Faculty of

Economic and
Management Sciences

CHAPTER 2
Economic systems

Text Book
pp. 34-48
 LECTURE OUTCOMES
Once you have studied this chapter you
should be able to:
•Identify three questions that all economic systems
must answer.
•Discuss the four Factors of Production.

•Describe a pure market economy, and identify its

problems.

•Describe a pure centrally planned economy, and

identify its problems.

•Describe traditional and mixed economy.

•Compare and contrast economic systems

Quick Recap (CHAPTER 1):The economic problem

UNLIMITED LIMITED
WANTS RESOURCES

SCARCITY

CHOICES

WHAT? HOW? FOR WHOM?

INTRODUCTION
▪ Different societies approach the economic problem in different ways

▪ In this chapter, the three central questions that have to be solved in every
society are used to introduce the basic types of economic systems

▪ These economic systems are used to solve these economic questions (What,
How, For Whom)

▪ Thus, economic systems refer to patterns of organisations that are aimed at

solving the three central questions of economics

▪ Having insight into the economic systems of various countries will give an
indication of how they address the scarcity problem

▪ Do you think the study of economic systems is of any relevance in the current
South African situation?
THREE ECONOMIC SYSTEMS
All economies must answer these three questions:

What goods and services will be produced? OUTPUT QUESTIONS. In what quantities?

How will they be produced? INPUT QUESTIONS. How much

of the scarce resources will be used?

For whom will they be produced? DISTRIBUTION QUESTIONS → Who will receive them? →

How much of the goods and services will they receive? → And where will the production occur?
WHAT SHOULD
BE PRODUCED?
What should be produced?
• Even though people have different wants, most of them are satisfied
by goods and services.

• Consider the following different types of goods and their categories:

Consumer goods and capital goods

• Consumer goods are used by consumers to satisfy wants.
Examples ____________

• Capital goods that are not consumed but are used in the
production of other goods.
Examples ____________
HOW SHOULD IT
BE PRODUCED
• Remember resources are scarce, they have to
be used efficiently.

• There are different types of resources used

for the production of goods and services.
• They are called factors of production; e.g.
• Land (natural resources)
• Labour
• Capital
• Entrepreneur
 FACTORS OF PRODUCTION
 Land (Natural resources)
 Consist of all the gifts of nature
 Their availability cannot be increased, e.g.
minerals. - non-renewable or exhaustible assets.
 Labour:- exercise of human mental and physical
efforts in the production of goods and services.

 Quantity of labour:- depends on the size and
proportion of the population that is able and
willing to work, i.e. work force.
 Quality of labour force:- it is the human capital
which refers to skill, knowledge and health of the
workers.
 Education and training are the determinants of
the labour force.
 FACTORS OF PRODUCTION
Capital
 Refers to manufactured resources which are used
in the production of goods and services.

 Capital goods do not have unlimited life. They are

subject to wear and tear therefore there should
all ways be a provision for depreciation
(depreciation allowance).

Entrepreneurship
 Entrepreneurs are people who see opportunities
and are willing to take a risk by producing
goods in the expectation that they will be sold.

 The entrepreneur is the driving force behind

production.
 FOR WHOM SHOULD
IT BE PRODUCED?
• How is production distributed among different individuals?

• Distribution is a normative issue and often very

emotional one particularly in society where distribution
is highly unequal e.g. South Africa.

• Factors of production earn incomes as follows:

• Labour → wages and salaries
• Land → rent
• Capital → interest
• Entrepreneurship → profit

• Distribution of income affects WHAT will be produced.

• Consumer vote for what they want by spending their

income.
 SOLUTIONS TO THE
CENTRAL QUESTIONS:

AN INTRODUCTION TO ECONOMIC SYSTEMS

AN INTRODUCTION TO ECONOMIC
SYSTEMS

An economic system is a pattern of organisation

aimed at solving the central economic questions

There are three mechanisms used to solve

central economic questions:

• FREE MARKET SYSTEM

• COMMAND (CENTRALLY PLANNED) SYSTEM

• MIXED ECONOMY
 ECONOMIC SYSTEMS
(T-C-M-M)

Traditional
System

Mixed System

Command
Market System
System
 Economic System
• An economic system is the set of mechanisms
and institutions that resolves the what, how, and
for whom questions.

• Two characteristics are used to compare economic

systems :

1 Property rights
− Who owns the resources?

2 Decision-making process or Coordination

system
− Who makes the decisions about what, how & for
whom
TRADITIONAL SYSTEM
 Traditional Economy
• It is the oldest system.

• Found in rural, and under-developed countries.

• All tasks and methods of production are prescribed by

custom.

• It tends to be subsistence economies - Farming, hunting

and gathering are done the same way as the generation
before.

• Men and women are given different economic roles and

tasks.

• It is a rigid system which is slow to adapt and to

innovation. Can still be found in parts of Asia, Africa and South America
Disadvantages Advantages

• Rigid • Important aspects of economic

− It is slow to adapt to change behaviour are still governed by
tradition
• Stubbornly resists innovation.
• Children still follow their parent's
• Tends to be subsistence economies
ways (not bound)
− no economic progress
• Provides clear and easy answers to
• Economic activity is not the first
priority compared to religious, the 3 economic questions.
cultural values and the perpetuation
of the status quo.
THE MARKET SYSTEM
 Free Market Economy

• Also known as Capitalist systems – driven by profit motive

• It is a theoretical construct.

• All resources are privately owned no state role.

• Businesses and Consumers decide what they will

produce and purchase and in what quantities.

• Decisions are made according to law of supply &

demand.

• Supply and demand of goods and services

determine what is produced and the price that
will be charged.
 Free Market Economy
Cont.…
Invisible Hand of Market
• There is no government involvement in economic
decisions.

• According to economist Adam Smith (1723–

1790), market forces coordinate production as if
by an “invisible hand.”
 The Price Mechanism

• Prices respond to shortages and surpluses.

• Shortages result in prices rising.

− Demand exceeds Supply.

• Surpluses result in prices falling.

− Supply exceeds Demand.
 Pure Market Economy
Cont.…

• What? Consumers decide what should be

produced in a market economy through the
purchases they make.
• How? Production is left entirely up to
businesses. Businesses must be competitive in
such an economy and produce quality products
at lower prices than their competitors.
• For whom? In a market economy, the people
who have more money are able to buy more
goods and services.
 Market Economy:
Advantages
• It is productively efficient because firms are always
under pressure to produce out at the lowest cost
possible.

• it is allocatively efficient because output produced

is that which maximises the total satisfaction
enjoyed by the members of the society.

• There are incentives to produce better products.

• It is flexible.
 Market Economy: Problems

• Great rift between the wealthy and the poor.

• Some firms try to monopolize markets.
• There`s no provision of public goods.
• Externalities
• Market failure.
THE COMMAND SYSTEM
 Command Economy
• All resources are government or state owned.

• Production is coordinated by the central plans of

government.

• Closely related with communism or socialism.

• Command economies are often described as
socialist and communist systems.
 Communism & Socialism

• Command or Central planning refers to the way

in which economic activity is coordinated.

• While socialism and communism refers to the

ownership of the factors of production.

• In a pure socialist system, all the factors of

production except labour are owned by the
state.

• In a pure communist system, all resources

are in principle owned by everybody –
everything is common property.
 Command Economy

• In such as system people have to do the work

allocated to them by the state - they have no
choice.

• Land, Capital, and Labour are allocated to the

production of each of output.

• It guarantees equal standard of living for

everyone and hence less poverty.
 Command Economy
Cont…
• What? A dictator or a central planning
committee decides what products are needed.

• How? Since the government owns all means of

production in a command economy, it decides
how goods and services will be produced.
• For whom? The government decides who will
get what is produced in a command economy.
 Command Economy:
Advantages
• It guarantees equal standard of living for
everyone and hence less poverty.

• One of the economic challenges South Africa is

facing today is the dualistic nature of the
economy.

• There is the first economy and the second

economy.

• This kind of system would guarantee equal

standard of living for everyone.
 Command Economy:
Disadvantages
1. Lack of incentives:
− No incentive to produce better product or engage in
entrepreneurship.
2. Bureaucracy
− requires a very large bureaucracy to carry out the
plans of the state.
3. Coordination problems
− It is impossible for the state to produce just the
right quantity of each type of output.
4. Inflexibility
− An economic system is inflexible when it cannot
adapt to change.
5. Corruption:
− Therefore members of the elite may act in their own
interest.
THE MIXED ECONOMIC SYSTEM
 Mixed Economy
• Combination of the market and command economy.

• Government takes care of peoples` needs.

• The market takes care of people`s wants.

• Most nations have a mixed economy.

• The South African economy is mixed, there is private

property, private interest as well as a degree of
government intervention.

• In SA some enterprises are directly or indirectly

owned by the state. Eg. Transnet, Eskom, SABC and
The Post Office
 THE GOVERNMENT
IN THE MIXED ECONOMY

(1) Business cycle

– decisions on taxation and spending may affect
the business cycle.

(2) Public goods

– goods that, even if consumed by one person,
are still available for consumption by others –
e.g. clean air.

– the free-rider problem prevents the market

from achieving production of the “right”
amount of such goods.
 THE GOVERNMENT
IN THE MIXED ECONOMY
(3) Externalities
– costs and benefits of production are not
always reflected in market prices e.g.
pollution, congestion.
(4) Information-related problems
– private markets may not produce the “right”
kinds and amounts of information e.g. food
labelling, health and safety regulations.
 THE GOVERNMENT
IN THE MIXED ECONOMY
(5) Monopoly and market power
– resource allocation may be improved by
limiting or regulating the market power of
monopoly firms.

(6) Income redistribution and merit goods

– concern with equity issues e.g. protecting
vulnerable groups
– merit goods are goods that society thinks
people should consume regardless of income
e.g. health, education
 MIXED ECONOMY:
ADVANTAGES
• The balance of needs and wants met by
government and in marketplace.

MIXED ECONOMY:
DISADVANTAGES
• Citizens have to pay taxes.
 IMPORTANT PIONEERS
IN ECONOMICS
• Adam Smith
− He is considered to be the founding father of
Economics and a classical theorist.
− He advocated for the free market and that there
should be no government interference in the market.

• Karl Marx
− He was against Capitalism. He advocated for a
classless society where everyone was equal.

• John Maynard Keynes

− He believed that the government had an important
role in the economy in times of economic crises.
− Fiscal and Monetary stabilization policies.
 Adam Smith
The Market System
• Claim to fame:

A book called "Wealth of Nations, 1776"

o Aim was to find the source of wealth of nations – believed to be

money (gold).

o Market system extended trade → export more, import less →

add to stock of silver → wealth of nations

o DECENTRALIZED DECISION MAKING

o Individuals have to pursue their own self interest

o In trying to produce the most value for themselves, they

will in effect be producing the greatest possible value
which promotes national interest (invisible hand)
1723 - 1790 o When pursuing self interest each nation will produce what
they are good at (efficiency)
 Adam Smith
The Market System
• Claim to fame:

A book called "Wealth of Nations, 1776"

o Aim was to find the source of wealth of nations – believed to be

money (gold).

o Market system extended trade → export more, import less →

add to stock of silver → wealth of nations

o DECENTRALIZED DECISION MAKING

o Individuals have to pursue their own self interest

o In trying to produce the most value for themselves, they

will in effect be producing the greatest possible value
which promotes national interest (invisible hand)
1723 - 1790 o When pursuing self interest each nation will produce what
they are good at (efficiency)
Cont.…
• Main View Points:

o Division of labour (promotes specialisation)

o Free trade (both domestically and Internationally) to

achieve increased market sizes

o Markets should be expanded as larger markets

would lead to more division of labour and economic
growth

o Limited role for the government in an economy

(i.e. provision of national defence, administration of
justice, some socially desirable services like
education)
 Karl Marx
Command/Communist System

• Claim to fame:
o Wrote a book "Das Kapital, 1867”
• Main View Points:
o Labour is NB = source (add value to the economy
o Against capitalism
o Capitalists (companies) only pay workers a small
portion of the value they create – evidenced by
large surplus value (profits) which is in the
hands of a small number of companies and
meagre wages (just enough to survive) for the
majority of the working class
o This is exploitation!
1818 - 1883
Cont….
o Capitalists also increase technological unemployment
o Capitalist were discriminating again race and gender!
Everyone is a worker at the end of the day!
o End capitalism by giving companies to their workers or to the
government
• Criticisms
o He saw communism as the final system to succeed
socialism (which was not the case)
o Failed to anticipate the possibility of capitalist system
to adapt in order to deal with these problem – e.g. The
rise of trade Unions (which enhanced the bargaining of
workers), active role of government in the economy
which improved the living conditions of the working
class)
 John Maynard Keynes
Mixed System

• Claim to fame:

o Wrote a book “The general theory of

employment, interest & Money, 1936”

o Did not propose a new system – He

questioned economic theory at the
time, i.e. that was laid by classical
economists like Adam Smith

o Just helped lay the foundation of mixed

economic system

• Main view points:

o The total level of economic activity will

be determined by the total demand for
goods and services.

1883-1946
Cont.…
o However, during periods of weak
aggregate demand (e.g. during high
unemployment periods OR recession
periods), the government can intervene
to stimulate economic activity and
reduce unemployment through
appropriate policy measures

− Government intervenes → stimulate

aggregate demand → reduces taxes
and/or increases spending (fiscal
policy)

− Reduce interest rates and/or increase

money supply (monetary policy)
 IMPORTANT PIONEERS IN
ECONOMICS
• Most economies today follow Keynesian
ideas:

1. South Africa uses fiscal and monetary policy to

stimulate or stabilize the economy, government
help the poor with social grants etc.
2. The US government bailed out financial
institutions in 2008 when the Global Financial
Crisis burst.
3. European Union helped Greece, the Greek Debt
issue.
 WHY SHOULD GOVERNMENTS
INTERVENE?
1) Business Cycles
• Decisions on taxation and spending may affect the
business cycle.

• Government uses stabilisation policies such as the fiscal

and monetary policy.

2) Public Goods
• goods that, even if consumed by one person, are still
available for consumption by others – e.g. clean air.

• the free-rider problem prevents the market from

achieving production of the “right” amount of such
goods.
 WHY SHOULD GOVERNMENTS
INTERVENE?
3)Externalities
• Costs and benefits of production are not
always reflected in market prices e.g. pollution,
congestion.

4)Information-Related Problems
• Private markets may not produce the “right”
kinds and amounts of information e.g. food
labelling, health and safety regulations.
 WHY SHOULD GOVERNMENTS
INTERVENE?
5) Monopoly and Market Power
• Resource allocation may be improved by
limiting or regulating the market power of
monopoly firms.

6) Income Redistribution and Merit Goods

• Concern with equity issues e.g. protecting
vulnerable groups.

• Merit goods are goods that society thinks

people should consume regardless of income
e.g. health, education.
 BRIEF ASSESSMENT
QUESTION 1
1 In economics, the 4 main factors of production are
A land, human capital, physical capital and finance capital.
B natural resources, man-made resources, labour and money.
C land, capital, labour and notes and coins in circulation.
D land, labour, capital and entrepreneurship.

QUESTION 2
2 In economics, the term “land” means
A only land that is used in agricultural production.
B land, mineral resources, and nature’s other bounties.
C land that is devoted to economic pursuits.
D land used for agricultural and urban purposes.
 BRIEF ASSESSMENT
QUESTION 3
Which of the following is a resource used to
3 produce goods and services?
A Land
B Labour
C Capital
D ALL of the above are sources

QUESTION 4
Which of the following is a resource used to
4
produce other goods and services?
A Land
B Labour
C Capital
D ALL of the above are sources
 BRIEF ASSESSMENT
QUESTION 5
The economic resource that organizes the
5 use of other economic resources is
A Labour
B Capital
C Entrepreneurship
D Land
QUESTION 6
Which of the following would not be viewed
6 by economists as capital?
A Lecture theatres at the NWU Mafikeng campus.
B VW motor vehicle service plant in Zeerust
C N4 national road between Mafikeng and Zeerust
Subsidy income received by NWU from Department of
D
Education
 BRIEF ASSESSMENT
QUESTION 7
Which of the following would not be viewed by
7 economists as a factor of production?
A The chemistry laboratories at Stellenbosch University
B An unskilled labourer.
C The wages earned by a skilled bricklayer.
D A Sugar-cane Plantation in northern KwaZulu-Natal

QUESTION 8
In a command economy, resource allocation
8 is brought about by
A price signals driven by relative price changes.
B the collective preferences of central planners.
C the principle of consumer sovereignty.
the behaviour of self-interested individuals striving to
D
maximise their own well-being.
 BRIEF ASSESSMENT
QUESTION 9

Adam Smith’s concept of the invisible hand

9
suggests that
the selfish actions of rational individuals will generate an
A
efficient allocation of scarce resources.
the public-spirited actions of individuals will generate an
B
efficient allocation of scarce resources.
the systematic but largely invisible intervention of
C government in the operation of markets will generate an
efficient allocation of scarce resources.
market failure cannot arise, and there is therefore no
D
economic role for the state.
 BRIEF ASSESSMENT
QUESTION 10
According to Adam Smith’s theory of the
10 invisible hand, an efficient overall allocation
of resources is likely to result from:
A The regulation of markets by economic planners.
The operation of command rather than market
B
economies.
The behaviour of public-spirited people who consider the
C
benefits that their actions will have on others.
The behaviour of self-interested individuals striving to
D
maximise their own wellbeing.
 BRIEF ASSESSMENT
QUESTION 11

X Y

W Z
Free Market Command

What letter on the graph represents the proper

location for South Africa`s economic system?
THE END