Economic Systems and

Decision Making
 Review! What 3 questions must every economy try to answer?

 What goods and services should be produced?

 How should these goods and services be produced?
 Who consumes these goods and services?

 All economic systems try to answer these Q’s

 Cuba: Cosmetic surgery NOT available—government refuses to
allow resources to be used on this service
 You don’t have to live like a refugee!
 4 Types of Economic Systems
 Traditional economies rely on habit, custom, or ritual
to decide what to produce, how to produce it, and to
whom to distribute it
 In a centrally planned economy/command economy
the central government makes all decisions about the
production and consumption of goods and services
 In a market economy economic decisions are made by
individuals and are based on exchange, or trade. AKA
“Laissez-faire economy” (“allow them to do” or more
simply, leave it alone)
 Mixed economies are systems that combine tradition
and the free market with limited government
intervention.
 Traditional Economy
 In a traditional economy, roles and economic
decisions are defined by custom
 Traditional economies rely on habit, custom,
or ritual to decide what to produce, how to
produce it, and to whom to distribute it
 Examples: Canadians living in Nunavut
 Advantages: Everyone knows which role to
play, little certainty about what, how, or for
whom to produce
 Disadvantages: Discourages new ideas, new
ways of thinking. LOW Standard of living
 Command Economy
 In a centrally planned economy/command
economy the central government makes all
decisions about the production and
consumption of goods and services
 Found in North Korea, Cuba, China, Vietnam
 Ex: Cosmetic surgery is illegal in Cuba
 Advantages: Can drastically change direction
quickly, little uncertainty
 Disadvantages:Consumer needs are not met,
hard work is not rewarded, decision making is
delayed, has little flexibility, individual initiative
is not rewarded, NO INCENTIVES!!!!!!
 Problems of a Centrally Planned Economy

Centrally planned economies face problems of poor-

quality goods, shortages, and diminishing production.
 The Former Soviet Union
Soviet Agriculture
– In the Soviet Union, the government created large
state-owned farms and collectives for most of the
country’s agricultural production.

Soviet Industry
– Soviet planners favored heavy-industry
production (such as steel and machinery), over the
production of consumer goods.

Soviet Consumers
– Consumer goods in the Soviet Union were scarce
and usually of poor quality.
The USSR Under Lenin & Stalin

 Lenin took large estates from the rich and gave them
to the peasants, while outlawing private property
 Factories were turned over to workers
 Workers lacked skill, so New Economic Policy was
instituted (Capitalism)
 Stalin’s 5-Year Plans were industrialization at any
cost
 Stalin instituted collectivization, particularly on
farms
 The USSR after Stalin
 The Communist Party and Gosplan, the central planning
authority, ran just about everything without any local input
 The agricultural sector was a problem—Khrushchev’s
“Virgin Lands” failed and the USSR imported grain from
the U.S.
 Finally, the people demanded better consumer goods, and
more of them
 Gorbachev’s “perestroika” and “glasnost” provided
opportunities to criticize and reform the economic system
 Transition in Russia
1. Communism in Russia--The Soviet government reorganized
farmland into state farms and collective farms. Much of the
economy was focused on the growth of heavy industry.
2. Glasnost and Perestroika--In the late 1980s, Soviet Premier
Mikhail Gorbachev introduced new reforms. Glasnost was a
policy of "openness" encouraging open speech. Perestroika
called for a gradual change from a centrally planned
economy to free enterprise.
3. Collapse of Communism--In 1991, Russians voted in their
first democratic election. Soon after, the Soviet republics
declared themselves independent nations. By the end of
1991, the Soviet Union ceased to exist.
4. Transition to a Free Market--Since 1991, the Russian
government has moved Russia towards free enterprise.
However, extensive corruption and government
mismanagement have hindered Russia's progress.
 Socialism and Communism
 Socialism is a social and political philosophy based on
the belief that democratic means should be used to
distribute wealth evenly throughout a society. EX:
Sweden
 Benefits: Better distribution of benefits
 Disadvantages: Lower efficiency, high taxes,
entrenched special interests

 Communism is a political system characterized by a

centrally planned economy with all economic and
political power resting in the hands of the government.
EX: Cuba, China (neither a great example)
 Advantage: Economy can shift quickly, lack of
uncertainty.
 Disadvantage: Poorly meets consumers’ needs
 Free Market Capitalism
 Producers and consumers determine how/what/for
whom to produce. Each consumer’s dollar is an
“economic vote.”
 Examples: United States, Canada, Western Europe,
Japan, South Korea, Singapore
 Advantages: Can adjust to change, gives a high degree
of individual freedom, small degree of government
involvement, consumers have a say in the economy,
leads to a wide variety of goods and services (think of
how many brands of dog food there are), and leads to
high levels of consumer satisfaction (more tattoos than
pocket squares right now)
 Disadvantages: More uncertain for individuals.
Unemployment and inflation do happen regularly.
 Price Theory
(Important Component of Free Market)
 Output in a free market is decentralized.
 You will work for wages. These wages represent income--
the amount of money a household earns in a year.
 Wealth is the accumulation of of past income or
inheritances.
 Wage rates determine the rewards for working in different
jobs and professions.
 The basic coordinating mechanism in the economy is price.
 Individuals will pursue their own self-interest, motivated
by profit, and produce what people want.
 Others will acquire skills and buy, save, or invest the
income they earn. Price is the determinant.
 The Continuum
 Parts of the US economy are almost completely
unregulated (Internet), but the Constitution permits
Congress to regulate any interstate commerce—which
since the 1930s has meant practically everything
 During World War II, the government limited
production of goods such as washing machines,
refrigerators, and automobiles so the resources used
to produce those goods could be funneled to different
industries (food, armaments, etc).
 Western Democracies vary widely in their level of
capitalism. Sweden is Socialist, Singapore is almost
unbridled capitalism
 An economic system that permits the conduct of
business with minimal government intervention is
called free enterprise. The degree of government
involvement in the economy varies among nations.

Continuum of Mixed Economies

Centrally planned Free market

Iran South Africa France United Kingdom Hong Kong

North Korea China Botswana Canada Singapore

Cuba Russia Greece Peru United States

Source: 1999 Index of Economic Freedom, Bryan T. Johnson, Kim R. Holmes, and Melanie Kirkpatrick
 Making the Transition
 Privatization in Eastern Europe and Russia has
been difficult.
 No Civil Society exists, and distributing
government owned property evenly is difficult
 In addition, there is little understanding by the
populace of free market economy values
 Eastern Germany has probably done the best, with
Poland a close second.
 Critical Thinking Question
 In the 1990s, many Eastern European
countries moved from command to
market economies.
 1) HST link: What political
developments made this possible?
 2) What problems did people in these
countries face as the made the change?
 Section 1 Review
1. In a socialist country,
– (a) central planning is unnecessary.
– (b) the government often owns major industries, such
as utilities.
– (c) an authoritarian government controls the economy.
– (d) economic equality is not important.

2. Which of the following is an advantage of a centrally

planned economy?
– (a) The system’s bureaucracies are small and flexible.
– (b) The system can work quickly to accomplish specific
goals.
– (c) Innovation is well rewarded.
– (d) Consumers’ needs are well met.
 Did You Know?
 The Fair Labor Standards Act of 1938
set the nation’s minimum wage at 25¢.
 Debate has raged for years about what
an acceptable minimum wage should be
—should it be a “living wage?”
 The answer to questions like this
depends on a society’s economic goals.
 Economic Goals
 Economic Freedom—Little government intervention in
the production and distribution of goods and services,
allows people to make their own economic decisions
 Economic Stability—avoiding wide swings in prices,
wages, unemployment, etc.
 Economic Equity—fair distribution of wealth (has not
been achieved in US)
 Economic Equality—everyone has equal opportunity to
participate in free market, buying and selling
 Economic Security and Predictability--Assurance that
goods and services will be available, payments will be
made on time, and a safety net will protect individuals
in times of economic disaster (Welfare, FDIC)
 More Economic Goals
 Economic Growth and Innovation--Innovation
leads to economic growth, and economic
growth leads to a higher standard of living.
 Economic Efficiency-Making the most of
resources
 Other goals: Environmental Protection, Using
Economics to reach political/military goals (US
selling grain to USSR in 1970s to coerce USSR
into behaving better)
 Full Employment—providing as many jobs as
possible. (See next slide)
 Unemployment
 It’s impossible for every member of the workforce to be
employed. Bad times often coincide with market failure--
a situation in which the market, on its own, does not
distribute resources efficiently
 Rate is higher among non-whites and males
 Frictional and structural unemployment:
 Frictional: between jobs
 Structural: you don’t have necessary skills
 Full employment: ~4.5% unemployment
 During World War II, 1% unemployment--overemployment
 Group Activity
 In groups of 4, take on the role I assign you and decide what
the US’s economic goals should be.
 Roles:
 CEO of large company, middle-aged
 Single mother on welfare
 Teenagers
 College Student
 Environmental activist
 Elderly couple
 YUPpy couple
 We will discuss these with 15 mins left
 Key Concept: Which economic goals conflict?
 Competition and Free Enterprise
 Capitalism is a market economy in which private
citizens own the factors of production. In a free
enterprise system, there is limited government
interference and businesses are free to compete,
within reason (NO monopolies though)
 During voluntary exchanges, buyers and sellers are
free to decide whether or not to complete
transactions. To complete a transaction, both must
usually agree that the good or service obtained is of
more value than the money or product given up
 Private property rights give people the motivation to
succeed because they can keep rewards they earn
 The profit motive encourages entrepreneurship
 Competition helps lower prices and improve allocative
efficiency
 Economic systems have 2 parts:
 Public sector  Private
 Government spending/investments Sector
A public good is a shared good or service
for which it would be impractical to  Consumer
make consumers pay individually and to
exclude nonpayers. spending
 EX: Government buys F-22 fighters  EX: You buy
 Quasi-Public goods are either any product
contestable or price-excludable or service
 EX: Government funds Amtrak; you may
decide not to ride
 EX: Mackinac Bridge toll
 The Free-Rider Problem
 A free rider is someone who would not choose to pay
for a certain good or service, but who would get the
benefits of it anyway if it is provided as a public good.
 EX: You don’t want money spent on a new highway,
but when it’s built, you use it during your commute to
work
 Answer: Fee-based system
 The Role of Economic Participants in Capitalism
 Entrepreneurs use land, capital, & labor to make profits
 The consumer has much power in a free market
economy. Consumers influence producers through their
buying decisions. Consumers influence the
government’s economic policies through voting and
other techniques. People in 2001 wanted a tax cut, less
spending, elected George W. Bush
 Both consumers and producers are dependent upon
each other.
 EX: Consumer desires size 16.5- 38 dress shirts.
Entrepreneur may decide tall people don’t represent
much of a market, so the entrepreneur won’t make tall
dress shirts. If entrepreneurs want to sell product,
however, they must offer clothing that fits.
 But what is the role of government???????????????
 The Role of Government
 What is government’s role in a capitalistic society?
 Answer: Depends on your political orientation
 Liberals: Favor big, all-powerful government, protect
environment and less pro-business
 Conservatives: “the government that governs least governs
best,” preserve initiative, reward success, sink or swim on your
own
 DO NOT confuse with “economic liberal”: favors free trade,
government noninterference, laissez-faire
 Laissez faire is the doctrine that government generally should
not interfere. Americans have traditionally favored economic
freedom over economic regulation
 Governments create laws protecting property rights and
enforcing contracts. They also encourage innovation through
patent and copyright laws.
 Patent=allows you to exclusively produce an invention.
 Copyright=intellectual and artistic work protection
 Japan’s “Role of Government”
 Japan is an advanced Western Capitalistic society
 But its government is much more active in the economy that
many capitalist governments
 Japan’s early success was due to management style and
willingness to embrace technology
 The government enacted Protective Tariffs to help these
industries develop, but it never got rid of them. Japan’s
economy is closed by non-tariff barriers as well.
 Protectionism in Japan, however, is hurting consumers and the
Japanese economy
 A 1990s banking crisis has still not been dealt with.
 The Japanese economy has been sick since 1990-91.
 Policy and Technology Review
1. Policymakers encourage all of the following EXCEPT
– (a) stable productivity.
– (b) high employment.
– (c) stable prices.
– (d) steady growth.

2. The government encourages advances in technology and

improvements in productivity by
– (a) maintaining steady price controls.
– (b) funding research and development projects at many
levels.
– (c) hiring more workers to reduce unemployment.
– (d) regulating banks and other financial institutions.
 Government’s Role in a Mixed Economy

Market economies, with Product market

all their advantages,

have certain
drawbacks. In a mixed
economy, the
government purchases
goods and services in
the product market,
and purchases land,
labor, and capital from Factor market

households in the
factor market.
 Protecting Health, Safety, and Well-Being
Major Federal Regulatory Agencies
Many federal
Agency and Date Created Role
agencies regulate 1906 Food and Drug Sets and enforces standards for food, drugs,
Administration (FDA) and cosmetic products
industries whose 1914 Federal Trade Enacts and enforces antitrust laws to protect
goods and services Commission (FTC) consumers
1934 Federal Communications Regulates interstate and international communications
affect the well- Commission (FTC) by radio, television, wire, and satellite, and cable

being of the public. 1958 Federal Aviation

Administration (FAA)
Regulates civil aviation, air-traffic and piloting
standards, and air commerce
1964 Equal Employment Promotes equal job opportunity through enforcement
Opportunity Commission (EEOC) of civil rights laws, education, and other programs
Consumers are also 1970 Environmental Protection Enacts policies to protect human health and the
aided by public Agency (EPA) natural environment
1970 Occupational Safety and Enacts policies to save lives, prevent injuries, and
disclosure laws, Health Administration (OSHA) protect the health of workers

which require 1972 Consumer Product Safety Enacts policies for reducing risks of harm from
Commission (CPSC) consumer products
companies to give 1974 Nuclear Regulatory Regulates civilian use of nuclear products
Commission
consumers full
information about
their products.
 Fiscal Redistribution
• Def’n: “Robin hood”: Taking money from the wealthier members of
society and giving it to less well-off members in a variety of
different ways
• The poverty threshold is an income level below that which is
needed to support families or households.
• The poverty threshold is determined by the federal government
and is adjusted periodically. Currently $20,000 for a family of 4.
• US poverty is RELATIVE poverty, much of the world is ABSOLUTE.
• # OF POOR IN WORLD HAS ACTUALLY DECLINED SINCE 1980
• Welfare is a general term that refers to government aid to the
poor.
• Welfare is funded by taxing the non-poor. Cash redistribution is
usually in the form of transfer payments
 Redistribution Programs
 1. Temporary Assistance for Needy Families (TANF)
 This program allows individual states to decide how to
best use federally provided funds.
 2. Social Security 
 Social Security provides direct cash transfers of
retirement income to the nation's elderly and living
expenses to the disabled.
 3. Unemployment Insurance
 Unemployment compensation provides money to
eligible workers who have lost their jobs.
 4. Workers' Compensation
 Worker's compensation provides a cash transfer of
state funds to employees injured while on the job.
 Other Redistribution Programs
Besides cash transfers, other redistribution programs
include:
• In-kind benefits
In-kind benefits are goods and services provided
by the government for free or at greatly reduced
prices. (Free school lunches)
• Medical benefits
Health insurance is provided by the government
for the elderly and disabled (Medicare) and for
poor people who are unemployed or are not
covered by their employer’s insurance (Medicaid).
• Education benefits
Federal, state, and local governments all provide
educational opportunities for the poor.
 Government Involvement Quiz
1. Welfare includes all of the following EXCEPT
– (a) Temporary Assistance to Needy Families.
– (b) Occupational Safety and Health Administration.
– (c) Social Security.
– (d) Medicaid.

2. Education programs make the economy more productive by

– (a) adding to human capital and labor productivity.
– (b) reducing taxes.
– (c) providing more jobs in manufacturing.
– (d) reducing injuries on the job.
 Fiscal and Monetary Policy
 Government can affect the performance of the economy and the
allocation of resources. It can:
 Impose TAXES (luxury tax on yachts, gas guzzler tax on Vipers,
“Sin tax” on cigarettes
 Outlaw certain products
 Spend more or less (change FISCAL POLICY)
 Alter the amount of money in the economy (MONETARY POLICY)
 A business cycle is a period of macroeconomic growth followed
by a period of contraction. Government can adjust interest rates
to stave off recession or inflation
 We will revisit all of these concepts later
 Externalities
 An externality is an economic side effect of a good or service
that generates benefits or costs to someone other than the
person deciding how much to produce or consume. Often the
result of incomplete property rights (Who owns the air?)
 Property rights must be 1) Clearly defined 2) Well-enforced 3)
Transferable
 EX: Chemical company produces DDT, dumps waste into river.
 But externalities can be positive
 EX: “Anchor stores” in malls generate traffic. As a result, they
often pay zero rent!
 EX: Bees benefit more than beekeepers—beekeepers and
orchard owners can work together. Symbiotic relationship is
necessary.
 The goal: Marginal social benefits = Marginal social cost
Save the Whales Activity
 Externalities: An Example
 The building of a new dam/creation of a lake generates:

 Positive Externalities
 ·      a possible source of hydroelectric power
 ·      swimming
 ·      boating
 ·      fishing
 ·      lakefront views 

 Negative Externalities
 ·      loss of wildlife habitat due to flooding
 ·      disruption of fish migration along the river
 ·      overcrowding due to tourism
 ·      noise from racing boats and other watercraft
 Critical Thinking Question
 What would be some positive externalities and
negative externalities of a city deciding to permit Dow
Chemical to build a brand new manufacturing facility?
 Positive: Jobs, tax revenue for the city, property
values might increase (due to need for housing
workers—shortage)
 Negative: Pollution, health problems, property values
may decrease
 Government tries to encourage positive
externalities (subsidies for ethanol) and limit
negative externalities (taxation) to avoid an
underallocation or overallocation of resources
 Think about this…
 The market system we have in the United States
is so efficient that…

 We make things like Beanie Babies—that we

don’t even use!
 98% of the poor own a color TV

 In a capitalistic system, the only way I can

become wealthy is by improving everyone else’s
standard of living.