Chapter 2. Economic Systems and the Economic Problem

2.1. Overview

In the previous chapter, the economic problem was discussed as the situation of insufficiency of resources against larger demands for those resources, i.e., the problem of relative scarcity. In this chapter, discussion is taken up about how nations, in the past and in the present, have organized their economic systems to approach this problem.

Nations must make three sets of decisions, and how they answer those decisions determines the type of economic system they create. The first decision about what goods will be produced and in what quantities. The second decision regards how the goods will be produced. Finally, the last decision is about how the goods get distributed across the population.

The answers to these questions have implications for how broad social goals are addressed. Those goals are economic efficiency, economic equity, economic freedom, economic growth, economic security, and economic stability.

Tradition-based economic systems. In earlier times when nations were no more than tribal units, decisions were made by a few individuals (tribal leaders), and custom and traditions formed the rules by which the decisions were made.

Some tradition-based nations grew, some absorbed by others in military victory, and others withered and died, the results of war, famine, and disease. Those that grew, maintained very strong ties to their customs and traditions, importantly the strong desire to remain isolated. China is a very good example of this. These nations maintained strong centralized forms of government, and the economic structures they created reflected such. These economic systems are known as Command Economies.

Other nations emerging from small scale tribal size units pursued other forms of governance and economic organization. Some, particularly those in Western Europe engaged in trade with other emerging nations, and those economies moved in the direction of building fairs and marketplaces where such trade, for profit, could take place. Eventually, trade led to long-distance exchange, but always based around the idea of making a profit. The means of production became centered on the notion of private property and less on a strong government. That profit could be made freely and property could be private promoted the notion of economic mobility. No longer was a person destined to live according to the rules created out of customs and traditions. A person could move out of any given socioeconomic status as long as they possessed the economic means to do so. These nations, therefore, moved in the direction of Market Economies.

Command Economies are characterized as having highly centralized forms of government with important political and economic goals set by the leadership and the implementation of those goals made by central planners.

In Market Economies, on the other hand, consumers decide how they will spend their incomes, and these patterns of expenditures create a set of profit incentives to which suppliers respond. Decisions, in this sense, are highly decentralized.

Today, with the exception of Cuba and North Korea, which continue to make extensive use of the Command Economy model, nations have built Mixed Economies, that is, the mixture of economic systems wherein decisions are made through markets based on private property and the profit incentive, but also wherein government also exercises a strong influence. Chapter 4 discusses how government in the U.S. influences decisions in the U.S.

The year 1989 marks the beginning of the movement of many Eastern European nations away from Command Economies toward Market Economies. Many of these nations are still in a transition period, and are often referred to as Transition Economies.

China began its gradual movement away from its Tradition-based Economic system as early as 1949 with the communist take-over. China adopted the Soviet model, and placed heavy emphasis on rapid economic growth, especially in manufacturing. In 1978, the communist government commenced the process of allowing individual profit incentives in agriculture and in manufacturing to provide goods for the consumer sector at prices determined by producers, not by the State. Starting in the late 1990s, China told bold measures to allow foreign investment, a very dramatic departure from policies of isolationism going back for more than 2,000 years. Curiously, China, while currently allowing for economic freedom has been reluctant to increase political freedoms.

2.2. Concepts

Relative scarcity and the economic problem

The three fundamental economic questions every society must address

The six broad social goals of efficiency, equity, freedom, growth, security, and stability

Tradition-based economies

Command economies and central planning

Market economies

Transition economies

Mixed economies

Profit incentives

Private property

2.3. Objectives

Explain how and why each society (nation) faces the same economic questions but can answer them in one of three ways.

Explain the composition of Tradition-based, Command, and Market Economies.

Explain that no one society (nation) under any form of economic arrangement can eliminate the problem of relative scarcity. Thus, each nation still faces tradeoffs and must make economic choices. The choices often result in conflict over the achievement of the six goals of efficiency, equity, freedom, growth, security, and stability.

Nations strictly based around tradition based societies was transformed into either Command or Market economies as they grew.

Explain that in modern times, economies reflect characteristics of all three systems in varying degrees; hence the concept of Mixed Economies is very relevant.

Explain the reasons for the failure of centralized planning and the failure of the Soviet Union.

Explain the process by which China emerged from centuries of a Tradition-based economy in isolation to one that currently is considered a Mixed Economy.

2.4. Content Standards

9-12 Benchmark IV-B: 1, 2, 3, 8, 14

NCEE: 3, 4, 7, 16

2.5. Time Required

2 classes of 45 minutes each

2.6. Lessons

Lesson 1. The Three Economic Systems

Lesson Overview

All societies have faced and will continue face the same economic issue of unlimited wants and limited resources. This is known as the fundamental economic problem. No one society has ever succeeded in eliminating that economic problem or of satisfying 100% of all needs at a given moment of time. For this reason, at any given moment of time, the particular configuration and mix of goods and services counted in a nation’s GDP reflect a series of decisions and choices made by decision makers.

It is useful to classify the economic organizations or economic systems that societies have used in responding to the economic problem. Each system has implications for how a society allocates is scarce resources and the answers that it gives to issues of economic efficiency, economic equity, economic freedom, economic growth, economic security, and economic stability.

By economic efficiency is meant obtaining the highest value from available resources at the lowest possible cost. Economic equity refers to issues of fairness. While equity is not a concept about which economists are in unanimous agreement, it is associated with concepts about how the value that is produced is distributed among citizens of a society. Economic freedom entails a set of liberties to choose what and how to consume and work. Economic growth refers to a sustained increase in the availability of goods and services. Economic security is focused on the levels of protection offered consumers and producers against economic risks over which they have little or no control.

Tradition-Based Economies. In ancient times, when nations were no larger than tribal units, economic organization was typically established and government by a set of rules reflecting customs and traditions of the tribe. Economic roles for each member of the tribe reflected those customs and traditions. Decisions were made and enforced by a strong collective few. For example, tribal males might have been expected to serve as hunters and protectors, while tribal females were expected to serve as gatherers, nurturers, and creators and maintainers of the physical tribal infrastructure. Methods of hunting as well as methods of producing shelter and food were part of the customs and traditions. Division and specialization of labor seldom changed because they also were determined by rules that seldom changed. These economic systems were largely self sufficient which means that they engaged in very little trade with other nations. Wars and disease eliminated nations, but these were replaced with other nations also fashioned around customs and traditions of their own.

Command Economies. As some tribes expanded in size, the result of military take-overs and natural population growth, customs and traditions and strong centralized decision-making authority continued to dominate the economic organizations of these emerging nations. However, the growth in size meant that implementation of the goals set by the central authority now required a more formal planning process that would coordinate the very large number of economic decisions required to achieve goals. If, for example, the central authority mandated that 50 new steel mills were to be built over the next 3 years, the achievement of that goal had to be the result of a plan that included the production of the capital goods required, the raw materials, as well as the recruitment and hiring of labor. Because resources are always scarce, decisions about what other projects had to be eliminated or cut in size had to be made. Imagine the complexity of the overall economic decision-making process in the presence of 10 other such major goals for the ensuing 3 years. The Soviet Union, which included several nations of Eastern Europe, adopted the concept of the planning bureau, the collection of planners whose job it was to make the necessary calculations regarding resource requirements as well as resource delivery schedules.

Market Economies. While nations of Eastern Europe were adopting a Command Economy model, nations of Western Europe were moving in the direction of adopting a Market Economy model. Very early in their histories, nations in this part of the world were intrigued by the notions of trade and exchange with neighboring nations. This lead to the creation of early forms of tangible market places between nations (“fairs,” or “bazaars”). At the same time, traditions and customs as organizing principles were quickly abandoned by notions of profit and private property. Enterprising individuals soon discovered that organizing trade was rewarded by profit which meant economic mobility and the acquisition of more goods. The system flourished as long as government did not take possession of the private goods and the profit that resulted from commerce. History books abound on the countless wars that were fought over the notion of private property and the roles of government.

Today, with the exception of Cuba and North Korea which continue to make extensive use of the Command Economy model, nations have created Mixed Economies wherein economic decisions are made through markets based on private property and the profit incentive but also wherein government exercises a strong influence. Chapter 4 discusses how government in the U.S. today influences decisions in the U.S.

The following table, based on Focus: High School Economics (National Council on Economic Education, New York, NY) provides a description how the Command and Market models answer the six broad goals, and as such yields information on how these systems function.

Broad Social Goals	Command Economies	Market Economies
Economic Efficiency	Decisions of resource usage made by the planning bureau in pursuit of goals set by central government	Decisions of what is most valued are made by consumers; profit incentives motivate suppliers to respond to these consumer choices at the lowest possible cost
Economic Equity	The planning bureau sets wage rates and creates jobs as part of the total economic plan; resulting income among those who have jobs are more equal than in a market economy	Individuals are free to choose their occupation or to not be employed; income depends upon the value created in the workplace; wage rates vary according to supply and demand and the dispersion in wages can produce more inequality than in a Command Economy
Economic Freedom	Individuals are free to choose but the range of choice is limited because ultimately what gets produced and what jobs are created are determined by the central planning process	Individuals are free to choose their occupation or to not be employed, and how they spend their income, and the range of choice is larger because it is not limited by central planning decision; suppliers are free to supply as they desire in the pursuit of profit
Economic Security	Government provides and often guarantees jobs, health care, pensions though the levels may be low	Government in most developed market economies provides varying levels of safety net programs to include health care, retirement benefits, schooling, unemployment compensation, disability, low-income family assistance
Economic Growth	The central political authority sets growth rate targets and because these are mandated and written into economic plans, are often achieved, as was true in the Soviet Union and in China; often these high growth rates are targeted to certain industries which means that other industries are deprived on resources	Individuals in pursuit of higher living standards and greater profits provide the core process by which growth takes place; government can encourage or discourage economic growth in choosing policies that promote or discourage increases in productivity and technological advancement
Economic Stability	Typically, protracted periods of unemployment and inflation are absent because the central planning authority rules out these cyclical changes in their economic plans; some industries can, however, be neglected and often fall into stages of long-term recession	When consumers are free to choose, changes in their purchases can set off cyclical changes (up or down); counter-cyclical monetary and fiscal policies have been adopted by government.

Quite often goals can and do conflict. For example, achieving high levels of economic efficiency might mean job destruction which can create economic instability. This can occur under both types of economic systems. Similarly, achieving great levels of economic security by allocating resources to economic security of the aged might mean a lowering of economic growth because resources are drawn away from research and development projects that would promote technological change. What other goal conflict examples can you propose?

Lesson Activities

Exercise 1.

Go to the end of this chapter and identify the VE 3 referenced source “Lesson Two, Who Decides?” That lesson contains a very useful class exercise on the differences between market and command economies.

Go to the end of this chapter and identify the VE 3 referenced source “Lesson Two, Broad Social Goals of an Economic System.” That lesson also contains some very interesting class exercises on decisions made in market and command economies.

Lesson 2. So Why Did the Soviet Union Fail? The Emergence of the Transition Economies

Lesson Overview

This lesson is based on a lesson cited at the end of this chapter, “Lesson One, The Legacy of Soviet Communism.” It blends a historical accounting of the 75-year history of communism in the Soviet Union with some class exercise that demonstrates the difficulties of achieving production efficiencies in a Command Economy—the production of class.

Also contained in this chapter is a research assignment on transitioning economies once part of the U.S.S.R.

There are two excellent data sources that should be consulted in learning more about transitioning economics. The first is the World Bank, Country Data site at www.worldbank.org/data which provides economic data as well as sociodemographic information. The second is the International Monetary Fund, World Economic Outlook Databases at www.imf.org. It is possible to generate data on major economic variables for a range of years and, therefore, to make comparisons across nations over time.

2.7. Suggested VE 3 Items

Economic Concepts - Fundamental Economics

Economic Systems

Economic Lessons

Focus: Institutions and Markets - Lesson 2: Property Rights and Contracts as Economic Institutions.

Capstone Exemplary Lessons for High School Economics—Teacher’s Guide. Unit 2: Lesson 6—Why Did Communism Collapse?

Economics in Action: 14 Greatest Hits for Teaching High School Economics. Lesson 4: Property Rights in a Market Economy.

Focus: Economic Systems. Lesson 2: Who Decides?

Focus: Economic Systems. Lesson 4: Sparta, Athens, Cuba and the United States: Ancient and Modern Examples of Command and Market Economies.

Focus: Economic Systems. Lesson 5: Anything Planners Do, Markets Do.

Focus: Economic Systems. Lesson 11: No Sacrifice Is Too Great for Someone else to Make.

Focus: International Economics. Lesson 19: Privatization Around the World.

Economies in Transition: Command to Market. Lesson 5: Economic Transition: The Role of the State.

From Plan to market: Teaching Ideas for Social Studies, Economics, and Business Classes. Lesson 1: The Legacy of Soviet Communism.

From Plan to market: Teaching Ideas for Social Studies, Economics, and Business Classes. Lesson 2: Different paths to Reform: Case Studies of Poland, China, and Russia.

From Plan to market: Teaching Ideas for Social Studies, Economics, and Business Classes. Lesson 3: Political and Economic Freedoms.

From Plan to Market: Teaching Ideas for Social Studies, Economics, and Business, and Classes. Lesson 10: Distribution of Income: Different Ways to Slice the Pie.

Civics and Government: Focus on Economics. Unit 1: Lesson 1—How Has the Constitution Shaped the Economic System in the United States?

Civics and Government: Focus on Economics. Unit 1: Lesson 2—Is Economic Freedom a Necessary Condition for Political Freedom?

World History: Focus on Economics. Lesson 12: The Fall of Communism.

Entrepreneurship in the U.S. Economy: Teacher Resource Manual. Lesson 6: Entrepreneurship in Different Economic Systems.