Economics

Chapter 2
Free Enterprise and Other Economic
Systems

Section 1: 3 Basic Economic Questions

What goods and services should be

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

Section 1: 3 Basic Economic Questions

Economic system- structure of methods and

principles a society uses to produce and
distribute goods and services
Society must decide what to produce in order
to satisfy societys needs and wants
Because resources are limited, each decision
comes with an opportunity cost

Section 1: 3 Basic Economic Questions

Society must decide how to produce

goods and services
All require land, labor, and capital

Section 1: 3 Basic Economic Questions

Societies must also make decisions that

determine how goods and services are
consumed
Largely determined by how societies
distribute income

Section 1: 3 Basic Economic Questions

Factor payments- income people receive in

return for supplying factors of production
Land, labor, and capital

Landowners- collect rent

Workers- collect wages
Money lenders- collect interest
Includes profits that entrepreneurs earn if their
enterprises succeed

Section 1: 3 Basic Economic Questions

Profit- the amount of money a business

receives in excess of its expenses
Questions answered by society based on
their priorities of economic goals

Efficiency
Freedom
Security
Equity
Growth

Section 1: 3 Basic Economic Questions

Efficiency
Societies want to maximize what they produce
If society can accurately assess what its people need and
want, it increases its economic efficiency
Reducing waste also involve answering other economic
questions
An economy that cannot deliver the right goods in the right
quantity to the right people at the right price is not efficient

Section 1: 3 Basic Economic Questions

Freedom
Own property, work where we want, choice
of what we buy, etc.
Are costs that come with freedom
Possible failure

Section 1: 3 Basic Economic Questions

Security
Economic systems seek to reassure people that
goods and services will be available when needed
and that expected payments will arrive on time
Safety net- set of programs to protect people who
face unfavorable economic conditions
Many economies also provide basic income for
retired people

Section 1: 3 Basic Economic Questions

Equity or Fairness
Should everyone get the same share of
goods and services a nation produces

Section 1: 3 Basic Economic Questions

Growth
Standard of living- level of economic
prosperity
Comes with economic growth

Section 1: 3 Basic Economic Questions

Innovation
Process of bringing new methods,
products, or ideas into use
Plays large roll in economic growth

Section 1: 3 Basic Economic Questions

Other possible goals

Environmental protection
Full employment
National industry

Sometimes goals conflict with one another

Must prioritize economic goals

Section 1: 3 Basic Economic Questions

There are 4 different economic systems

to address these basic questions
Reflect different prioritization

Section 1: 3 Basic Economic Questions

Traditional economy- relies on habit custom,

or ritual to answer 3 economic questions

Little room for innovation or change

Revolves around family unit
Work divided along gender lines
May lack modern conveniences and have a low
standard of living

Section 2: Free Markets

Market- any arrangement that allows
buyers and sellers to exchange things
Allows us to exchange the things we have
for the things we want

Section 2: Free Markets

Specialization- the concentration of the
productive efforts of individuals and
businesses on a limited number of activities
Leads to efficiency in the use of capital, land, and
labor
Benefits the business to allow them to use their
factors of production more efficiently

Section 2: Free Markets

In a modern market-based economy people earn
income by specializing in particular jobs- they then
use his income to buy the products that they want to
consume
Free market economy- 3 economic questions are
answered by voluntary exchange in markets
capitalist economies
free enterprise

Section 2: Free Markets

Participants in a free market are households and
firms
Household- a person or group living in a single residence
own the factors of production
Consumers of goods and services

Firm (business)- an organization that uses resources to

produce a product or service, which it then sells
Transforms inputs (factors of production) into outputs (goods or
services)

Section 2: Free Markets

Can represent exchanges in a diagram
called a circular flow model

Section 2: Free Markets

Factor market- firms purchase factors of
production from households
Product market- households buy the
goods and services that firms produce

Section 2: Free Markets

According to Adam Smith- competition and
our own self-interest actually help to keep the
market functioning
The Wealth of Nations- 1776
How markets function

Self-interest is the motivation force in the free

market- the push that leads people to act

Section 2: Free Markets

Incentive- the hope of reward or fear of
penalty that encourages a person to
behave in a certain way
Adam Smith observed that people respond
in a predictable way to both positive and
negative incentives

Section 2: Free Markets

Competition- struggle among producers
for the dollar of consumers
While self-interest is the motivating force
behind the market, competition is its
regulating force

Section 2: Free Markets

Under ideal conditions, the free market meets
many goals
Economic efficiency- because its self-regulating
Can respond to rapidly changing conditions

Economic freedom- highest degree of economic

freedom of any system
Economic Growth- competition encourages
innovation

Section 2: Free Markets

Other positives: wide variety of goods,
consumer sovereignty- consumers have
the power to decide what gets
produced- consumer is king

Section 3: Centrally Planned Economies

Centrally planned economy- government

rather than individual producers and
consumers answer the 3 basic economic
questions
A central bureaucracy decides what to produce,
how to produce, and for whom to produce
Government owns both land and capital
Controls where people work and what they get
paid

Section 3: Centrally Planned Economies

Command economies- oppose private

property, free market pricing,
competition, and consumer choice
No consumer sovereignty

Section 3: Centrally Planned Economies

Socialism: not a single economic

system
Range of economic and political systems
based on belief that wealth should be
evenly distributed throughout society

Section 3: Centrally Planned Economies

Socialism can co-exist with free market

practices
Example: Sweden
Use of heavy taxes

Or can have government ownership of the

means of production
Socialism is considered by some the intermediate
stage between capitalism and communism

Section 3: Centrally Planned Economies

Communism: central government owns and

controls all resources and means of
production and makes economic decisions
Karl Marx
Stressed conflict between labor and capital
Believed labor was the sources of all value
The inevitable result of capitalism was the exploitation of
workers and an unfair distribution of wealth

Section 3: Centrally Planned Economies

Communist governments have always

been authoritarian
Limit individual freedoms and require strict
obedience
Book examples of the USSR and China

Section 3: Centrally Planned Economies

Disadvantages:
Economic efficiency
Lack of worker incentive to work faster or produce more
Lack of flexibility

Economic freedom
Takes almost all economic choices away from producers and
consumers

Economic growth
Doesnt tend to reward innovation
No profit motive

Economic equity
Tends to be only in theory

Section 4: Mixed Economies

Most economies are a form of a mixed
economy
Adam Smith believed in laissez faireidea that government should not
intervene in the marketplace
Some limited degree of government
involvement

Section 4: Mixed Economies

Examples of Government involvement:
National defense
Highways
Public schools
Private property rights

Section 4: Mixed Economies

Private Property- property owned by
individuals or companies and not by the
government or the people as a whole
Also have laws protecting intellectual
property
Private property is a fundamental element
of the American economy

Section 4: Mixed Economies

Governments look to make sure
exchanges are fair
Honest
Keep competition

Section 4: Mixed Economies

Government also collects taxes and has
some redistribution of wealth
Social Security
Disability Payments

No nation today is a complete free

market

Section 4: Mixed Economies

Mixed Economy- an economic system that has some
market- based elements and some government
involvement
Degree of government involvement varies from nation to
nation

Some goals are solved by open market, some are

better met with government involvement
Must evaluate the opportunity cost with each goal

Section 4: Mixed Economies

Must Add government into the circular flow
diagram

Section 4: Mixed Economies

Governments can purchase land, labor,
and capital from households in the
factor market
US Government pays nearly 3 million
employees over $150 billion a year for their
labor

Section 4: Mixed Economies

Governments also purchase goods and
services from firms in the product
market
Governments can also provide certain
goods and services by combining the
factor resources they have purchased

Section 4: Mixed Economies

Governments collect taxes from both
households and businesses
Transfer some of this money to businesses
and individuals

Section 4: Mixed Economies

Most modern economies are mixed
economies
Economic transition- period in which a nation
moves one economic system to another
Privatization- selling enterprises operated by
government to individual and then allowing
them to compete in the marketplace

Section 4: Mixed Economies

US Economy
Mixed economy with its foundation of the free
market
Government plays a substantial role in American
economy
Keeps order
Provides vital services
Promotes general welfare

Section 4: Mixed Economies

Federal and state laws protect private property
Marketplace operates with a limited degree of
government regulation
High level of economic freedom
Economy is open
Foreign investment is encouraged
Does protect some domestic industries
Does retaliate against trade restrictions imposed by other
nations

Section 5: Benefits of Free Enterprise

Freedom to try out business ideas and compete in
the marketplace
Basic characteristics of a free enterprise system
Incentives- reward or a cost resulting from specific behavior
Profit
Personal Satisfaction
Can also be negative

Section 5: Benefits of Free Enterprise

The American economy rests on recognition of profit
motive as a key incentive
Profit motive- drives individuals and businesses to
make decisions that improve their material well-being

Forces business owners to exercise financial discipline

Encourages entrepreneurs to take risks
Rewards innovation by letting creative companies grow
Improves productivity by allowing more efficient companies
to make more money

Section 5: Benefits of Free Enterprise

In order to make a profit, businesses

must compete with one another for
consumers money
competition- serves to regulate the market
Keeps prices from rising too high
Encourages businesses to improve the quality
of their products in order to attract consuemrs

Section 5: Benefits of Free Enterprise

Open opportunity- the principle that

anyone can compete in the marketplace
Legal equality- the principle that
everyone has the same legal rights

Section 5: Benefits of Free Enterprise

Private property rights- the right to

control their possessions and use them
as they wish
Provides an incentive for property owners
to use property wisely and conserve
resources

Section 5: Benefits of Free Enterprise

Free contract- allows people to decide

what agreements they want to enter into
Voluntary exchange- allows consumers
and producers to decide what, when
and how they buy and sell
Encourages competition

Section 5: Benefits of Free Enterprise

Key Roles in the Free Enterprise System:
Consumer
Sends signals to businesses. Telling them what and how much
to produce
Interest group- private organization that tries to persuade public
officials to act in ways that benefit its members

Entrepreneur
Decide how to combine resources to create new goods and
services
Seeks to make a profit

Section 5: Benefits of Free Enterprise

5th Amendment- protects private property rights
Eminent domain- right of the government to take private
property for public use

Individuals or businesses cannot use the political

process to be excused from their contracts
No legislature can pass a law changing the terms of
someone's business agreements

Section 5: Benefits of Free Enterprise

The governments primary role is to carry out its
constitutional responsibilities to protect property
rights, contracts, and other business activities
Actions to promote public interest
Public disclosure laws- require companies to give
consumers important information about the products or
services they offer
Often attached to product when its offered for sale

Section 6: Supporting Economic Growth

Even in our free enterprise system,

government intervenes to influence
macroeconomic trends
Macroeconomics- the study of
economic behavior and decisionmaking in a nations whole economy

Section 6: Supporting Economic Growth

Microeconomics- the study of economic

behavior and decision-making in small
units, such as households and firms

Section 6: Supporting Economic Growth

GDP- Gross Domestic Product- total

value of all final goods and services
produced in a country in a given year
Business cycle- the alternating pattern
of periodic expansion and contraction
Major fluctuations

Section 6: Supporting Economic Growth

Government tries to make public policies that

promote economic strength
3 Goals:
High Employment- 4-6%
Growth- increasing GDP
Stability- stable prices and secure financial institutions
General level of prices
Security of financial institutions

Section 6: Supporting Economic Growth

Referendums- proposed laws submitted

directly to the public
Patent- gives the inventor of a new product
the exclusive right to reproduce and sell it in
20 years
Copyright- grants an author exclusive rights
to publish and sell his or her creative works

Section 7: Public Goods and Externalities

Public good- shared good or service for

which it would be inefficient or
impractical to make consumers pay
individually and to exclude those who
did not pay
Example: Roads and Bridges

Section 7: Public Goods and Externalities

Public Goods:
Any number of consumers can use them
without reducing the benefits of a single
consumer
Financed by the public sector- the part of
the economy that involve transactions by
the government

Section 7: Public Goods and Externalities

Private sector- part of the economy that

involves transactions of individuals and
businesses
Has little incentive to produce public goods

Infrastructure- basic facilities that are

necessary for a society to function
efficiently and grow

Section 7: Public Goods and Externalities

Cost-benefit criteria for a public good

The benefit to each individual is less than
the cost that each would have to pay if it
were provided privately
The total benefits to society are greater
than the total cost

Section 7: Public Goods and Externalities

Free rider- someone who would not be

willing to pay for a certain good or
service, but would get the benefit of it
anyway if it were provided as a public
good
Example: out of state roads

Section 7: Public Goods and Externalities

Market failure- specific situation in

which the free market, operating on its
own, does not distribute resources
efficiently

Section 7: Public Goods and Externalities

Externality- 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 consumer
Can be positive or negative

Section 7: Public Goods and Externalities

Government may try to create positive

externalities and tries to limit negative
externalities

Section 7: Public Goods and Externalities

Poverty threshold- income level below

that which is needed to support families
Changes based on household size

Welfare- general term for government

aid for the poor
Began under FDR in the depression