Answering the Three Economic
Questions
Chapter 2 Section 1
The Three Economic Questions
• Every society must
answer three
questions:
– What goods and
services should be
produced?
– How should these
goods and services be
produced?
– Who consumes these
goods and services?
Economic Goals
• Societies answer the three economic
questions based on their values:
– Economic Efficiency
– Economic Freedom
– Economic Security and Predictability
– Economic Equality
– Economic Growth and Innovation
– Other Goals
Hand Tools
+
1 acre of land
+
56 worker-hours
=
capital
15 bushels of
wheat
Identify the opportunity costs of hand tool
farming?
Modern Mechanical Equipment
+
1 acre of land
+
2.9 worker-hours
=
capital
40 bushels of
wheat
Identify the opportunity costs of modern
mechanical equipment farming?
Economic Efficiency
• Making the most of
resources
Economic Freedom
• Freedom from
government
intervention in the
production and
distribution of goods
and services
Economic Security and Predictability
• Assurance that
goods and services
will be available
• Payments will be
made on time
• A safety net will
protect individuals
in times of
economic disaster
Economic Equity
• Fair
distribution
of wealth
Economic Growth and Innovation
• Innovation leads
to economic
growth
• Economic growth
leads to a higher
standard of living
Other Goals
• Societies pursue
additional goals
– environmental
protection
Which economic goal could help
them recover from a storm?
• Economic Efficiency
• Economic Freedom
• Economic Equality and
Predictability
• Economic Equity
• Economic Growth and
Innovation
• Other goals
Four Economic Systems
• An economic system is the method used by a
society to produce and distribute goods and
services.
– Traditional Economies
– Centrally Planned Economy
– Market Economy
– Mixed Economies
Traditional Economies
• They rely on habit,
custom, or ritual to
decide what to
produce, how to
produce it, and to
whom to distribute it.
Traditional Economies
• Existed in earlier ages
and in some
industrialized nations
today
• Goods are produced
and distributed in the
same ways that have
been used for centuries
– Caste System in India
Centrally Planned Economy
• The central government
makes all decisions
about the production
and consumption of
goods and services.
– The Former Soviet Union
Market Economy
• Economic decisions are
made by individuals and
are based on exchange,
or trade.
Mixed Economies
• Are systems that
combine tradition and
the free market with
limited government
intervention.
The Free Market
Chapter 2 Section 2
What is a Market?
• A market is an
arrangement that
allows buyers and
sellers to exchange
goods and services.
• Specialization is the
concentration of the
productive efforts of
individuals and firms on
a limited number of
activities.
Why Do Markets Exist?
Markets exist because none of us produces
all the goods and services we require to satisfy
our needs and wants.
The Free Market Economy
• Households and
business firms use
markets to exchange
money and products.
• Households own the
factors of production
(land, Labor, and
capital)
• Households also
consume the goods
and services.
What is the exchange in the factor market? In the product market?
Circular Flow Diagram of a Market Economy
Households pay
firms for goods and
services.
Product market
monetary flow
physical flow
Firms supply
households with
goods and services.
Households
Firms
Households supply
firms with land,
labor, and capital.
physical flow
monetary flow
Factor market
Firms pay
households
for land,
labor, and
capital.
Circular Flow Diagram of a Market Economy
Product market
Households pay
firms for goods and
services.
monetary flow
physical flow
Firms supply
households with
goods and services.
Households
Firms
Households supply
firms with land,
labor, and capital.
physical flow
monetary flow
Factor market
Firms pay
households
for land,
labor, and
capital.
How does the Free Market Work?
• In every transaction,
the buyer and seller
consider only their selfinterest, or their own
personal gain.
• Self-interest is the
motivating force in the
free market.
Self-Interest Creates Competition
• Producers in a free
market struggle for the
dollars of consumers.
• This is known as
competition, and is the
regulating force of the
free market.
Competition Creates the Invisible Hand
• The interaction of
buyers and sellers,
motivated by selfinterest and regulated
by competition, all
happens without a
central plan.
• This phenomenon is
called “the invisible
hand of the
marketplace.”
What Makes the Free Market Great?
• The Free Market gives buyers and seller to
interact with little or no government
interaction
• This happens through:
–
–
–
–
Economic Efficiency
Economic Growth
Economic Freedom
Many other additional goals
Economic Efficiency
• As a selfregulating system
• A free market
economy is
efficient.
Economic Growth
• Because competition
encourages innovation,
free markets encourage
growth.
Economic Freedom
• Free market economies
have the highest degree
of economic freedom of
any economic system.
Additional Goals
• With the freedom to do
anything in the
economy:
– Free markets offer a
wider variety of goods
and services than any
other economic system.
Chapter 2 Section 3
Centrally Planned Economies
What is a Centrally Planned Economy?
• In a centrally planned economy:
– The government owns both land and capital.
– The government decides the three economic
questions:
• What to produce
• How much to produce
• But, How much to charge (This one is different)
• Centrally Planned Economies are classified as
Socialist and Communist
How would you describe
production in this Chinese factory?
Socialism
• Socialism is a social and
political philosophy based
on the belief that
democratic means should
be used to distribute wealth
evenly throughout a society.
• Real equality can only be
achieved when political
equality is combined with
economic equality.
– Economic equality only
happens when the public
controls the centers for
economic power.
• Real equality can only
be achieved when
political equality is
combined with
economic equality.
– Economic equality only
happens when the
public controls the
centers for economic
power.
• These nations may
claim to be democratic
but need a high degree
of centrally planning to
work.
Communism
• Communism is a
political system
characterized by a
centrally planned
economy with all
economic and political
power resting in the
hands of the
government.
• In theory Communism
works
• After a violent
revolution to create a
communist state:
– Ruled by a single
leader
– Try to build a national
power by using the
best of the factors of
production
– Communism promises
equality for everyone
The Former Soviet Union
• The former Soviet
Union used three
factors to create a
national powerhouse:
– Agriculture
– Industry
– Consumers
Soviet Agriculture
• In the Soviet Union:
• The government
created large stateowned farms and
collectives for most
of the country’s
agricultural
production.
How would you describe the farming techniques
in this photo of a Soviet Collective?
Soviet Industry
• Soviet planners favored
heavy-industry
production (such as
steel and machinery),
over the production of
consumer goods.
Soviet Consumers
• Consumer goods
in the Soviet
Union were
scarce and
usually of poor
quality.
Problems of a Centrally Planned
Economy
• Centrally planned
economies face
problems of poorquality goods,
shortages, and
diminishing
production.
• A lack of
competition due
do equality causes
this
Modern Economies
Chapter 2 Section 4
The Problem with Market Economies
• Laissez faire is the
doctrine that
government generally
should not interfere in
the marketplace.
– The economy runs itself
• Market economies, with
all their advantages,
have certain drawbacks.
– They will need help to
keep stability
The Mixed Economy
• How do
government actions
affect the circular
flow model in a
mixed economy?
The Mixed Economy
• In a mixed
economy:
– The government
purchases land,
labor, and capital
from households in
the factor market
– Purchases goods
and services in the
product market.
Comparing Mixed Economies
• Economic systems are classified by the amount of
government involvement.
– Centrally Planned has lots of government intervention
– Free Market (Free Enterprise) has very little if any government
• The degree of government involvement in the economy
varies among nations.
Label by Economy
• Cuba
• United States
• Canada
• China
• Hong Kong
• France