Unit 1.B - Economic Systems

Question 1

How are different economic systems distinguished?

Answer 1

different economic systems distinguished by their responses to the four basic economic questions

Question 2

What are the four basic economic questions?

Answer 2

• What to produce? (Food or shelter? Capital or consumer goods? luxuries/necessities, wheat/oats)
• How to produce? (Using capital or labour? Laws on child labour, OHS, environment, consumer protection)
• How much to produce? (Avoid waste or shortage. Farmer: how much to sow?)
• How to distribute? (Equal sharing, by merit, by need, by might, by political influence, random, lining up, turns)

They’re another way or level of asking how to use the resources available to minimise effects of the economic problem.

Question 3

What’s a pure planned economic system?

Answer 3

In a pure planned economy, answers to the four economic questions are decided by a central planning authority (the govt, a dictator, ‘the workers’, the king) and so to do this the central planning authority must own or otherwise control the factors of production (inc. labour: limited free will).

This may lead to a farmer being forced to be a carpenter and a carpenter being forced to farm. Given that they are being forced to do whatever is best for the country but will receive the same benefits regardless there is no incentive to work harder and so labour productivity generally declines. Even if you ‘own’ your land you don’t get to decide what to do with it. Thus, all up, very limited individual freedoms, and very profound govt precense… Democracy is NOT associated with planned economies because you don’t get a say as an individual. A planned economy can’t permit dissent (people digressing about how much to produce, how to produce, etc).

Regular people can’t be entrepreneurs: you can’t take risks with your resources if you don’t own anything.

E.g. Soviet Russia, China, N. Korea, Vietnam, command economies, Cuba

Question 4

What’s a pure free market economic system?

Answer 4

A pure free market is a form of economic system in which the answers to the four basic economic questions are addressed by firms interpreting and responding to changes in movements of the price mechanism.

It falls to these firms to respond with changes in production to meet shortfalls, changes in consumer tastes and preferences, etc. - consumer sovereignty.

• What: according to what buyer’s want (what will sell)
  
  • > Decided by workers, landowners, capital owners
• How much: according to price fluctuations
• How: however will reduce production costs and satisfy consumers
• For: whoever is willing and able to pay (you get shut out if you don’t have enough income).

Individuals own and control factors of production: everything is privately owned (inc. natl parks + pavements) (can be voluntarily owned collectively). They are free to decide how to use their resources to do whatever they’re best at, and if they make the wrong choices they stand to lose so generally work harder and contribute to a higher labour productivity.

Govt is seen as unnecessary, and given that government intervention may decrease supply, govt precense is v. minimal or non-existant.

Closest thing to a free market economy is currently Singapore or bitcoin.

Question 5

Describe life in a pure free market society

Answer 5

You have complete freedom, but absolutely no protections. Freedom to start a business, freedom to buy drugs, freedom to work whatever job you like, freedom to die of hunger in a ditch.

Weak businesses are weeded out bc they don’t make a profit, so in this way the market is more efficient.

Inequality is practically inevitable: if you have more resources, you have more income, so you invest in more resources to increase your income, so you can invest in more resources… etc. Intergenerational inequality: some people are born with more resources and income than others, thus can get ahead of those with nothing.

People wouldn’t trust each other: e.g. food handling laws. You never know what people did to get that low price on the shelves, you only have their word that they have a clean kitchen and used fresh produce and not rotten eggs.

You have to pay for everything.

“The freer the markets the freer the people.”

Question 6

What is the price mechanism?

Answer 6

The interaction of demand and supply as can be represented as curves on a market diagram, the intersection of which determines equilibrium price and quantity. It is the process used to determine the quantity of goods and services that will be produced and consumed in a free market economy and a way of addressing the economic problem in a free market.

Question 7

What is a mixed-market economic system?

Answer 7

In a mixed-market economic system, answers to the four basic economic questions are decided partially based off the price mechanism and partially by a central planning authority. For example, in Australia, the volume of shoes produced by Nike is decided by the price mechanism, but the volume of cancer drugs produced is decided by a govt order. Price signals do not determine impartiality of a judge, for example. Some goods are privately owned, others owned by govt/planning authority.

Govt. compulsorily acquires some income (all forms of income are taxed) through the progressive tax system to generate revenue to fund gov. interventions and provisions.

Good because it combines the dynamism, adaptability, and productivity of the free market system with the checks and balances of govt intervention.

We intervene to make the economic system more acceptable while harvesting the benefits, because at the end of the day the economy doesn’t exist in a vacuum, it exists to serve a society so if the society isn’t served then there is little point.

Allows for the addression of market failures incl. provision of goods and services and management of common resources, externalities, income inequality, and abuse of market power.

Question 8

Problems of planned economies?

Answer 8

Incentives:
- Circumvents the basic principle of reward for effort/merit which results in people trying harder and being more productive.

Innovation:

• No entrepreneurship on an individual level
• If the state is responsible for all decisions, there tends to be less diversity in approaches to ‘how to produce’
• Planned economies lack competition between businesses which otherwise encourages innovation.

Information:
- Difficult for planners to know what consumers want, what producers are good at, and which resources are scarce or abundant.

Some forms of market failure also exist in planned economy.

Question 9

Benefits of market economies?

Answer 9

Prices - provide vital information to suppliers about consumer wants to minimise shortages and waste.

Competition between producers - improves quality, lowers prices, produces innovation: incentives firms to work harder to avoid getting cut out of the game.

Freedom - allows people to make their own choices about what to produce and what to consume.
- At its best capitalism is the economic expression of democracy

Question 10

What’s the difference between a factor market and a product market?

Answer 10

Product and factor markets are both markets: they’re places (real or abstract) where goods and services are bought and sold, so they both use prices to help determine the quantity of goods/services using the forces of demand and supply.

Factor markets are where resources (land, labour, capital, enterprise) are bought and sold: by firms from households. For example, the labour market, or banks: household savings are loaned to businesses to purchase capital equipment.

Product markets are where goods for consumption (e.g. shoes or novels) are bought and sold: by consumers from firms.

Question 11

What are the four factors of production or economic resources?

Answer 11

Land - natural resources: the ‘bounty of the Earth’ e.g. natural fisheries, undeveloped land, clean air, mineral deposits.

Labour - the work of humans e.g. farming, teaching.

Capital - the produced means of production: goods used to produce other goods and services. E.g. piece of factory equipment, a work computer, a commercial taxi.

Enterprise - the ability to combine other factors of production and take calculated risks to produce new goods and services.

Question 12

What is income?

Answer 12

The returns on the factors of production are known collectively as income

Land - rent
Labour - wages
Capital - interest
Enterprise - profit

Question 13

What is the circular flow of income model?

Answer 13

The circular flow of income model describes financial flow through a simplified, five-sector model of the economy, describing impacts of leakages and injections to changes in equilibrium.

Question 14

What are three assumptions underpinning the TWO-sector circular flow of income model?

Answer 14

• Households own all factors of production
• Households must spend all their income
• Businesses must sell everything they make

Question 15

How can equilibirum be expressed mathematically in the circular flow of income model?

Answer 15

Equilibirum occurs when leakages = injections or when S + T + M = I + G + X.

If S + T + M > I + G + X then the economy will contract.
If S + T + M < I + G + X then the economy will expand.

Question 16

How is equilibirum re-established in the circular flow model following a change?

Answer 16

If leakages does not equal injections, disequilibrium occurs. Usuallly injections are more stable that leakages, which are quite related to incomes, and so the volume of leakages will proportionally fluctuate until they are equal to the more the stable injections. As some examples:

• Following a rise in taxation:
  this means that S + T + M > I + G + X, so less money will be spent on businesses resulting in a contraction of the economy over time: if less money is spent on businesses, less money will be received as income by business owners and workers. This means they will have less money to spend, and so over time as their incomes decrease they’ll fall into lower tax brackets and have less money to spend, resulting in a reduction in the level of leakages so that once again leakages = injections so that a new, state of equilibrium is reached at a smaller level of output.
• Following a reduction in taxation:
  This means that S + T + M < I + G + X, so more money will be spent on businesses overall, meaning that workers and business owners will have higher incomes, and so the economy will expand over time. However, as incomes increase, so too does the level of leakages as with higher incomes people can put more money away and will enter higher tax brackets. In this way, over time equilibrium is re-established at a higher level of output when leakages = injections.
• Following a rise in govt spending:
  This means that injections will exceed leakages resulting in an increase in spending on businesses, so business owners and workers will have more money to spend: over time the economy expands. However, as income levels increase so too do levels of leakages as people can save more and will fall into higher brackets, paying more tax, until eventually leakages equals injections and the economy re-establishes equilibrium at a larger size.

Question 17

What is the paradox of thrift?

Answer 17

The paradox of thrift states that the more people fear an economic decline in the future, the more likely it it is that they will save money, just in case, which leads to an increase in leakages and reduction in spending on businesses, a fall in incomes (which feed into each other as a vicious cycle: if people spend less on businesses, less income will be received by owners and workers, and as incomes increase people have less money to spend on business: the cycle continues) and consequently a contraction of the economy: that economic decline they feared. A self-fulfilling prophecy.

Question 18

What is the business cycle?

Answer 18

The business cycle can be modelled graphically as an expression of economic growth as a percent change in GDP over time.

Question 19

What are the phases of the business cycle?

Answer 19

Upswing: accelerating economic growth
Downturn: decelerating economic growth
Trough: period of lower than average economic growth
Recession: more than two quarters of negative economic growth.
Boom: period of higher than average economic growth.