1

Economics Lecture Economics Lecture 4 4

Economics Lecture Economics Lecture 4 4

2007 Economics Dept2007 Economics DeptMr Lim Peng YeowMr Lim Peng Yeow

2

Self-Discovery Slides

• Types of Economic Systems• What is Free Enterprise

(market system)?• How does it work?

3

Types of Economic Systems

GovernmentMarket forces

CentrallyPlanned

FreeEnterprise

Mixed

4

ECONOMIC SYSTEMS: free-market economy

• Free enterprise / free-market economy

- an economy where all economic decisions are taken by individual households and firms and with no government intervention

5

ECONOMIC SYSTEMS: free-market economy

• Main features of the free enterprisePrivate ownership of all resourcesLimited ownership by governmentFreedom of choice

– consumer sovereigntyconsumers’ willingness and ability to pay high prices resources allocated into the production of this good

6

Freedom of choice – free enterprise for producers

•governed by profit motive producers can sell what they want to

– free mobility of resources•governed by returns factor owners are free to sell their factors anywhere

ECONOMIC SYSTEMS: free-market economy

7

Economic Freedomabsence of obstacles to effective choices

Freedom ofConsumer Choice

Freedom of Enterprise

• acquire any resource

• use any technology

• produce any product

• charge at any price

• invest their profits• buy any product • accept any job

• quit any job

Households Firms

Consumers Workers

Freedom ofChoice of Jobs

8

Motivated by self interest– consumers - maximum satisfaction– producers - maximum profits– factor owners - maximum returns

(rent, wages, interest)

ECONOMIC SYSTEMS: free-market economy

9

Existence of competition– large numbers of buyers and sellers – free flow of information – little or no advertising– free entry and exit of firms

ECONOMIC SYSTEMS: free-market economy

10

• Meaning of price mechanism the system in a market economy

whereby changes in price in response to changes in demand and supply have the effect of making demand equal to supply

ECONOMIC SYSTEMS: free-market economy

11

• Price mechanismdetermines the allocation of

resources within the economyworks through interaction of

demand & supply and price signalsprices measure the value of goods

and services measured in terms of standard monetary unit

ECONOMIC SYSTEMS: free-market economy

12

PRICE MECHANISM

Prices on Factor MktsPrices on Factor Mkts(wages, rents, interest)(wages, rents, interest)Prices on Factor MktsPrices on Factor Mkts(wages, rents, interest)(wages, rents, interest)

HouseholdsHouseholdsHouseholdsHouseholds FirmsFirmsFirmsFirms

Prices on Goods MktsPrices on Goods MktsPrices on Goods MktsPrices on Goods Mkts

Demand g & s

Supply fop

WHAT? WHAT? HOW?HOW?

FOR WHOM?FOR WHOM?

WHAT? WHAT? HOW?HOW?

FOR WHOM?FOR WHOM?

Supply g & s

Demand fop

Factor income

Consumers’ expdt

Firms’ expdt

Firms’ rev.

13

What to produce? Consumer sovereignty: Consumers, through their money “votes”, dictate what goods should be produced.

Demand for cars

Price of cars

Profits of car manufacturers

Firms will want to supply more cars

Firms pay more to attract workers & other fops

Workers & other fops move away from other industries into the auto industry

14

How to produce?• Firms will choose the method of

production which minimises the cost of production.

• Hence, if the price of one resource is high relative to its productivity, producers will try to substitute a cheaper input for a more expensive one.

15

For whom to produce?

Since the demand for a good must be effective, i.e. backed by the ability to pay, goods will be produced for those who have the purchasing power (higher income).

16

• Advantages of a free-market economyfunctions automatically - no need for

costly and complex bureaucracies to co-ordinate economic decisions

highly competitive market - more responsive to consumer wishes

efficient use of resources (what, how, how much and for whom to produce)

ECONOMIC SYSTEMS: free-market economy

17

• Problems of a free-market economy competition between firms is often

limited - a few large firmslack of competition and high profits

- little incentive for firms to be efficientunequal distribution of power and

propertyignore external costs of productionno production of public goods

ECONOMIC SYSTEMS: free-market economy

18

• Problems of a free-market economymacroeconomic instability - periods of

recession with high unemployment and falling output, and other periods of rising prices

by rewarding self-interest - may encourage selfishness, greed, materialism and acquisition of power

ECONOMIC SYSTEMS: free-market economy

19

Features of the 3 Economic Systems

Free Enterprise

System

Centrally Planned

Economy

Mixed Economy

Alternative Names

• Laissez-faire

• Capitalist system

• Command economy

• Planned economy

20

Features of the 3 Economic Systems

Free Enterprise

System

Centrally Planned

Economy

Mixed Economy

Examples • Hong Kong

• North Korea

• Cuba

• US

• UK

• Singapore

21

Features of the 3 Economic Systems

Free Enterprise

System

Centrally Planned

Economy

Mixed Economy

Features

1. Ownership of Resources / Factors of Production (fops)

• Private ownership (i.e. by individual households & firms) of almost all fop

• Public ownership (i.e. by the state) of almost all fop

• Public & private ownership

22

Features of the 3 Economic Systems

Free Enterprise

System

Centrally Planned

Economy

Mixed Economy

• Price mechanism

• Govt directives

Feature

2. How economic decisions are made

• Price mechanism & govt directives

23

Features of the 3 Economic Systems

Free Enterprise

System

Centrally Planned

Economy

Mixed Economy

• Self-interest

• For the common good of the nation

Feature

3. Dominating motive

• Self-interest & common good