In the last section of the series on the economic
problem, I wanted to briefly discuss the types
of economies that exist, and the one that
the rest of the series will be based on.
Throughout history, two main types of economies
have emerged as viable options for organizing
a nation’s resources.
The first type of economy is one which is
centrally planned.
This means that an institution such as a government
will answer the three basic economic questions
we have seen in a previous video.
What to produce, how to produce, and for whom
to produce is all decided by the government.
Free markets are also known as decentralized
markets.
This means that no one person or institution
runs the entire economy.
Prices and quantities of all goods in the
economy are determined by the market forces
of supply and demand, which we will explore
in the next series.
Historical evidence suggests that central
planning does not work very well in the long
run because the central planners don’t know
people’s production possibilities and their
preferences, thus resources are misallocated
and the economy ends up producing at a point
inside the PPF.
Additionally, centrally planned economies
ignore the concept of incentives, thus any
firm within the economy would not be functioning
as efficiently as possible.
There would be no incentive to become more
efficient in producing a given good, thus
old and outdated methods of production would
continue to be used.
This is only one example of the inefficiencies
caused be a lack of incentives.
For decentralized markets to work, we need
four things to be in place first.
A firm is an economic unit that hires factors
of production and organizes them to produce
and sell goods and services.
A market is some arrangement that allows buyers
and sellers of goods to get information and
to do business with each other.
This doesn’t have to be a physical place,
just some arrangement.
Amazon is an example of a marketplace that
does not have a physical location; the website
allows buyers and sellers from around the
world to connect with each other.
Markets, however, can only work when property
rights exist.
Property rights are the social arrangements
that govern the ownership, use, and disposal
of anything that people value.
The term “real property rights” refers
to rights of ownership to land, building,
machinery.
Financial property includes stocks, bonds,
money in the bank.
Intellectual property refers to the intangible
product of creative effort.
This property includes music, books, inventions,
etcetera.
Property rights is an incentive to innovate.
Financial gain is the reward for those who
choose to innovate.
If property rights didn’t exist, and people
could simply steal property, then resources
would be diverted to protecting people’s
property rather than innovation.
Money is a commodity or token that is uniformly
accepted as a method of payment.
The circular flow model is a highly simplified
model of the free market economy, but illustrates
the basic idea of how the economy works.
In this model we are going to assume that
there is no government, and that there is
no international trade either.
The first main entity in our economy is households.
This consists of the general population.
The second main entity in our economy is firms.
We also have goods markets.
This is simply the marketplace where goods
and services are traded between buyers and
sellers.
It is not an entity like a household or a
firm.
Factor markets are similar to the goods markets
in that they allow buyers and sellers to trade,
but in this case we are not trading goods
or services.
We are trading the factors of production of
land, labour, capital, and entrepreneurship
on these markets.
The circular flow works like this.
Households spend money in the goods market.
This money goes straight to the firms, as
firms are the sellers of these goods.
Households, in return for their spent money,
get some good or service.
This good or service comes directly from the
firm.
The firm offers goods and the household buys
the goods.
In order to produce the goods, the firm needs
to buy resources from the factor markets.
It is households that provide the resources
of land, labour, capital, and entrepreneurship.
The firm must buy these resources from the
factor markets, so it spends its money over
there.
At the end of the day, households are selling
the factors of production, so the money goes
back to them.
From the diagram it is clear that money simply
flows from households and firms through the
goods and factor markets.
Goods and services flow from the firm to the
household through the goods market, and the
economic resources flows from households to
firms in factor markets.
