Economic System

BACHELOR OF ARTS IN PUBLIC ADMINISTRATION PA 118 – Economic System and Public Administration
Pangasinan State University
Social Science – PSU Lingayen
CHAPTER 1
ECONOMIC SYSTEM
1st Semester, S.Y 2014–2015

A. Meaning of Economic System
B. Economics vs. Public Administration
C. Economic Activities
D. Fundamental Economic Questions
E. Economic Resources
F. Circular Flow Diagram: Three-Sector Model
G. Economic Models
H. Economic Systems: Basic Comparison
I. Salient Functions of Economic System
J. Decision Making Structures of an Economy
K. Types of Economic System
L. Traditional Economy
M. Market Economy (Capitalism)
N. Command Economy (Communism)
O. Mixed Economy
Chapter Outline

Meaning of Economic System
Economic System is a particular set of institutional
arrangements and a coordinating mechanism—to
respond to the economizing problem. It is a society
decides what goods to produce, how to produce
them, and for whom goods will be produced.
An economic system is a set of economic
institutions that provides the economic structure of a
given economy.

Economics deals with the proper allocation
and efficient use of scarce resources to satisfy
the unlimited wants of individuals.
Public Administration is concerned with the
implementation of government policy
(economic policies) and management of
government programs.
Economics vs. Public Administration

Economic Activities
1. Production. The process of transforming inputs into
outputs.
2. Distribution. The way total output, income, or
wealth is distributed among individuals or among the
factors of production
3. Exchange. The process of trading goods between
buyers and sellers in a particular market.
4. Consumption. The process of how goods and
services are utilized that give satisfaction to the
consumers.

Economic System is the way in which a society decides
what goods to produce, how to produce them, and for
whom goods will be produced. Whether rich or poor,
every nation must answer the same three fundamental
economic questions:
1. What to produce?
2. How to produce?
3. For whom to produce?
Three Economic Questions

What to Produce?
To answer the first fundamental economic question, a society
must decide the mix of goods and services it will produce. Will
it produce mainly food, or will it also produce automobiles,
televisions, computers, furniture, and shoes? The goods and
services a society chooses to produce depend, in part, on the
natural resources it possesses.
Because of scarcity, no country can produce every good it
wants in the quantity it would like. More of one good (say,
television sets) leaves fewer resources to produce other
goods (such as cars). No matter what nation we are talking
about—the United States, China, Japan, India, Russia, Cuba,
or Brazil—each must decide what goods will be produced.

Consumption goods and services
 Goods and services that are bought by individuals and used
to provide personal enjoyment and contribute to a person’s
quality of life.
Capital goods
 Goods that are bought by businesses to increase their
productive resources.
Government goods and services
 Goods and services that are bought by governments.
Export goods and services
 Goods and services that are produced in one country and
sold in other countries.
Categories of Goods and Services

How to Produce?
The next question every society has to answer deals with
the ways in which people produce the goods. Will farmers
using modern tractors produce food, or will farmers using
primitive tools produce it? Will the food be produced on
private farms, where production decisions are made by
individual farmers, or will it be produced on collective farms,
where production decisions are made by people in the
government?
Answering this second question involves using scarce
resources in the most efficient way to satisfy society’s wants.
Again, decisions on methods of production are influenced, in
part, by the natural resources society possesses.

Land
 It includes all the natural resources found in nature a country
possesses, such as water, minerals, animals, and forests.
Labor
 the work time and work effort that people devote to producing
goods and services.
Capital
 This refers to produced goods that can be used as resources
for further production.
Entrepreneurship
 human resource that combines these factors of production
creatively and efficiently.
Economic Resources

Circular Flow Diagram: Three Sector
Model

Households are individuals or groups of people living
together and considered the consuming-unit of the economy.
They sell economic resources, buy goods and services, pay
taxes and receive transfer to the government.
Firms are the institutions that organize the production of
goods and services and are considered the producing-unit of
the economy. They buy economic resources, sell goods and
services, pay taxes and receive subsidies from the
government.
Government is a mechanism that determines the rules of the
game in the economy. It buys goods and services and
resources from firms and households, imposes taxes and
provides transfers to households and firms
Components of the Circular-Flow Model:
Households, Firms and Government

Market is a place or any arrangement that brings
buyers and sellers together and enables them to get
information and do business with each other. The
circular flow model has two classifications of market.
Resource Market is a market in which a resource
(land, labor and capital) is bought and sold.
 Land market, capital market, labor market
Product Market is a market in which a good or
service is bought and sold.
Resource Market and Product Market

Real Flows (input-output flows) depicts the
flows of the economic resources (inputs) that go
from households through resource markets to
firms and of the goods and services that go from
firms through goods markets to households.
Money Flows indicates the flows of payments
made in exchange for the services of factors of
production and of expenditures on goods and
services.
Real Flows and Money Flows

When households choose the quantities of services of land,
labor, capital, and entrepreneurship to offer in resource
markets, they respond to the incomes they receive—rent for
land, wages for labor, interest for capital, and profit for
entrepreneurship. When firms choose the quantities of
factor services to hire, they respond to the rent, wages,
interest, and profits they must pay to households. Similarly,
when firms choose the quantities of goods and services to
produce and offer for sale in goods markets, they respond to
the amounts that they receive from the expenditures that
households make. And when households choose the
quantities of goods and services to buy, they respond to the
amounts they must pay to firms
Real Flows and Money Flows

For Whom to Produce?
This answers how goods and services are distributed among
people in society. This actually involves two questions.
Exactly how much should people get and how should their
share be delivered to them? Should everyone get an equal
share of the goods and services? Or should a person’s
share be determined by how much he or she is willing to
pay? Once the question of how much has been decided,
societies must then decide exactly how they are going to get
these goods to people. To do this, societies develop
distribution systems, which include road and rail systems,
seaports, airports, trains, ships, airplanes, computer
networks—anything that helps move goods and services
from producers to consumers in an efficient manner.

1. Economic efficiency
2. Economic growth and economic development
3. Economic freedom
4. Economic security
5. Equitable distribution of income
6. Full employment
7. Price level stability
8. Reasonable balance of trade
Economic Goals

An economic system is composed of two features: a mechanism for allocating
resources and a mode of resource ownership.
Economic System

Economic Systems: Basic Comparison

Salient Functions of Economic System
1. To produce the goods for consumption of the
population
2. To utilize the resources in efficient method of
production
3. To employ the labor force in occupations where
productivity is at optimum
4. To apportion the wealth and income available to
everyone in an equitable manner
5. To encourage innovation and technology in order
to maximize efficiency, optimize satisfaction and
minimize waste

Decision-making structures of an
Economy
The decision-making structures of an economy determine the
use of economic inputs (the means of production), distribution of
output, the level of centralization in decision-making, and who
makes these decisions. Decisions might be carried out by
industrial councils, by a government agency, or by private
owners. Some aspects of these structures include:
1. Coordination mechanism. How information is obtained
and used to coordinate economic activity. The two
dominant forms of coordination include planning and the
market; planning can be either centralized or de-
centralized, and the two mechanisms are not mutually
exclusive.

Decision-making structures of an
Economy
2. Productive property rights. This refers to ownership
(rights to the proceeds of output generated) and control
over the use of the means of production. They may be
owned privately, by the state, by those who use it, or
held in common by society.
3. Incentive system. A mechanism for inducing certain
economic agents to engage in productive activity; it can
be based on either material reward (compensation) or
moral reward (social prestige).

1. Traditional Economy
2. Market Economy (Capitalism)
3. Command Economy (Communism)
4. Mixed Economy
Types of Economic System

 Traditional economy is an economic system in
which people make economic decisions based on
customs and beliefs that have been handed down
from generation to generation.
 Resources are allocated according to long-lived
practices from the past.
 The society produces what best ensures its
survival.
 Examples: Caste system in India, Kavango people
of Namibia
Traditional Economy

 Market economy is characterized by the private
ownership of resources and the use of a system
of markets and prices to coordinate and direct
economic activity.
 Private individuals own most, if not all, the
resources and control their use.
 The prices of goods and services are determined
in a free price system.
Market Economy

Market Economy
According to Adam Smith (1723–1790), market forces
allocate resources as if by an “invisible hand”—an
unseen force that harnesses the pursuit of self-interest to
direct resources where they earn the greatest reward.
According to Smith, although each individual pursues his or
her self-interest, the “invisible hand” of market forces
promotes the general welfare. Capitalism or market
economy is sometimes called laissez-faire; translated from
the French, this phrase means “to let do,” or to let people
do as they choose without government intervention. Thus,
under capitalism, voluntary choices based on rational self-
interest are made in unrestricted markets to answer the
questions what, how, and for whom.

Characteristics and Features of a Free
Enterprise Economy
1. Private Property
2. Freedom of Enterprise or Choice
3. Self-interest
4. Competition
5. Markets and Prices
6. Economic Incentives
7. Technology and Capital Goods
8. Specialization
9. Use of Money
10.Active, but Limited, Government

Private Property
In a market system, private individuals and firms, not
the government, own most of the property resources
(land and capital). It is this extensive private ownership
of capital that gives capitalism its name. This right of
private property, coupled with the freedom to
negotiate binding legal contracts, enables individuals
and businesses to obtain, use, and dispose of property
resources as they see fit. The right of property owners
to designate who will receive their property when they
die helps sustain the institution
of private property.

Freedom of Enterprise or Choice
Freedom of enterprise ensures that entrepreneurs and
private businesses are free to obtain and use economic
reources to produce their choice of goods and services and
to sell them in their chosen markets.
Freedom of choice enables owners to employ or dispose
of their property and money as they see fit. It also allows
workers to try to enter any line of work for which they are
qualified. Finally, it ensures that consumers are free to buy
the goods and services that best satisfy their wants and
that their budgets allow.
The market system requires that various economic units make certain choices,
which are expressed and implemented in the economy’s markets:

Self-interest
In the market economy, self-interest is the motivating force
of the various economic units as they express their free
choices. Self-interest simply means that each economic unit
tries to achieve its own particular goal, which usually
requires delivering something of value to others.
Entrepreneurs try to maximize profit or minimize loss.
Property owners try to get the highest price for the sale or
rent of their resources. Workers try to maximize their utility
(satisfaction) by finding jobs that offer the best combination
of wages, hours, fringe benefits, and working conditions.
Consumers try to obtain the products they want at the lowest
possible price and apportion their expenditures to maximize
their utility.

Markets and Prices
The coordinating mechanism of capitalism is a system
of markets and prices. A market is an institution or
mechanism that brings buyers (“demanders”) and
sellers (“suppliers”) into contact. A market system
conveys the decisions made by buyers and sellers of
products and resources. The decisions made on each
side of the market determine a set of product and
resource prices that guide resource owners,
entrepreneurs, and consumers as they make and
revise their choices and pursue their self-interest.

Economic Incentives
An incentive is something that encourages or
motivates a person toward action. Under free
enterprise, money acts as an incentive to produce. If
you produce goods and services that people are
willing and able to buy, you receive money in return.
Adam Smith wrote about the usefulness of economic
(or monetary) incentives in a free enterprise economy.
He explained that business owners are interested in
making themselves better off. This desire to earn an
income strongly motivates them to produce for others.

Competition
The market economy depends on competition among
economic units. The basis of this competition is freedom of
choice exercised in pursuit of a monetary return. Very
broadly defined, competition requires:
• Two or more buyers and two or more sellers acting
independently in a particular product or resource market.
(Usually there are many more than two buyers or sellers.)
• Freedom of sellers and buyers to enter or leave markets,
on the basis of their economic self-interest.

Technology and Capital Goods
In the market system, competition, freedom of choice, self-
interest, and personal reward provide the opportunity an
motivation for technological advance. The monetary
rewards for new products or production techniques accrue
directly to the innovator. The market system therefore
encourages extensive use and rapid development of
complex capital goods: tools, machinery, large-scale
factories, and facilities for storage, communication,
transportation, and marketing. Advanced technology and
capital goods are important because the most direct
methods of production are often the least efficient. The only
way to avoid that inefficiency is to rely on capital goods.

Specialization
The extent to which market economies rely on
specialization is extraordinary. Specialization is the use of
resources of an individual, firm, region, or nation to produce
one or a few goods or services rather than the entire range
of goods and services. Those goods and services are then
exchanged for a full range of desired products. The
majority of consumers produce virtually none of the goods
and services they consume, and they consume little or
nothing of the items they produce.
 Human specialization (Division of labor)
 Geographic specialization (International trade)

Use of Money
A rather obvious characteristic of any economic
system is the extensive use of money. Money performs
several functions, but first and foremost it is a medium
of exchange. It makes trade easier.
Functions of Money
 Medium of exchange
 Unit of account
 Store value
 Standard of deferred payment

Active, but Limited, Government
An active, but limited, government is the final characteristic
of market systems in modern advanced industrial
economies. Although a market system promotes a high
degree of efficiency in the use of its resources, it has
certain inherent shortcomings, called “market failures.”
This includes:
• Monopolies
• Public Goods
• Externalities
• Bounded Rationalities
• Information Asymmetry
• Property Rights as Right of Control

Some Advantages of a Market
Economy)
1. Goods and services go where they are most in
demand and free market responds quickly to
people’s wants plus wide variety of goods and
services.
2. No need for and overriding authority to
determine allocation of goods & services.
3. Producers and consumers are free to make
changes to suit their aims.
4. Competition and the opportunity to make large
profits, greater efficiency, innovation

Flaws of Market Economy
1. No central authority protects property rights, enforces
contracts, and otherwise ensures that the rules of the game
are followed.
2. People with no resources to sell could starve.
3. Some producers may try to monopolize markets by
eliminating the competition.
4. The production or consumption of some goods involves side
effects that can harm or benefit people not involved in the
market transaction.
5. Private firms have no incentive to produce so-called public
goods, such as national defense, bec. private firms cannot
prevent nonpayers from enjoying the benefits of public goods.
In practice, market economy has its flaws. The most notable market
failures are:

Some Disadvantages of a Market
Economy)
1. It misallocates resources to those with more
money
2. It creates inequality of incomes
3. It is not competent in providing certain services
4. It leads to inefficiency (market imperfection)
5. It can encourage the consumption of harmful
goods

 an economy characterized by public ownership of
virtually all property resources and the rendering of
economic decisions through central economic
planning.
 Government owns most of the businesses and
makes all economic decisions.
 There is no free competition because the
government is the only seller.
 Countries using mainly the command system include
Turkmenistan, Laos, Belarus, Libya, Myanmar, Iran,
North Korea and the former Soviet Union.
Command Economy

Command Economy
Command economies are disappearing fast. Until a few
years ago, examples would have included the former
Soviet Union, Poland, Rumania, Bulgaria, Albania, and
many others. Beginning in the late 1980s, all of these
nations have abandoned central planning. The only
examples left are Cuba, China, and North Korea, and even
these economies—though still dominated by central
planning— are moving away from it.
Other countries using mainly the command system include
Turkmenistan, Laos, Belarus, Libya, Myanmar, and Iran,
North Korea, Russia

Command Economy
 An economic system characterized by the public ownership of
resources and centralized planning. In this system,
government owns most property resources and economic
decision making occurs through a central economic plan
 A central planning board appointed by the government makes
nearly all the major decisions concerning the use of
resources, the composition and distribution of output, and the
organization of production
 The government owns most of the business firms, which
produce according to government directives. The central
planning board determines production goals for each
enterprise and specifies the amount of resources to be
allocated to each enterprise so that it can reach its production
goals.

 Mixed Economy is a blend of market system and
some form of government regulation and control.
Private ownership of resources exists side by side
with substantial public ownership of resources and
government participation in economic activities.
 This involves a degree of private economic
freedom mixed with a degree of government
regulation of markets.
 The major and strategic industries are owned and
managed by the state while the minor industries
belong to the private sector.
Mixed Economy

Elements of a Mixed Economy
The elements of a mixed economy have been demonstrated to
include a variety of freedoms:
1. to possess means of production (farms, factories,
stores, etc.)
2. to participate in managerial decisions (cooperative
and participatory economics)
3. to travel (needed to transport all the items in
commerce, to make deals in person, for workers and
owners to go to where needed)
4. to buy (items for personal use, for resale; buy whole
enterprises to make the organization that creates wealth
a form of wealth itself)
5. to sell (same as buy)

Flaws of Command Economy
1. Running an economy is so complicated that some
resources are used inefficiently.
2. Because nobody in particular owns resources, each
person has less incentive to employ them in their highest-
valued use, so some resources are wasted.
3. Central plans may reflect more the preferences of central
planners than those of society.
4. Because government is responsible for all production, the
variety of products tends to be more limited than in a
capitalist economy.
5. Each individual has less personal freedom in making
economic choices.
In practice, the pure command system also has flaws, most notably:

Elements of a Mixed Economy
6. to hire (to create organizations that create wealth)
7. to fire (to maintain organizations that create wealth)
8. to organize (private enterprise for profit, labor unions,
workers' and professional associations, non-profit
groups, religions, etc.)
9. to communicate (free speech, newspapers, books,
advertisements, make deals, create business partners,
create markets)
10. to protest peacefully (marches, petitions, sue the
government, make laws friendly to profit making and
workers alike, remove pointless inefficiencies to
maximize wealth creation)

Economic System

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