2.1 Economic Questions and
Economic Systems
Objectives
Objectives
 Identify the three questions that all economic
systems must answer.
 Describe a pure market economy, and identify
its problems.
 Describe a pure command economy, and
identify its problems.
 Compare mixed, transitional, and traditional
economies.
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2.1 Economic Questions and
Economic Systems
Key Terms
 economic system
 pure market economy
 pure command economy
 mixed economy
 market economy
 transitional economy
 traditional economy
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2.1 Economic Questions and Economic Systems
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The Three Economic Questions
All economies must answer three questions:
1. What goods and services will be
produced?
2. How will they be produced?
3. For whom will they be produced?
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2.1 Economic Questions and Economic Systems
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Economic System
 An economic system is the set of mechanisms
and institutions that resolves the what, how, and
for whom questions.
 Some standards used to distinguish among
economic systems are:
 Who owns the resources?
 What decision-making process is used to allocate
resources and products?
 What types of incentives guide economic decision
makers?
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2.1 Economic Questions and Economic Systems
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Pure Market Economy
All resources are privately owned.
Coordination of economic activity is based
on the prices generated in free,
competitive markets.
Any income derived from selling resources
goes exclusively to each resource owner.
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Invisible Hand of Markets
According to Adam Smith (1723–1790),
market forces coordinate production as if
by an “invisible hand.”
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Problems with
Pure Market Economies
Difficulty enforcing property rights
Some people have few resources to sell
Some firms try to monopolize markets
No public goods
Externalities
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Pure Command Economy
All resources government-owned
Production coordinated by the central
plans of government officials
Sometimes called communism
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The Visible Hand
of Central Planners
Central planners direct the allocation of
resources and products
Control resources
Direct production
Allocate products
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Problems with
Command Economies
Consumers get low priority
Little freedom of choice
Central planning can be inefficient
Resources owned by the central authority
are sometimes wasted
Environmental damage
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Mixed Economy
United States is a mixed economy.
Because markets play a relatively large
role, it is considered a market economy.
Government regulates the private sector in
a variety of ways.
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Transitional Economy
A transitional economy is in the process
of shifting orientation from a command
economy to a market economy.
This transition involves converting
government enterprises into private
enterprises—privatization.
The transition now under way will shape
economies for decades to come.
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Traditional Economy
A traditional economy is shaped largely
by custom or religion.
Family relations also play significant roles
in economic activity.
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2.2 Production Possibilities
Frontier
Objectives
 Describe the production possibilities
frontier, and explain its shape.
 Explain what causes the production
possibilities frontier to shift.
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2.2 Production
Possibilities Frontier
Key Terms
 production possibilities frontier (PPF)
 efficiency
 law of increasing opportunity cost
 economic growth
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2.2 Production Possibilities Frontier
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Efficiency and Production
Possibilities Frontier
Simplifying assumptions
PPF model
Inefficient and unattainable production
Shape of the PPF
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Production Possibilities Frontier
 A through F are
attainable
 I represents
inefficient use of
resources
 U represents
unattainable
combinations
Figure 2.1
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Shifts in the PPF
Changes in resource availability
Increases in stock of capital goods
Technological change
Lessons from the PPF
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Shifts in the PPF
Increase in
Available Resources
Decrease in
Available Resources
Figure 2.2
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2.3 Comparative Advantage
Objectives
 Explain the law of comparative
advantage.
 Understand the gains from specialization
and exchange.
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2.3 Comparative Advantage
Key Terms
 absolute advantage
 law of comparative advantage
 specialization
 barter
 money
 division of labor
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Comparative Advantage
 Absolute advantage—to be able to make
something using fewer resources than other
producers require
 Law of comparative advantage—the worker,
firm, region, or country with the lowest
opportunity cost of producing an output should
specialize in that output
Specialization—occurs when individual workers
focus on single tasks, enabling each one to be more
efficient and productive
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Gains from Specialization
Absolute advantage focuses on which of
you uses the fewest resources, but
comparative advantage focuses on what
else those resources could have
produced—that is, on the opportunity cost
of those resources.
The law of comparative advantage
indicates who should do what.
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Exchange
Barter—a system of exchange in which
products are traded directly for other
products
Money—anything that everyone is willing
to accept in exchange for goods and
services
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Wider Application
Resources are allocated most efficiently
across the country and around the world
when production and trade conform to the
law of comparative advantage.
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Specialization
Because of specialization based on
comparative advantage, most people
consume little of what they produce and
produce little of what they consume.
Division of labor sorts the production
process into separate tasks to be carried
out by separate workers.
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Division of Labor
Takes advantage of individual preferences
and natural abilities
Allows workers to develop more
experience at a particular task
Reduces the time required to shift
between different tasks
Permits the introduction of labor-saving
machinery
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Specialization that Results with
Division of Labor
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Does not occur among individuals only
Also occurs among firms, regions, and
entire countries
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