BEC - Economic Systems and the Circular Flow Lesson

APMicroeconomics_LessonTopBanner.png

Economic Systems and the Circular Flow Lesson

Societies have developed three economic systems for dealing with the problem of scarcity. These systems include the traditional economy, the command economy, and the market economy. Each of these systems has developed its own way of answering the three major economic questions faced by every society.

Three Major Economic Questions

  1. What to produce?
  2. How to produce?
  3. For whom to produce?

Economic Systems Video

View the video below to learn more. To make the video full screen, click the double arrows at the bottom right corner of the object.

 

Economic Systems

Traditional (Answers three economic questions through habit, ritual, and custom) Strengths • Members of society have specific, predetermined economic roles • Economic life is very stable and predictable, tomorrow will be much like today due to lack of change, it affords a great deal of security Weaknesses • Innovation and new ideas are discouraged because they will change the fabric of society • Low levels of economic progress because of the aversion to change • Compared to other structures, standard of living is low (from the perspective of well being); most examples of traditional economics are found in tribal units and remote areas Command (Central authority answers the three basic economic questions) Strengths • Basic needs are provided by a central authority for the public at large • Capable of significant change courtesy of direction by government authority (consider the USSR under Stalin's regime) Weaknesses • Poor incentives, no profit motive, no private property • Centralized decision making creates the need for a large bureaucracy • Goods and Services are not determined based on the desires of the consumer, rather a government entity determines what is to be produced (product variety is very low) • Economic freedom is not valued or encouraged; the desires of the individual are second to the good of society Market (Three basic economic questions are answered by individuals and businesses Strengths • Large amount of individual freedom • Producers and consumers direct the economy and determine what is produced • The consumer rules the market (consumer sovereignty); great degree of product variety Weaknesses • Lack of government involvement in the economy • Can adjust gradually to the changing desires of consumers • Lack of stability; fluctuations in the market • Lack of economic safety nets to protect those who cannot or aren't able to find work • Market does not naturally provide public goods

The type of economic system used to answer these basic questions will also determine which economic goals are a priority for a nation. The basic economic goals for most nations are summarized below.

Economic Freedom: Producers and Consumers are free to participate in voluntary trade; the government has little involvement in the economy; Examples:  you are free to open your own business, shop where you want, and own private property.

Economic Efficiency: Involves producing the socially desirable level of output and producing it at the lowest cost possible because resources are scarce and must be used wisely in an attempt to satisfy unlimited wants

Economic Security: Provides safety nets to care for individuals in the event of economic catastrophes and hardships. Examples include unemployment insurance, welfare, and food stamps.

Economic Equity: Members of the society have equal opportunities to be successful. Examples include non-discrimination laws for employment and education.

Economic Growth: Innovation is encouraged and leads to economic growth, which in turn results in an increase in the standard of living and quality of life for citizens. Examples include incentives to businesses (subsidies, etc), changes in tax codes (fiscal policy), and changes in money supply to influence interest rates (monetary policy).

Price Stability: Maintaining steady economic growth so prices do not drastically fluctuate. Examples include laws to prevent price gouging in times of disaster, maintaining appropriate fiscal and monetary policy to allow for restrained growth, and the use of price controls.

Practically speaking, most countries have a desire to achieve, at least to a degree, each of the economic goals listed above. However, in their pure forms, the major economic systems are not able to attain each goal.  As a result, societies have created mixed economic systems - that is, systems that are a combination of two or more of the basic systems. Depending on the priorities of the goals, some mixed economies lean more toward a command economy, and some lean more toward a market economy.

Comparing Communism, Socialism, and Capitalism

Factors of Production Communism - Factors of production and businesses are owned by the government Socialism - The government controls the major factors of production and large industries in the economy; small businesses may be owned by individuals Capitalism - Individuals control the factors of production and own the businesses Economic Activity Communism – the government determines and directs all economic activity Socialism – the direction of economic activity is shared between the government and the people Capitalism – all economic activity is determined by individuals and businesses Distribution of Wealth Communism – Wealth is distributed equally according to need Socialism – wealth is redistributed to achieve greater income equality Capitalism – wealth is distributed based on individual merits with no significant attempt to gain income equality

Economic Interdependence

The sheer size of most economies results in a variety of interactions between several distinct entities. These interactions can be simplified using the circular flow model of the economy. This model highlights the basic interactions among the major components of an economy - the individuals, the businesses, and the government. It demonstrates how economic participants are interdependent and how resources, goods, and money flow through the economy. 

Circular Flow Model

View more details about the Circular Flow Model by moving your cursor over the image below. Notice that the outer arrows represent the flow of inputs and outputs; while the inside arrows represent the flow of money in the form of spending and income. The government sector also interacts in the economy as illustrated inside the Circular Flow Model.

APMicroeconomics_LessonBottomBanner.png

IMAGES CREATED BY GAVS