Types of Economic Systems
Economics is the study of how wealth is created and distributed. By wealth, we mean “anything of value,” including the goods and services produced and sold by business. How wealth is distributed simply means “who gets what.” Experts often use economics to explain the choices we make and how these choices change as we cope with the demands of everyday life. In simple terms, individuals, businesses, governments, and society must make decisions that reflect what is important to each group at a particular time. For example, suppose you want to take a weekend trip to some exotic vacation spot, and you also want to begin an investment program. Because of your financial resources, though, you cannot do both, so you must decide what is most important. Business firms, governments, and to some extent society face the same types of decisions. Each group must deal with scarcity when making important decisions. In this case, scarcity means “lack of resources”—money, time, natural resources, and so on—that are needed to satisfy a want or need.
Today, experts often study economic problems from two different perspectives: microeconomics and macroeconomics. Microeconomics is the study of the decisions made by individuals and businesses. Microeconomics, for example, examines how the prices of homes affect the number of homes individuals will buy. On the other hand, macroeconomics is the study of the national economy and the global economy. Macroeconomics examines the economic effect of national income, unemployment, inflation, taxes, government spending, interest rates, and similar factors on a nation and society.
The decisions that individuals, business firms, government, and society make, and the way in which people deal with the creation and distribution of wealth determine the kind of economic system, or economy, that a nation has.
Factors of production are the resources used to produce goods and services. There are four such factors:
Land and natural resources—elements that can be used in the production process to make appliances, automobiles, and other products. Typical examples include crude oil, forests, minerals, land, water, and even air.
Labor—the time and effort that we use to produce goods and services. It includes human resources such as managers and employees.
Capital—the money, facilities, equipment, and machines used in the operation of organizations. Although most people think of capital as just money, it can also be the manufacturing equipment in a Pepperidge Farm production facility or a computer used in the corporate offices of McDonald’s.
Entrepreneurship—the activity that organizes land and natural resources, labor, and capital. It is the willingness to take risks and the knowledge and ability to use the other factors of production efficiently. An entrepreneur is a person who risks his or her time, effort, and money to start and operate a business.
A nation’s economic system significantly affects all the economic activities of individuals, businesses, government, and society within a country. This far-reaching impact becomes more apparent when we consider that a country’s economic system determines how the factors of production are used to meet the needs of society. Today, two different economic systems exist: capitalism and command economies. The way each system answers the four basic economic questions listed here determines a nation’s economy.
Capitalism
Capitalism is an economic system in which individuals own and operate the majority of businesses that provide goods and services. Capitalism stems from the theories of the Scottish economist Adam Smith. In his book Wealth of Nations, published in 1776, Smith argued that a society’s interests are best served when the individuals within that society are allowed to pursue their own self-interest. According to Smith, when individuals act to improve their own fortunes, they indirectly promote the good of their community and the people in that community. Smith went on to call this concept the “invisible hand.” The invisible hand is a term created by Adam Smith to describe how an individual’s own personal gain benefits others and a nation’s economy. For example, the only way a small-business owner who produces shoes can increase personal wealth is to sell shoes to customers. To become even more prosperous, the small-business owner must hire workers to produce even more shoes. According to the invisible hand, people in the small-business owner’s community not only would have shoes but also would have jobs working for the shoemaker. Thus, the success of people in the community and, to some extent, the nation’s economy are tied indirectly to the success of the small-business owner.
A command economy is an economic system in which the government decides what goods and services will be produced, how they will be produced, for whom available goods and services will be produced, and who owns and controls the major factors of production. Today, two types of economic systems—socialism and communism—serve as examples of command economies.
Socialism
In a socialist economy, the key industries are owned and controlled by the government. Land, buildings, and raw materials may also be the property of the state in a socialist economy. Depending on the country, private ownership of smaller businesses is permitted to varying degrees. Usually, people may choose their own occupations, although many work in state-owned industries. Today, China, Canada, Sweden, and Norway are often referred to as socialist nations.
What to produce and how to produce it are determined in accordance with national goals, which are based on projected needs and the availability of resources. The distribution of goods and services—who gets what—is also controlled by the state to the extent that it controls taxes, rents, and wages. Among the professed aims of socialist countries are the equitable distribution of income, the elimination of poverty, and the distribution of social services (such as medical care) to all who need them. The disadvantages of socialism include increased taxation and loss of incentive and motivation for both individuals and business owners.
Communism
If Adam Smith was the father of capitalism, Karl Marx was the father of communism. In his writings during the mid-1800s, Marx advocated a classless society whose citizens together owned all economic resources.
All workers would then contribute to this communist society according to their ability and would receive benefits according to their need.
Since the breakup of the Soviet Union and economic reforms in China and most of the Eastern European countries, the best remaining example of communism is North Korea. Today, the basic four economic questions are answered through centralized government plans. Emphasis is placed on the production of goods and services the government needs rather than on the needs of consumers, so there are frequent shortages of consumer goods.
The Importance of Productivity in the Global Marketplace
One way to measure a nation’s economic performance is to assess its productivity. While there are other definitions of productivity, for our purposes, productivity is the average level of output per worker per hour. An increase in productivity results in economic growth because a larger number of goods and services are produced by a given labor force. To see how productivity affects you and the economy, consider the following three questions:
Question: How does productivity growth affect the economy?
Answer: Because of increased productivity, it takes fewer workers to produce more goods and services. As a result, employers can reduce costs, earn more profits, and may sell their products or services for less. Finally, productivity growth helps American business to compete more effectively with other nations in a global, competitive world.
Question: How does a nation improve productivity?
Answer: Reducing costs and enabling employees to work more efficiently are at the core of all attempts to improve productivity.
Question: Is productivity growth always good?
Answer: Fewer workers producing more goods and services can lead to lower salary expenses for employers and higher unemployment rates for workers. In this case, increased productivity is good for employers but not good for unemployed workers.
Other Important Economic Indicators That Measure a Nation’s Economy
In addition to productivity, GDP, and real GDP, other economic measures exist that can be used to evaluate a nation’s economy. One very important statistic is the unemployment rate. The unemployment rate is the percentage of a nation’s labor force unemployed at any time. Although the unemployment rate for the United States is typically about 4 to 6 percent, it peaked during the 2008 economic crisis. At the time of publication, the unemployment rate was 4.6 percent. This is an especially important statistic—especially if you are unemployed.
The consumer price index (CPI) is a monthly index that measures the changes in prices of a fixed basket of goods purchased by a typical consumer in an urban area. Goods listed in the CPI include food and beverages, transportation, housing, clothing, medical care, recreation, education, communication, and other goods and services. Economists often use the CPI to determine the effect of inflation on not only the nation’s economy but also individual consumers. Another index is the producer price index. The producer price index (PPI) measures prices that producers receive for their finished goods. Because changes in the PPI reflect price increases or decreases at the wholesale level, the PPI is an accurate predictor of both changes in the CPI and prices that consumers will pay for many everyday necessities in the future.
Some additional economic measures are described in Table 1-1. Like the measures for GDP, real GDP, unemployment rate, and price indexes, these measures can be used to compare one economic statistic over different periods of time.
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