Economic Systems Title? NO SAMPLE - Frank Schneemann CH-2.pdf · Title? NO SAMPLE Asystem is a way of doing something. The trains, tracks, platforms, routes, and schedules of a subway

Title? NO SAMPLE

AA system is a way of doingsomething. The trains,

tracks, platforms, routes, andschedules of a subway systemmove people around a city. Oureducation system teaches usreading, writing, and arithmetic.Economic systems enable soci-eties to produce and distributegoods and services.

Economic Systems

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Make a list of all the different systemsyou used yesterday. How would yourday have been different without thesesystems?

Economics JournalEconomics Journal

ECON_07NA_se_CH02_CO 8/3/05 8:51 AM Page 22

IIn Chapter 1, you read about theeconomic concept of scarcity—that we

cannot have all that we want or need.Indeed, in some places in the world, peoplecannot even meet their basic needs forfood, clothing, and shelter because theirresources are too scarce. Scarcity forcessocieties and nations to answer some hardeconomic questions. Different economicsystems have evolved in response to theproblem of scarcity. An economic system isthe method used by a society to produceand distribute goods and services. Whicheconomic system a society employsdepends on that society’s goals and values.

Three Key EconomicQuestionsBecause economic resources are limited,every society must answer three keyeconomic questions:

• What goods and services should beproduced?

• How should these goods and services beproduced?

• Who consumes these goods and services?

What Goods and Services Should Be Produced?Each society must decide what to producein order to satisfy its needs and wants. Intoday’s complex societies, it is often difficultto distinguish between needs and wants.While it may be obvious that we need foodand shelter, modern societies face addi-tional important considerations. Howmuch of our resources should we devote tonational defense, education, public healthand welfare, or consumer goods? Whichconsumer goods should we produce?

Recall the guns-and-butter trade-offdescribed in Chapter 1. Because of ourlimited resources, each production decisionthat a society makes comes at an opportu-nity cost.

How Should Goods and Services Be Produced?The next question we face is how to useour resources to produce goods andservices. For example, should we produceelectricity with oil, solar power, or nuclearpower? Should teachers have classes of 20students or 50 students? Should weproduce food on large corporate farms oron small family farms?

economic system themethod used by asociety to produce anddistribute goods andservices

Answering the ThreeEconomic Questions

Preview ObjectivesAfter studying this section you will be able to:1. Identify the three key economic questions

of what to produce, how to produce, andwho consumes what is produced.

2. Analyze the societal values that determinehow a country answers the three economicquestions.

3. Explain the characteristics of traditional,command, and market economies anddescribe the societal values that influencethem.

Section FocusAll societies must answer three keyeconomic questions about theproduction and consumption ofgoods and services. How a societyanswers these questions depends onhow much it values differenteconomic goals. Four differenteconomic systems have developedin response to these three questions.

Key Termseconomic systemfactor paymentspatriotismsafety netstandard of livingtraditional economymarket economycentrally planned

economycommand economymixed economy

Chapter 2 ■ Section 1 23

ECON_07NA_se_CH02_S1 8/3/05 8:57 AM Page 23

24 Economic Systems

Although there are countless ways tocreate all of the things we want and need,all require land, labor, and capital. Thesefactors of production can be combined indifferent ways. For example, examine thechart above (Figure 2.1). Before the intro-duction of modern farming equipment, atypical combination of resources forproducing 15 bushels of wheat was 56hours of labor, 1 acre of land, and simplehand tools. With today’s mechanicalfarming equipment, farming is much moreefficient. Forty bushels of wheat can beharvested from one acre of land with just2.9 worker-hours of labor.

Who Consumes Goods and Services?In recent years, the top 25 goods manufac-turers in the United States have launchedan average of 13 new products each day.Retail stores, which 50 years ago typicallycarried about 3,000 items, now offerabout 30,000 different products. Americanfarms produce 315 million metric tons ofwheat, rice, and corn and maintain about180 million head of livestock. Despite thisstaggering output, quantities are notunlimited.

How does this abundance get dividedup? Who gets to drive a new luxury car andwho can only afford a subway pass? Whoattends a concert and who stays home?Who eats a well-balanced diet and whoeats nothing but hot dogs for every meal?Who gets access to a good education?Societies must decide how to distribute theavailable goods and services.

The answer to the question of distribu-tion is determined by how societies chooseto distribute income. Factor payments arethe income people receive for supplyingfactors of production—land, labor, capital,or entrepreneurship. Landowners receiverent, workers receive wages, and thosewho lend money to build factories or buymachinery receive payments calledinterest. Entrepreneurs earn profits if theirenterprises succeed.

How much should we pay the owners ofthe factors of production? How do wedecide how much a particular piece of landis worth, how much teachers should earnversus how much doctors should earn, orwhat the interest rate should be?

The question of who gets to consumewhich goods and services lies at the very

Hand tools

Modern mechanical equipment

1 acre of land + 2.9 worker-hours + capital = 40 bushels of wheat

1 acre of land + 56 worker-hours + capital = 15 bushels of wheat

Figure 2.1 Combining Factor ResourcesFigure 2.1 Combining Factor Resources

factor payments theincome people receivefor supplying factors ofproduction, such asland, labor, or capital

Today, capital–notlabor–dominates the

answer to how wheatis produced.

Opportunity CostIdentify the

opportunity costs ofeach method of

farming.


heart of the differences between economicsystems today. Each society answers thequestion of distribution based on its uniquecombination of social values and goals.

Economic Goals and SocietalValuesDifferent societies answer the threeeconomic questions based on the impor-tance they attach to various economicgoals. Figure 2.2 lists some generaleconomic goals that most economicsystems try to address. Bear in mind thatsocieties pursue each of these goals, tosome degree, at the expense of the others.

Economic EfficiencyBecause resources are always scarce—thatis, they always involve an opportunitycost—most societies try to maximize whatthey can get for the resources they have towork with. If a society can accurately assesswhat to produce, it increases its economicefficiency. A manufacturer would bewasting resources producing record albumsif people prefer to buy CDs. Knowing thebest way to produce a product cuts waste,too. Of course, in the end, products need toreach consumers. An economy that can’tdeliver goods isn’t efficient.

Economic FreedomMost of us value the opportunity to makeour own choices. How do you feel aboutlaws that keep you from earning anincome? What about laws that forbid youto make certain purchases or possesscertain items? The economic systems ofdifferent nations allow different degrees ofeconomic freedoms. In general, however,people all over the world face limitationson economic freedom.

In the United States, the economicfreedoms that we as Americans enjoy arean important reason for our patriotism.Patriotism is the love of one’s country—thepassion that inspires a person to serve hisor her country, either in defending it frominvasion or protecting its rights and main-taining its laws and institutions. Thefreedoms that allow any American who sochooses to become an entrepreneur, forexample, are continuing sources of prideand patriotism.

Economic Security and PredictabilityMost people don’t like uncertainty. Wewant to know that we can get milk andbread every time we go to the grocery store,or that the gas pumps will be full when we

Economic efficiency Making the most of resources

Economic freedom Freedom from government intervention in the production and distribution of goods and services

Economic securityand 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

Economic equity Fair distribution of wealth

Economic growthand innovation

Innovation leads to economic growth, and economic growth leads to a higher standard of living.

Other goals Societies pursue additional goals, such as environmental protection.

Figure 2.2 Economic GoalsFigure 2.2 Economic Goals

This family (left) will need to rebuild theirhome after a devastating hurricane. Government Which economic goal couldhelp them recover from the storm?


patriotism the love ofone’s country; thepassion that inspires aperson to serve his orher country


go to gas up our cars. We want to feelconfident that we will get our paychecksevery payday. Ideally, economic systemsreassure people that goods and services willbe available when they need them and thatthey can count on receiving expectedpayments on time.

We also want the security of knowingthat help is available if we are elderly,poor, unemployed, or facing some otherpotential economic disadvantage. Mostpeople feel that the government shouldprovide some kind of safety net, or set ofgovernment programs that protect peopleexperiencing unfavorable economic condi-tions. These include injuries, layoffs,natural disasters, or severe shortages.Most countries also believe in providingsome sort of base income for retiredpersons to ensure that older people cansupport themselves after retirement.

Economic EquityEach society must decide the best way todivide its economic pie. What constitutes afair share? Should everyone get the same,or should one’s consumption depend onhow much one produces? How muchshould society provide for those who areunable or unwilling to produce?

Many people believe in equal pay forequal work, but society does not value alljobs equally. Most lawyers earn more thanmost nurses. Most computer programmers

earn more than most truck drivers. Noteveryone is able to work. How should weprovide for the ill and infirm?

Economic Growth and InnovationA nation’s economy must grow for a nationto improve its standard of living, or level ofeconomic prosperity. This is especially trueif a country’s population is growing. Theeconomy also must grow to provide newjobs and income for people.

Innovation plays a huge role in economicgrowth. Think of the changes broughtabout by the shift from nomadism to agri-culture, from the agricultural age to theindustrial age, from the industrial age tothe information age. Innovations in tech-nology increase the efficiency of productionand usher in new goods and services. Inyour lifetime, you are witnessing innova-tions in computer and networking tech-nology that are changing the ways peoplework, shop, conduct business, locate infor-mation, and communicate.

Additional GoalsA society may value goals in addition to thosedescribed above. Environmental protection,full employment, universal medical care, andother important concerns may be among anation’s chief economic goals.

All nations must prioritize theireconomic goals, or arrange them in orderof importance. No matter how a nationprioritizes its goals, one fact remains:achieving any economic goal comes onlywith some kind of economic trade-off.

Economies and ValuesFour different economic systems havedeveloped to address the three keyeconomic questions. Each system reflects adifferent prioritization of economic goals.It also reflects the values of the societies inwhich these systems are present.

Traditional EconomiesA traditional economy relies on habit,custom, or ritual to decide what to

safety net governmentprograms that protectpeople experiencingunfavorable economicconditions

standard of living levelof economic prosperity

traditional economyeconomic system thatrelies on habit, custom,or ritual to decidequestions of productionand consumption ofgoods and services

� The traditionaleconomy ofGuatemala’s QuichéMaya includesregular market days.



produce, how to produce it, and to whomto distribute it. There is little room forinnovation or change. The traditionaleconomic system revolves around thefamily. Work tends to be divided alonggender lines. Boys tend to take up the occu-pations of their fathers, while girls followin the footsteps of their mothers.

Traditional economies are usuallycommunities that tend to stay relativelysmall and close. Often these societies workto support entire groups, rather than justthemselves or their immediate families.Agricultural and hunting practices usuallylie at the very heart of the people’s lives,laws, and religious beliefs.

Societies with traditional economieshave few mechanisms in place to deal effec-tively with the effects of environmentaldisaster, such as a flood or drought. Theyalso tend to remain stagnant, resistingchange at both the individual and commu-nity level. They may be slow to adopt newtechnology or radical new ideas. They maynot have access to goods you see every dayat the grocery store. In most cases, thesecommunities lack modern conveniencesand have a low standard of living.

Market EconomiesIn a market economy, economic decisions aremade by individuals and are based onexchange, or trade. The choices made byindividuals determine what gets made andhow, as well as who consumes the goodsand services produced. Market economiesare also called free markets, or capitalism.You will read about the free market indetail in Section 2.

Command EconomiesIn a centrally planned economy, the centralgovernment alone decides how to answerall three key economic questions. Centrallyplanned economies are sometimes calledcommand economies, because a centralauthority is in command of the economy.Section 3 discusses the theories behindcentrally planned economies.

Mixed EconomiesMost modern economies are mixedeconomies—market-based economic systemsin which government plays a limited role.Section 4 describes the reasons for mixedeconomies and the various ways govern-ment is involved in such economies.

Section 1 Assessment

Key Terms and Main Ideas1. What is an economic system?

2. How do a traditional economy, a market economy, acommand economy, and a mixed economy differ?

3. Why aren’t all people paid the same amount in factorpayments for the resources they provide? Provide yourown example of two unequal factor payments.

4. Why do governments provide safety nets for their citizens?

5. Give at least one example of a traditional, a command, and a market economic system.

Applying Economic Concepts6. Using the Databank Examine the graph “Government

Spending, by Category” on page 543. Based on the infor-

mation in the graph, identify what you think are someeconomic goals of the United States.

7. Critical Thinking Create a chart in which you list thesocietal values of each of the four economic systemsdescribed in the section.

8. Try This You and your friends decide to earn money bywashing cars. How are the three economic questionsanswered in this market?

market economyeconomic system inwhich decisions onproduction andconsumption of goodsand services are basedon voluntary exchangein markets

centrally plannedeconomy economicsystem in which thecentral governmentmakes all decisions onthe production andconsumption of goodsand services

command economyeconomic system inwhich a centralauthority is incommand of theeconomy; a centrallyplanned economy

mixed economymarket-basedeconomic system withlimited governmentinvolvement

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28 Economic Systems

WWhat do a farmers’ market, a sportinggoods store, the New York Stock

Exchange, and the sign you posted on yourcommunity bulletin board advertisingbaby-sitting services have in common? Allare examples of markets. A market is anarrangement that allows buyers and sellersto exchange things.

Why Markets ExistMarkets exist because no one is self-suffi-cient. In other words, none of us producesall we require to satisfy our needs andwants. You probably didn’t grow the plantsto make the fibers to weave the cloth tomake the shirt you’re wearing. Instead, youpurchased your shirt at a store, which is anexample of a market. Markets allow us toexchange the things we have for the thingswe want.

SpecializationInstead of being self-sufficient, each of usproduces just one or a few products. A nurse specializes in caring for the sick. A

market an arrangementthat allows buyers andsellers to exchangethings

The Free MarketPreviewObjectivesAfter studying this section you will be able to:1. Explain why markets exist.2. Analyze a circular flow model of a free

market economy.3. Understand the self-regulating nature of

the marketplace.4. Identify the advantages of a free market

economy.

� This Thai spicestand, Brazilianstock exchange, andIndian barber shop(left to right) are allexamples of markets.

Section FocusMarkets exist so that peoplecan exchange what they havefor what they want. A freemarket is a self-regulatingeconomic system directed byindividuals acting in their ownself-interest.

Key Termsmarketspecializationhouseholdfirmfactor marketprofitproduct market

self-interestincentivecompetitioninvisible handconsumer

sovereignty



marine mechanic specializes in repairingmachinery aboard sea craft. A bakerspecializes in making breads, cakes, andcookies. Specialization is the concentrationof the productive efforts of individuals andfirms on a limited number of activities.

Specialization leads to efficient use ofresources, including capital, land, andlabor. It is easier to learn one task or a fewtasks very well than to learn them all.

Buying and SellingBecause each of us specializes in producingjust a few products, we need markets tosell what we have and to buy what wewant. The typical person earns an income(specializing at a particular job) and usesthis income to buy the products that he orshe wants to consume. If each person wereself-sufficient, producing everything he orshe wanted to consume, there would be noneed for markets.

Free Market EconomyEconomic systems that are based on volun-tary exchanges in markets are called freemarket economies. In a free marketeconomy, individuals and businesses usemarkets to exchange money and products.

In a free market system, individuals andprivately owned businesses own the factorsof production, make what they want, andbuy what they want. In other words, indi-viduals answer the three key economic

questions of what to produce, how toproduce it, and who consumes that whichis produced. As you might guess, a freemarket economy functions best in an envi-ronment of decentralized decision-makingsuch as enjoyed in the United States.

We can represent a free market economyin a special kind of drawing called acircular flow diagram, or model. A circularflow diagram shows at a glance how indi-viduals and businesses exchange money,resources, and products in the marketplace.Figure 2.3 shows a circular flow diagram ofa free market economy. The inner ring ofthe diagram represents the flow ofresources and products. The outer ringrepresents the flow of money.

Households and FirmsThe players in the free market economy arehouseholds and firms. A household is aperson or group of people living in thesame residence. Households own thefactors of production—land, labor, andcapital. Households are also the consumersof goods and services.

A business, or firm, is an organizationthat uses resources to produce a product,which it then sells. Firms transform“inputs,” or factors of production, into“outputs,” or products.

Factor MarketAs you can see from the lower half of thecircular flow diagram in Figure 2.3, firmspurchase factors of production from house-

holds. This arena of exchange iscalled the factor market. Firmspurchase or rent land (naturalresources). They hire workers,paying them wages or salariesfor their labor. They alsoborrow money from householdsto purchase capital, payinghouseholds interest or profits inreturn. Profit is the financial gainmade in a transaction.

Product MarketTake a close look at the top halfof the circular flow diagram in

specialization theconcentration of theproductive efforts ofindividuals and firms ona limited number ofactivities

household a person orgroup of people living inthe same residence

firm an organizationthat uses resources toproduce a product,which it then sells

factor marketmarket in which firmspurchase the factors ofproduction fromhouseholds

profit the financial gainmade in a transaction


30 Economic Systems

Figure 2.3. You can see that the goods andservices that firms produce are purchasedby households in the product market.

If you follow the rings of the diagram,you will see that households purchase theproducts made by firms with the moneythey received from firms in the factormarket. The flow between the factor marketand the product market is truly circular.

The Self-Regulating Natureof the MarketplaceHow is it that firms and households coop-erate to give each other what they want—factor resources, in the case of firms, and

products, in the case of households? Asanyone knows who has tried out for thetrack team, a part in a play, or has appliedfor a job or to a college, we live in acompetitive society. According to AdamSmith, it is, in fact, competition and ourown self-interest that keep the marketplacefunctioning.

Self-InterestAdam Smith was a Scottish social philoso-pher who, in 1776, published a book titledThe Wealth of Nations, in which hedescribed how the market functions. Smithobserved that an economy is made up ofcountless individual transactions. In eachtransaction, the buyer and seller consider

product market the market in whichhouseholds purchasethe goods and servicesthat firms produce

monetary flow

monetary flow

physical flow

physical flow

Households Firms

Product market

Factor market

Figure 2.3 Circular Flow Model of a Market EconomyFigure 2.3 Circular Flow Model of a Market Economy

Households supply firms with land, labor, and capital.

Firms supply households with goods and services.

Households pay firms for goods and services.

Firms pay households for land, labor, and capital.

A circular flow modelshows the interactions

between householdsand businesses in the

free market.Economic Systems

What is exchanged inthe factor market? Inthe product market?


only their self-interest, or their ownpersonal gain. Self-interest, in other words,is the motivating force in the free market.

CompetitionConsumers (households), in pursuit of theirself-interest, have the incentive to look forlower prices. An incentive is the hope ofreward or the fear of punishment thatencourages a person to behave in a certainway. Adam Smith observed that peoplerespond predictably to both positive andnegative incentives. As for consumers, wecan predict that they will respond to thepositive incentive of lower prices, becausespending less money on a good lowers theopportunity cost of the purchase.

Firms, meanwhile, seek to make greaterprofits by increasing sales. Let’s take, forexample, a shirt manufacturer. The manufac-turer finds that striped shirts are far outsellingpolka-dotted shirts. The manufacturer hasthe incentive—from more potential sales andprofits—to produce more striped shirts.Other manufacturers, observing consumers’desire for striped shirts, also have the incen-tive to sell them. With all these manufacturersin the market, consumers have all the stripedshirts they want.

Manufacturers also have a second incen-tive—to make the most profit in sellingstriped shirts. What keeps manufacturers’pursuit of profit from causing prices toskyrocket? If one begins charging $30.00 fora striped shirt, another can sell striped shirtsfor $25.00. If the first manufacturer wants

to sell any more striped shirts, he or she hadbetter drop the selling price. Consumers,pursuing their self-interest, will buy thelower-priced shirt. Economists call thisstruggle among producers for the dollars ofconsumers competition. While self-interest isthe motivating force behind the free market,competition is the regulating force.

Incentives come in two forms. Profit is amonetary incentive, or an incentive thatrewards in the form of money. Nonmonetaryincentives reward consumers and business inother ways, such as gifts, services, and othergoods.

The Invisible HandSelf-interest and competition work togetherto regulate the marketplace. Self-interestspurs consumers to purchase certain goods

self-interest one’s ownpersonal gain

incentive anexpectation thatencourages people tobehave in a certain way

competition thestruggle amongproducers for thedollars of consumers

� Competingbusinesses screamfor the attention ofconsumers.

31

“Son, your mother and I have decided to let thefree market take care of you.”

� How could thefree market takecare of this youngman?


and services and firms toproduce them. Competitioncauses more production andmoderates firms’ quests forhigher prices. The overallresult is that consumers getthe products they want atprices that closely reflect thecost of producing them. Allof this happens without anycentral plan or direction.Adam Smith called thisphenomenon “the invisiblehand of the marketplace.”

Advantages of the Free MarketCompetition and the pursuit of self-interestserve the public interest. The free market,on its own, meets many economic goals.

1. Economic efficiency Because it is self-regulating, a free market economyresponds efficiently to rapidly changingconditions. Producers make only whatconsumers want, when they want it, andgenerally at prices they are willing to pay.

2. Economic freedom Free marketeconomies have the highest degree of

economic freedom of any system. Thisincludes the freedom of workers to workwhere they want, of firms to producewhat they want, and of individuals toconsume what they want.

3. Economic growth Because competitionencourages innovation, free marketsencourage growth. Entrepreneurs arealways seeking profitable opportunities,contributing new ideas and innovations.

4. Additional goals Free markets offer awider variety of goods and services thanany other system, because producershave incentives to meet consumers’desires. Consumers, in essence, decidewhat gets produced. This is calledconsumer sovereignty.

Despite its advantages, no pure marketeconomy exists on any meaningful scale.The same features that make free marketsattractive also represent the weaknesses ofthe free market. The goals of economicequity and economic security are difficultto achieve in a pure market system. InSection 4, you will read about how the freemarket system has been modified byvarious nations in order to better meet theentire array of economic goals.

32 Economic Systems


Key Terms and Main Ideas1. How does specialization make us more efficient?2. What is the difference between the factor market and the

product market?3. What is profit?4. What are the roles of households and firms in a market

economy?5. How does competition among firms benefit consumers?6. Explain what Adam Smith meant by “the invisible hand of

the marketplace.”7. What is the connection between incentives and consumer

sovereignty in a free market economy?

Applying Economic Concepts8. Critical Thinking Why is economic equity difficult to

achieve in a free market economy?

9. Try This You will need a stack of paper and two staplers.You and a friend create “fold-its” by folding each sheetof paper in thirds and stapling both ends. How manyfold-its can you make in two minutes? Next, try special-izing: one of you folds while the other staples. Now howmany fold-its can you make in two minutes?

10.Critical Thinking Provide at least three real-worldexamples to illustrate the circular flow model of a marketeconomy.

Self-interest and the free market will provide social services—if there’s a profit to be gained. One large temporary employee agency recruits and trains workers from the ranks of the urban poor. Bypassing the social-welfare agencies that are charged with getting people off public assistance, it finds work for individuals and employees for businesses, and makes a profit for itself.

FAST FACT

invisible hand termeconomists use todescribe the self-regulating nature of themarketplace

consumer sovereigntythe power ofconsumers to decidewhat gets produced

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ECONOMICEconomist

Entrepreneur

One of the first people to offer an explanation of how a marketeconomy works was the Scottish philosopher Adam Smith.Beginning in his early twenties, Smith enjoyed a long career teach-ing at universities in Scotland. Although more than a little absent-minded, Smith was adored by his students and respected by hisfellow professors. More importantly, his ideas won him fame and

influence across Britain.

Adam SmithAdam Smith (1723–1790)

The Wealth of NationsToday, we most remember Adam Smith forthe theories expressed in his book TheWealth of Nations. Published in 1776, The Wealth of Nations still stands as anauthoritative description of how a marketsystem can flourish.

In the book, Smith identifies land, labor,and capital as the factors of production thatgenerate a nation’s wealth. When the pro-duction of goods is divided into many steps,and workers specialize in only one step, productivity increases. Higher productivityincreases the overall wealth of the nation.

Laissez FaireAdam Smith also called for restricting therole of government in the economy. Smithinsisted that government must leave indi-viduals as free as possible to pursue theirown interests if a market economy is torun smoothly. This policy is known as laissez faire, which means “let them do (as they please).” In Smith’s view, individu-als left alone to try to better themselveswill produce a multiplication of riches:more jobs and more goods and services.

The Invisible Handand Self-InterestAdam Smith also noticed that businessescould provide the goods and services thatconsumers needed without the help of acentral plan telling them what to do. Howdo they do it? Smith gave credit to aninvisible hand.

In Smith’s view, the invisible handguides a nation’s resources to their mostproductive use. One of the invisible hand’stools is self-interest. Individuals, each pur-suing what is best for him or her, makedecisions that ultimately benefit thenation.

For example, consumers can satisfytheir self-interest by buying goods.Business people satisfy their self-interestby making the goods consumers want andselling them for a profit. As sales increase,businesses can raise prices. At this pointthe invisible hand takes over. Another per-son sees the profits and starts a competingbusiness, charging a slightly lower price.Other businesses must follow if they wantto keep their customers, and balance isrestored to the market.

1. Source Reading Rewrite the fol-lowing passage from The Wealth ofNations in your own words: “It is notfrom the benevolence [kindness] of thebutcher, the brewer, or the baker thatwe expect our dinner, but from theirregard to their own interest.”

2. Critical Thinking What are theforces that together comprise theinvisible hand?

3. Learn More Conduct furtherresearch and describe the similari-ties between two 1776 publications:The Wealth of Nations and theDeclaration of Independence.

CHECK FOR UNDERSTANDING

33

ECON_05_se_PR_CH02 6/16/05 2:32 PM Page 33

CCentrally planned economies operate indirect contrast to free market systems.

Centrally planned economies opposeprivate property, free market pricing,competition, and consumer choice.

How Is a Centrally PlannedEconomy Organized?In a centrally planned economy, the centralgovernment, rather than individualproducers and consumers in markets,

answers the key economic questions ofproduction and consumption. A centralbureaucracy makes all the decisions aboutwhat items to produce, how to producethem, and who gets them. After collectinginformation, bureaucrats tell each firmwhat and how much to produce. It is up tothe bureaucrats to ensure that each firm hasenough raw materials and workers to meetits production goals.

Government Control of Factor Resources and ProductionIn a centrally planned economy, thegovernment owns both land and capital. Ina sense it owns labor, too, by controlling

Centrally Planned EconomiesPreviewObjectivesAfter studying this section you will be able to:1. Describe how a centrally planned

economy is organized.2. Analyze the centrally planned economy of

the former Soviet Union.3. Identify the problems of a centrally

planned economy.

Section FocusIn a centrally planned, orcommand, economy, the centralgovernment controls the economy.Central planning has limitationsand disadvantages not found inmarket economies.

Key Termssocialismcommunismauthoritariancollectiveheavy industry

34 Economic Systems

� Governmentposters in Cuba (left)and Cambodia (right)try to inspire workerproductivity in thesecentrally plannedeconomies.



where individuals work and what wagesthey are paid. The government decideswhat to produce, how much to produce,and how much to charge. Each year, itdirects workers to produce a certainnumber of trucks, so many yards of cottonfabric, a certain amount of glass, and so on.Farmers are told what to plant, how toplant, and where to send their crops. Thefree market forces of self-interest andcompetition are absent from the system.

For example, let’s follow the decision-making process for the production ofmilitary uniforms and a consumerproduct—sweaters.

1. The top planners decide that moremilitary uniforms than sweaters will bemade. They send this decision to thematerials committee.

2. Knowing how much cotton is available,the materials committee decides howmany sweaters and how many militaryuniforms will be made. They send theirdecision to the cotton makers, the buttonmakers, and the elastic makers.

3. The cotton, the buttons, and the elasticarrive at sweater factories and uniformfactories where they are manufacturedinto sweaters and uniforms.

As you can see, decisions on what toproduce and how much to produce are notdetermined by consumers. Chances are thatmany citizens living under this economywould still need new sweaters. This lack ofconsumer voice in production and distribu-tion shows that under centrally plannedeconomies, consumers do not haveconsumer sovereignty.

Socialism and Communism The words most often associated withcentrally planned economies are socialismand communism. They are often used inter-changeably, but we need to make a distinc-tion between the two terms.

Socialism is a social and political philos-ophy based on the belief that democraticmeans should be used to distribute wealthevenly throughout a society. Real equality,socialists argue, can only exist when

political equality is coupled with economicequality. Economic equality is possible onlyif the public controls the centers ofeconomic power. Although socialistnations may be democracies, socialismrequires a high degree of central planningto achieve economic equality.

In socialist countries the governmentoften owns major industries, such as utili-ties. Socialism, as you will see in Section 4,exists to varying degrees in differentnations throughout the world.

Communism is a political system thatarose out of the philosophy of socialism.Communism is characterized by a centrallyplanned economy with all economic andpolitical power resting in the hands of thecentral government.

Unlike socialists, however, communistsbelieved that a socialist society can onlycome about after a violent revolution.While socialist economies can still allowfor democracy, communist governmentsare authoritarian. Authoritarian govern-ments exact strict obedience from theircitizens and do not allow individualsfreedom of judgment and action.Throughout history, communist nationshave been dominated by a single political

socialism a social andpolitical philosophybased on the belief thatdemocratic meansshould be used toevenly distribute wealththroughout a society

communism a politicalsystem characterizedby a centrally plannedeconomy with alleconomic and politicalpower resting in thehands of the centralgovernment

authoritarian requiringstrict obedience to anauthority, such as adictator

� How would you describe production in thisRomanian factory?


36 Economic Systems

party or dictator. The former Soviet Unionwas a communist nation that provides uswith a good case study of how a centrallyplanned economy works—and doesn’twork.

The Former Soviet UnionThe Soviet Union arose out of a pair ofrevolutions in Russia in 1917. In March,imperial rule in Russia came to an endwhen Czar Nicholas II was forced from thethrone. A provisional republican govern-ment was set up, but by November it, too,was toppled. It was taken over by theBolsheviks, revolutionary socialists led byVladimir Lenin. Once in power, theyrenamed themselves communists. Underthe control of the Communist party, centralplanning was introduced during the 1920sand continued to operate until the breakupof the Soviet Union in 1991.

Soviet planners were most concernedwith building national power and prestigein the international community. As a result,they allocated the best land, labor, andcapital to the armed forces, space program,and production of capital goods such asfarm equipment and factories. Thecommittees that ran the system wereresponsible for deciding the quantity,production process, and distribution of 24million different goods and services.

Soviet Agriculture In the Soviet Union, the central governmentcreated large state-owned farms and collec-tives for most of the country’s agriculturalproduction. On state-run farms, the stateprovided farmers with all equipment, seed,and fertilizer. Farmers worked for dailywages set by economic planners.

Collectives were large farms leased fromthe state to groups of peasant farmers.Farmers managed operation of the collec-tives, though they still were required toproduce what the government instructedthem to. Farmers either received a share ofwhat they produced or income from its sale.

Agricultural workers were guaranteedemployment and income, and the govern-

collective large farmleased from the state togroups of peasantfarmers

� Karl Marx (left) andFriedrich Engels (center)introduced their socialistphilosophy in TheCommunist Manifesto in1848. The term communistwas adopted by theBolsheviks who, led byVladimir Lenin (right), tookcontrol of Russia in 1917.

� How would you describe the farming techniquesshown in this photo of a Soviet collective?


ment established quotas and distribution.Under such a system, individuals had fewincentives to produce more or better crops.While Russia had been a major exporter ofwheat until 1913, before long the SovietUnion could not keep its own people fed.Soviet agriculture bore much of the opportunity cost of Soviet central planningdecisions.

Soviet IndustrySoviet factories also were state-owned.Planners favored the defense industry, thespace program, and heavy industry. (Heavyindustry requires a large capital investmentto produce items used in other industries.Chemical, steel, and heavy machinerymanufacturing are heavy industries.) Themakers of consumer goods and servicespaid the opportunity cost of this concentra-tion of resources. They were stuck withleftover, lower-quality resources withwhich to create their products.

Like agriculture, industry was character-ized by a lack of incentives. Jobs were guaranteed, and wages were set by thegovernment. Once a production quota wasmet, there was no reason to produce moregoods. Workers had little incentive to workharder or to innovate. In fact, it was illegalfor workers to exhibit entrepreneurialbehavior and start their own businesses.

Soviet ConsumersConsumers, too, experienced the opportunitycost of central planners’ decisions. A popularjoke in the Soviet Union went, “We pretendto work, and they pretend to pay us.” Aworker’s wages were not worth muchbecause consumer goods were scarce andusually of poor quality. Manufacturers hadthe incentive to focus on quantity, not quality.For example, a manufacturer assigned toproduce a certain number of suits couldloosely stitch the buttons and mismatch coatsand trousers. Still, the state store had toaccept delivery of the suits. Consumerswould be left with no alternatives.

Consumers often had diffi-culty getting goods, too. Theywasted countless hours waitingin line to purchase goods andservices. Luxuries such as meatwere made affordable bygovernment price setting, butthey were rarely available.Housing shortages forcedpeople to live in crowded andpoorly constructed apart-ments. Because of the longwaiting list for apartments, itwas not unusual to find afamily living in just two rooms.

heavy industry industrythat requires a largecapital investment andthat produces itemsused in other industries

� Shifting from communism to a free market economy has been a difficulttransition. Consumers often waited hours in long lines only to discovernearly empty store shelves.


In the News Read more about theformer Soviet Union in “Laying Down theLaw,” an article in The Wall Street Journal Classroom Edition.

The Wall Street JournalClassroom Edition

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Problems of CentrallyPlanned EconomiesCentral planning can be used to jumpstartselected industries and guarantee jobs andincome. The other side of the coin, however,is poor quality, serious shortages of non-priority goods and services, and dimin-ishing production.

In theory, centrally planned economiescan work effectively toward explicitlystated goals. For example, in 1928, Sovietleader Joseph Stalin instituted the first of

several five-year plans to boost produc-tion. While a disaster in terms of agri-culture, Stalin had some success inincreasing output in heavy industries.

Perhaps the greatest disadvantage ofcentrally planned economies is thattheir performance almost always fallsfar short of the ideals upon which thesystem is built. In addition, suchsystems generally cannot meetconsumers’ needs or wants. Since thegovernment owns all productionfactors, workers lack any incentive towork hard. These systems also do notreward innovation, actively discour-aging any kind of change. The large,expensive bureaucracy necessary tomake the thousands of production anddistribution decisions to run the

economy lacks the flexibility to adjust toconsumer demands. Decisions becomeoverly complicated. Finally, commandeconomies sacrifice individual freedoms inorder to pursue societal goals.

Many areas of the world, especially lessdeveloped countries, have experimentedwith centrally planned economies, but mostof these experiments have failed. Instead,most of these nations have moved towardmixed economies over the past twentyyears. In the next section, you will readabout today’s mixed economies.

38 Economic Systems


Key Terms and Main Ideas1. How do socialism and communism differ?2. What characterizes an authoritarian government?3. Why did Soviet collectives offer little incentive to farmers? 4. In the Soviet Union, what was the opportunity cost of the

emphasis on heavy industry?

Applying Economic Concepts5. Critical Thinking Why do centrally planned economies

have difficulty meeting consumer needs?

6. Decision Making Which of the following economic goalsare difficult to achieve in a centrally planned economy?(a) economic efficiency (b) economic security andpredictability (c) economic equity (d) economic growthand innovation

� Statues of Leninwere toppled afterthe collapse ofcommunism in theSoviet Union in 1991.

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Russia in CrisisIn 1991, when the Communist system in Russia collapsed, many Russians rejoiced

at the prospect of living under a freer political and economic system. Manyspecifically looked forward to living in a Western-style free market economy.

During the next decade, Russians experienced an economic crisis. Althougheconomists had predicted that switching to afree enterprise system would be difficult, fewpredicted how traumatic it would be.

Corruption The confusion caused by the sud-den upheaval of both the political and eco-nomic systems opened the door for crime andcorruption on an enormous scale. Some busi-nessmen and politicians took advantage of thenation’s inexperience with a market economyand abused their power by robbing thenation’s assets.

Financial Problems Russia’s gross domesticproduct fell sharply until 1997. The nationhad to devalue its currency and postponepayments on loans owed to Western nations.Hardest hit of all have been Russia’s citizens, many of whom survive onincomes of less than $40 a month. Retirees were squeezed when pricesincreased much faster than the value of their government pensions.

Success in Sight Despite these problems, Russia’s economy has improved considerably since 1998. As the devaluation of the ruble made foreign importsmore expensive, consumers bought more locally-made goods. A new president,Vladimir Putin, brought political and financial stability to the government.

Growth has been uneven. The streets of the capital, Moscow, shine withfine restaurants and fashionable stores while the rest of country lags behind.Much of the nation’s good fortune is due to exports of oil and natural gas,leaving Russia vulnerable to price changes on international markets.

Russia has not yet succeeded in building a stable, modern free market econ-omy. Officials actively discourage start-ups by imposing unpredictable regula-tions and occasionally demanding bribes. Insolvent businesses can still stayafloat because of the elaborate system of bartering among suppliers. This discour-ages Russian businesses from becoming more efficient.

It is now obvious that Russia’s problems in making the transition were seri-ously underestimated. As this painful process continues, Russians look forwardto the day when a prosperous free market economy becomes a reality.

Applying Economic Ideas1. What problems has Russia experienced in switching from a state-controlled

to a free market economy?2. Why might Western nations be willing to make loans to troubled Russia?

39

� Many Western businesses saw the collapseof Communism as a business opportunity.

Economic Systems

ECON_07NA_se_CH02_CS 6/16/05 10:26 AM Page 39

YYou cannot find today any economicsystem that relies exclusively on central

planning or the individual initiative of thefree market. Instead, most economies are amixture of economic systems. Mostcontemporary mixed economies blend themarket with government intervention, orinvolvement, in the marketplace.

The Rise of Mixed EconomiesNo single economic system has all theanswers. Centrally planned economies are

cumbersome, do not adequately meetconsumer needs, and limit freedom.Traditional economies have little potentialfor growth or change. Even marketeconomies, with all their advantages, havecertain drawbacks.

The Limits of Laissez FaireAdam Smith and other early free marketphilosophers believed that, left to its owndevices, the free market system wouldprovide the greatest benefit for consumersand raise the standard of living. They

Modern EconomiesPreviewObjectivesAfter studying this section you will be able to:1. Explain the rise of mixed economic

systems. 2. Interpret a circular flow model of a mixed

economy.3. Compare the mixed economies of various

nations along a continuum betweencentrally planned and free marketsystems.

4. Understand the role of free enterprise inthe economy of the United States.

Section FocusIt is doubtful that any nation can existsuccessfully under a pure centrallyplanned economy or a pure marketeconomy. Most modern economiesmix features of both systems. Theeconomy of the United States isbased on the principles of the freemarket.

40

Key Termslaissez faireprivate propertyfree enterprisecontinuumtransitionprivatize

� Most public parksrely on governmentdollars for support.



preached laissez faire, the doctrine thatgovernment generally should not intervenein the marketplace. (See the Profile ofAdam Smith on page 33.) Even Smithacknowledged, however, the need for acertain limited degree of government inter-vention in the economy.

As market economies have evolved sinceSmith’s time, government intervention hasbecome greater because some needs andwants of modern society are difficult toanswer in the marketplace. How well, forexample, could the marketplace providefor national defense or for roads andhighway systems?

Some needs that markets could meet fallto governments so that all members ofsociety can participate. Education is oneexample. Other needs that could fall intothis category are health care and masstransit.

Governments create laws protectingproperty rights and enforcing contracts.There would be little incentive to developnew products without property rights orpatent laws (laws that give the inventor of anew product the exclusive right to sell it fora certain period of time). Without lawsinsisting on competition, many people fearthat some firms would dominate others intheir industry and be able to chargeconsumers any price.

You will recall from your study ofAmerican history that the 5th and 14thamendments to the Constitution declarethat no person may be deprived of “Life,liberty, or property, without due process oflaw.” The 5th Amendment also says that“just compensation” must be paid toowners when private property is taken forpublic use. Private property is property thatis owned by individuals or companies, notby the government or the people as awhole. The Framers of the Constitutionensured that the United States governmentwould protect this fundamental right.

Balancing Control and FreedomA society must assess its values and priori-tize its economic goals. Some goals are

better met by the open market and othersare better met by government action. Inaddition, societies must evaluate the oppor-tunity cost of pursuing each goal.

Each nation decides what it is willing togive up to meet its goals. What are youwilling to give up? Are you willing to paytaxes to fund the army? To give money topeople without jobs? To give all people aneducation? To subsidize farms? Should thegovernment establish job-safety guidelinesor a minimum wage?

laissez faire thedoctrine that states thatgovernment generallyshould not intervene inthe marketplace

private propertyproperty owned byindividuals orcompanies, not by thegovernment or thepeople as a whole

Sweden’s Mixed Economy Sweden’s mixed economy has mixedbenefits for the Swedish people. The Swedish government redistributes morethan half of Sweden’s wealth through social benefit programs. When a child isborn, his or her parents are entitled to a combined 450 days of parental leave,with three quarters of their base salary paid by the government. Swedish patientsrarely pay more than 1,800 Swedish kronor (about $230) per year for prescriptions.If you were a teen in Sweden, your new braces would be free. Employers arerequired to give employees a minimum of 30 days vacation. The trade-off forthese benefits is the second-highest tax burden of any industrialized country.Swedes pay around 56 percent of their gross domestic product in taxes,compared to only 32 percent in the United States. How would you describe thelevel of government involvement in Sweden’s economy?

Global Connections

� Thesekindergartenstudents in thisschool lunchprogram are enjoyinga benefit of govern-ment intervention.


42 Economic Systems

A Circular Flow Model of aMixed EconomyTo illustrate the structure of most moderneconomies accurately, we need to addgovernment to our picture of the circularflow of economic activity. Figure 2.4 illus-trates the government’s role in the market-place in a mixed economy. The governmentcan enter the circular flow of economicactivity in many ways.

Government in the Factor MarketJust like businesses, the governmentpurchases land, labor, and capital from

households in the factor market. Forexample, the United States governmentpays 2.8 million employees $9.7 billion ayear for their labor.

Government in the Product MarketGovernments purchase goods and servicesin the product market. They need buildingsand office supplies, telephones, computers,and fax machines, for example.

Governments also provide certain goodsand services through the factor resourcesthat they combine. The federal, state, andlocal governments in the United States, forexample, provide 4 million miles of roads.

monetary flow

monetary flow

physical flow

physical flow

taxes

taxes

government -

owned factors

gove

rnment

purchases

Product market

Factor market

Figure 2.4 Circular Flow Model of a Mixed EconomyFigure 2.4 Circular Flow Model of a Mixed Economy

Governmentexpenditures expendituresHouseholds Firms

This circular flowmodel shows howgovernment typicallyinteracts withhouseholds andbusinesses in themarketplace.Economic SystemsExplain howgovernment actionsaffect the circularflow model in amixed economy.


Transferring MoneyAs you can see from the outer ring of Figure 2.4, governments collect taxesfrom both households and businesses.Governments then transfer the money theycollect to businesses and individuals for avariety of reasons ranging from workerdisability to the survival of an industry. Thegreatest expenditure of the United Statesgovernment is Social Security.

Comparing Mixed EconomiesThe foundation of the United Stateseconomy is the free market. An economicsystem characterized by private or corpo-rate ownership of capital goods is calledfree enterprise. In a free enterprise systeminvestments are determined in a freemarket by private decision rather than bystate control. Figure 2.5 below shows acontinuum of mixed economies. Acontinuum is a range with no clear divisions.On one end of the scale is the centrallyplanned economy. On the opposite end isthe free market economy.

Mixed Economies Where GovernmentIntervention DominatesReflecting an economy almost totallydominated by the government, NorthKorea occupies one end of the scale.

Government owns all theproperty and all economicoutput. State-owned industriesproduce 95 percent of NorthKorea’s goods. Almost allimports are banned, andproduction of goods andservices by foreign companiesis forbidden.

In China, where the economyis dominated by government,one quarter of all enterprisesare at least partly owned byindividuals. China, like many nations thathave relied heavily on central planning inthe past, is in transition, a period of changein which an economy moves away fromcentral planning toward a market-basedsystem. To make the transition, state firmsmust be privatized, or sold to individuals, andthen allowed to compete with one anotherin the marketplace. As you will read inChapter 18, economic transition is a diffi-cult, and often painful, process.

Mixed Economies Where the MarketSystem DominatesAt the other end of the scale, with one of theworld’s freest markets, is Hong Kong. HongKong, once administered by Great Britain, isnow a special administrative region of China.It continues, at the beginning of the twenty-

free enterprise aneconomic systemcharacterized by privateor corporate ownershipof capital goods;investments that aredetermined by privatedecision rather than bystate control; anddetermined in a freemarket

continuum a range withno clear divisions

transition period ofchange in which aneconomy moves awayfrom a centrally plannedeconomy toward amarket-based system

privatize to sell state-runfirms to individuals

Figure 2.5 Continuum of Mixed Economies Figure 2.5 Continuum of Mixed Economies

North Korea

Iran

Cuba Russia Poland Japan United States

China South Africa Canada Singapore

Mexico France United Kingdom Hong Kong

Free marketCentrally planned

Source: 2003 Index of Economic Freedom, Bryan T. Johnson, Kim R. Holmes, and Melanie Kirkpatrick

In competition with foreign fast-food restaurant chains, Chinese entrepreneur Shen Qing started his own restaurant chain—the Baked Pig Face restaurants. The seasoned pigs‘ heads, served in a modern setting, are wildly popular. Mr. Shen benefits by receiving profits, and consumers benefit by being able to choose a traditional Chinese dish over Western-style fast food.

FAST FACT

The degree of government intervention in the marketplace varies among nations.Economic Systems How would you explain China’s position on this continuum?Why is Hong Kong, technically part of China, so far to the right on this diagram?



44 Economic Systems


Key Terms and Main Ideas1. What is laissez faire?2. Why have some nations begun a transition to free

enterprise? 3. Why are nations with centrally planned economies some-

times slow to succeed when they privatize industry?4. Compare the U.S. free enterprise system with other

economic systems you have read about in this chapter.

Applying Economic Concepts5. Critical Thinking What benefits might citizens of a

centrally planned economy derive from a move toward amarket-based system?

6. Try This Survey newspapers and magazines to findarticles describing life in different economic systems.Construct a bulletin board of the continuum ofeconomies in Fig. 2.5. Place each article on the appro-priate location on the continuum.

first century, largely under the free economicsystem it enjoyed under British rule.

In Hong Kong, the private sector rules.The government protects private propertyand rarely interferes in the free market,aside from establishing wage and pricecontrols on rent and some public services.It is highly receptive to foreign investmentand imposes virtually no barriers on

foreign trade. Banks in Hong Kong operateindependently of the government, andforeign-owned banks have nearly all thesame rights as domestic ones.

The United States EconomyThe United States has a free enterpriseeconomy. Still, the government intervenesto keep order, provide vital services, and topromote the general welfare. Some peopleargue for more government services, whileothers say that the government alreadyintervenes too much in the economy.Nevertheless, the United States enjoys ahigh level of economic freedom.

United States law protects privateproperty. The marketplace operates with alow level of government regulation.Foreign investment is encouraged. So, too,is free trade, although the United Statesdoes protect some domestic industries anddoes retaliate against trade restrictionsimposed by other nations. The bankingindustry operates under relatively fewrestrictions, and foreign-owned banks havefew additional restrictions. In the nextchapter, you will read in detail about thegovernment and the free enterpriseeconomy of the United States.

� What type ofeconomic system doyou see reflected inthis busy mall?

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1. Identify the steps of the process. Readthe labels in the boxes to familiarizeyourself with the process of writing an article. (a) What does Laura do

after she interviews people for thearticle? (b) What are the two choicesfor step one of the process?

2. Analyze the relationships among steps.A flowchart shows a series of actionsand decisions. (a) According to thisparticular chart, who can make adecision that directly affects the flow?(b) Why does the path split into twonew paths after Laura submits thearticle to her editor?

3. Predict possible future developments.New arrows and steps can be addedanywhere along the flowchart, notjust at the ends. Picture how differentdecisions and actions might changethe look of Laura’s flowchart. (a)Where else might the flowchart splitinto two new paths? (b) Give anexample of a new step that could beadded to start a new path.

Building Flowcharts

A flowchart is a visual guide to a process that breaks the process downinto individual steps. Arrows often indicate the order and relationships

among the steps. In economics, flowcharts help people visualize the waysgoods are produced, how money flows through the economy, and howdecisions can affect many people. Use the following steps to analyze theflowchart below.

Construct a flowchart to show thesteps that you could take to offer anew product for sale in your smallfood store.

Additional Practice

Laura hearsabout a story

that would makea good article.

Laura interviewsseveral students.

Laura writes an article andsubmits it toher editor.

Laura's editordecides not toprint the article

in the nextissue.

Laura's editorrevises the articleand includes it in

the next issue.

Laura's articleappears in the

newspaper that week.

Laura's editorassigns her a

story to researchfor an article.

LIFESkills for

45

ECON_05_se_SK_CH02 6/16/05 12:05 PM Page 45

46

Chapter SummaryChapter Summary

AA summary of the major ideas in Chapter 2 appearsbelow. See also the Guide to the Essentials

of Economics, which provides additional review andtest practice of key concepts in Chapter 2.

Section 1 Answering the Three Economic Questions (pp. 23–27)

The three basic economic questions societies ask are(1) What goods and services should be produced?(2) How should these goods and services be pro-duced? and (3) Who consumes these goods and ser-vices? An economic system is the way a societydecides to answer these three economic questions.There are four general types of economic systems:traditional economies, market economies, centrallyplanned (or command) economies, and mixedeconomies.

Section 2 The Free Market (pp. 28–32)A free market is a self-regulating economic systempowered by individuals acting in their own self-interest. In a free market economy, the factors ofproduction are privately owned, and individualsdecide how to answer the three economic questions.

Section 3 Centrally Planned Economies (pp. 34–38)In a centrally planned economy the central governmentcontrols the factors of production and answers thethree basic economic questions for all of society.Two systems often mentioned when centrallyplanned economies are discussed are socialism andcommunism.

Section 4 Modern Economies (pp. 40–44)Most of the economic systems in the world todayare mixed economies. These systems use a combina-tion of government involvement and free markets.Throughout the world there are different levels ofgovernment intervention in mixed economies.

Key TKey TermsermsMatch the following terms with the definitionslisted below. You will not use all of the terms.

1. System that combines the free market withsome government intervention

2. One’s own personal gain3. The doctrine that states that government

generally should not intervene in the mar-ketplace

4. System in which the central governmentmakes all decisions on the production andconsumption of goods and services

5. The struggle among producers for the dol-lars of consumers

6. System in which decisions on productionand consumption of goods and services arebased entirely on exchange, or trade

Using Graphic OrganizersUsing Graphic Organizers7. On a separate sheet of paper, copy the web

map below showing the advantages andvalues of a mixed economy. Complete theweb map with examples from your knowl-edge or experience.

competitionsocialismmixed economyself-interestcommand economy

laissez faireprivatizeconsumer

sovereigntymarket economy

Economic security: disaster

relief

Mixed

Economy

ECON_07NA_se_CH02_CA 8/3/05 9:23 AM Page 46

47

Reviewing Main IdeasReviewing Main Ideas8. Think of a business in your local area. Describe

its operation in terms of factor markets andproduct markets.

9. Explain how a factory assembly line is an exam-ple of specialization.

10. Why are there no pure free market economies inthe world?

11. Compare the circular flow diagrams of a freemarket and a mixed economy. Describe how theydiffer, and why.

Critical ThinkingCritical Thinking12. Synthesizing Information Suppose that your

household is its own society. How are the threekey economic questions answered?

13. Predicting Consequences Think of three waysyour life would change if the United Statesbegan using a pure free market system or a purecentrally planned system instead of the freeenterprise system.

14. Analyzing Information Review the advantages anddisadvantages of both free market economiesand centrally planned economies. Assess theway each system values economic freedom andeconomic equity.

Problem-Solving ActivityProblem-Solving Activity15. Suppose that you are opening a new music store

in your town. What resources would you needfrom the factor market? What would you offer inthe product market? How would the governmentaffect your business?

Skills for LifeSkills for LifeBuilding Flowcharts Review the steps on page 45;then answer the following questions using the flowchart below.

16. What does Megan do to try to make extramoney this weekend?

17. Why does the flowchart split into two paths afterMegan sets up her stand?

18. What step does Megan take if the neighbors likeher cookies?

19. If the neighbors do not like cookies, where coulda step or steps be added so Megan could succeednext time?

20. Organize a flowchart for yourself depicting agoal that you did not achieve. (a) Take a closelook at the steps you took. (b) What errors didyou make? (c) Decide which steps you canchange so you can succeed in the future.

There is a yard sale this weekendin Megan’s neighborhood.

Megan wants to make extra money this weekend.

Neighbors buy cookiesfrom Megan.

Megan decides to openher cookie stand next timea neighbor has a yard sale.

Neighbors do not buy anycookies from Megan.

Megan sets up a stand, offering her homemade gourmet cookies for sale.

Organizing Ideas Review your personal list of systems. Rewrite your list in two columns. Inone column, list the systems that are more influ-enced by central planning. In the other column,list the ones that are more influenced by the freemarket. Add to each list other systems you use ona regular basis.

Economics Journal Progress Monitoring Online

As a final review, take the Economics Chapter 2 Self-Testand receive immediate feedback on your answers. Thetest consists of 20 multiple-choice questions designed totest your understanding of the chapter content.

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ECON_07NA_se_CH02_CA 8/3/05 9:23 AM Page 47

Most people live and work within an established economicsystem. Sometimes government economic policy decisionsbring gradual shifts or changes to an established system.

For example, in the United States during the Great Depression,many new federal programs—notablySocial Security—changed the role ofgovernment in the American economy.Occasionally, a revolution overthrowsan established economic system andputs in place a new one, as you read inChapter 2.

What if you could design an eco-nomic system from scratch? Supposethat you are part of a group of peoplewho have inherited an uninhabitedisland. As the first settlers on thisisland, one of your tasks will be toestablish an economic system.

MaterialsNotebook paperBox or paper bag

Preparing the SimulationIn this simulation, your group will playthe role of an island’s first settlers. Yourgoal is to plan an economic system. Eachgroup has members who represent themajor economic systems—free marketand centrally planned economies. As thefounders of a new community, you maychoose either of those systems or you maytake elements from different systems andcreate a new one.

Step 1: The teacher or several student vol-unteers should prepare one slip of paperfor each student in the class, as follows:

One half labeled “Free Market Economy(Capitalist, Democratic)”

One half labeled “Centrally PlannedEconomy (Socialist, Authoritarian)”

Step 2: Place the slips in a box or paperbag. Form groups of six to eight people,

representing Island A, Island B, Island C,and so on. When the groups are set, eachmember should draw one of the labeledslips of paper, which will determine theeconomic system that member argues for in the discussion.

Be aware that the groups will probably notbe evenly balanced between both econ-omies. (If any group has representatives ofonly one system, redo the drawing.)

Step 3: Review the basics of the economicsystem that you represent. You will beadvocating this system, so play your role asif this is the system you grew up in and aremost familiar with.

� Will services such as postal delivery be provided by the government or by private companies?

Designing an Economic SystemEconomicsSimulation Designing an Economic System

48

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49

After listening to each group’s speakerpresent the group’s conclusions, answerthe following questions:

1. Did the systems your class createdclosely resemble the systems of anyspecific countries? If so, which ones?

2. How much did the roles of group mem-bers influence the economic decisionsyou made?

3. What was the most problematic issuefor each group?

4. Making Comparisons How does livingin a free market economy affect yourview of another economic system?

Conducting the Simulation This simulation will consist of four phases. Each groupwill identify and discuss its options, reach an agree-ment, and present its plan to the class.

Presentation of Options: Within your group, determinethe options for your island economy. Delegates foreach of the economic systems represented in thegroup should present the benefits of their systems in apersuasive manner.

Discussion: After the benefits of both systems havebeen explained, each group should debate the bene-fits and drawbacks of each economic system. You may want to make a decision-making grid to see thetrade-offs.

Negotiation: Then your group should decide whetheryou wish to accept one of the systems as a whole orcreate a new system using elements of both systems.

You should answer these questions:a) Who decides how resources will be allocated? b) Who owns the factors of production?c) Who determines what goods and services will beproduced? d) Who determines prices?e) How is income distributed?f) Must all members contribute equally? g) What social benefits does the system supply?h) What is the role of government in the economy?Create a chart like the one on this page to summarizethe structure of your island’s economy.

Class Presentation: Each group should choose aspeaker to present the system to the class. After eachpresentation, class members may ask questions aboutthe system, so the spokesperson should be ready todefend the group’s decisions.

Feature of How Defined in

Economic SystemIsland Economy

Role of Government

Ownership of Land

and Capital

Decision Makers for

Production and Pricing

Income Distribution

Social Benefits

Summary of Island

Economic SystemSimulation AnalysisSimulation Analysis

ECON_05_se_SIM_Un01 6/17/05 7:08 AM Page 49

Documents

Economic Systems Title? NO SAMPLE - Frank Schneemann CH-2.pdf · Title? NO SAMPLE Asystem is a way of doing something. The trains, tracks, platforms, routes, and schedules of a subway