the seller. In our example, we assumed that Nebraskans had
excess wheat to trade and wanted oranges. And we assumed that Floridians had excess oranges to trade
and wanted wheat. So an exchange occurred. But if such a coincidence of wants is missing, trade is
stymied.
The use of money in market systems facilitates the exchange of goods and services that specialization
requires.
The output mix of the market system is determined by profits, which in turn depend heavily on consumer
preferences. Economic profits cause industries to expand; losses cause industries to contract.
Competition forces industries to use the least costly production methods.
Competitive markets reallocate resources in response to changes in consumer tastes, technological
advances, and changes in availability of resources.
In a market economy, consumer income and product prices determine how output will be distributed.
Competitive markets create incentives for technological advance and capital accumulation, both of which
contribute to increases in standards of living.

The Circular Flow Model

The dynamic market economy creates continuous, repetitive flows of goods and services, resources, and
money. The circular flow diagram illustrates those flows. Observe that in the diagram we group private
decision makers into businesses and households and group markets into the resource market and the
product market.

Resource Market
The upper part of the circular flow diagram represents the resource market: the place where resources or
the services of resource suppliers are bought and sold. In the resource market, households sell resources
and businesses buy them. Households (that is, people) own all economic resources either directly as
workers or entrepreneurs or indirectly through their ownership of business corporations.
They sell their resources to businesses, which buy them because they are necessary for producing goods
and services. The funds that businesses pay for resources are costs to businesses but are flows of wage,
rent, interest, and profit income to the households. Productive resources therefore flow from households to
businesses, and money flows from businesses to households.

Product Market
Next consider the lower part of the diagram, which represents the product market: the place where goods
and services produced by businesses are bought and sold. In the product market, businesses combine
resources to produce and sell goods and services. Households use the (limited) income they have received
from the sale of resources to buy goods and services. The monetary flow of consumer spending on goods
and services yields sales revenues for businesses. Businesses compare those revenues to their costs in
determining profitability and whether or not a particular good or service should continue to be produced.
The circular flow model depicts a complex, interrelated web of decision making and economic activity
involving businesses and households. For the economy, it is the circle of life. Businesses and households
are both buyers and sellers. Businesses buy resources and sell products. Households buy products and
sell resources. As shown in Figure 2.2, there is a counterclockwise real flow of economic resources and
finished goods and services and a clockwise money flow of income and consumption expenditures.