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Module 1.2 - The Three Basic Economic Questions

The document outlines the three basic economic questions that every economy must address: what/how much to produce, how to produce, and for whom to produce. It describes three main types of economic systems—free market, command, and mixed economies—along with the role of government intervention in influencing economic activities. The advantages and limitations of each economic system are discussed, highlighting the balance between market forces and government control in mixed economies, which are prevalent worldwide.

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19 views

Module 1.2 - The Three Basic Economic Questions

The document outlines the three basic economic questions that every economy must address: what/how much to produce, how to produce, and for whom to produce. It describes three main types of economic systems—free market, command, and mixed economies—along with the role of government intervention in influencing economic activities. The advantages and limitations of each economic system are discussed, highlighting the balance between market forces and government control in mixed economies, which are prevalent worldwide.

Uploaded by

Ogyam
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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MODULE 1.

2 - THE THREE BASIC ECONOMIC QUESTIONS

THE THREE BASIC ECONOMIC QUESTIONS

An economy is a system which provides a solution to the basic economic problem. In other words, an
economic system must allocate available resources between competing uses, and output between
economic agents, in order to reach the highest possible level of satisfaction.

To that end, an economic system must answer 3 fundamental questions : What / how much to produce,
how to produce, and for whom to produce.

Choosing what / how much to produce consists in determining the combination (or basket) of goods and
services that should be produced with the resources available. For example, should we produce 100
phones and 20 cars, or 50 phones and 40 cars?

Choosing how to produce consists in determining the combination of resources that should be used in
the production of each good or service. For example, should we produce 100 phones with 10 machines
and 100 workers, or with 5 machines and 200 workers? Should we produce furnitures with solid or
agglomerated wood?

Choosing for whom to produce consists in determining the mechanism that will distribute the economy’s
output between economic agents. For example, market-based, lottery, government decree, need or
merit-based, etc.

ECONOMIC SYSTEMS

There are 3 main types of economic systems : free market economies, planned (or command)
economies, and mixed economies.

GOVERNMENT INTERVENTION

Government intervention refers to the various actions and policies implemented by a government to
influence or regulate economic activities. Government intervention modifies resource allocation and
output distribution (i.e. it leads to a different outcome from what markets would have achieved working
on their own). Policy instruments include taxes & subsidies, regulation / legislation, price control, quotas,
etc. Almost everyone supports government intervention in the economy, but there are debates about
the extent of that intervention.
PUBLIC VS PRIVATE SECTOR

The public sector is the part of the economy owned, managed and controlled by the government. The
private sector is the part of the economy owned, managed and controlled by households and private
organisations (e.g. firms, NGOs, interest groups, etc.).

FREE MARKET ECONOMY

In a free market economy :

- There is no public sector and no government intervention


- Resources are privately owned (i.e. private sector resource ownership)
- Resources are allocated and output is distributed by market forces (i.e. the price mechanism).

Even if there is no government intervention, the government needs to provide a stable and secure
environment for markets to work effectively. In particular, the government must protect property rights
(i.e. legal ownership and control over assets, allowing use, transfer, and disposal within the law) so firms
and individuals have incentives to produce and trade goods and services.

The distribution of output is closely related to income distribution, since the amount of output that
people can get depends on how much they can afford.

Main advantages

- The profit incentive encourages efficiency


- Wide variety of goods and services
- Competition keeps prices down, quality up, and it encourages innovation

Main limitations

- Market failures (i.e. when the market does not allocate resources in the best possible way) caused
by market powers, public goods, imperfect information or externalities.
- Higher levels of inequality

COMMAND ECONOMY

In a command economy:

- There is no private sector and no markets (or only limited market operations)
- Resources, especially land and capital, are publicly owned (i.e. public sector resource ownership)
- Resource allocation and output distribution are controlled by the government (i.e. non-price
mechanism).
Main advantages :

- Low level of inequality


- No market failures (i.e. the government aims at maximising social welfare)
- Low unemployment & high job security

Main limitations :

- Absence of competition leading to a low productive efficiency and product quality, to low
incentives to innovate, to high prices and to a narrow range of goods and services.
- Government intervention is costly (e.g. operational costs which are usually high due to
bureaucratic red tape), and it can be misguided (e.g. imperfect information, political interests,
regulatory capture, etc.)

MIXED ECONOMY

In a mixed economy :

- The public and private sector coexist. In particular, resource ownership is a blend of public and
private ownership, with the government holding control over certain resources, while others are
under the ownership of private economic agents.
- Resource allocation and output distribution are jointly influenced by both market forces and
government intervention.

In particular, the government may intervene in the economy for 2 primary purposes: to correct market
failures and to reduce inequalities. Therefore, a mixed economy benefits from the main advantages of a
market economy, and it has the potential to overcome its main limitations. However, as was the case in
a command economy, government intervention is costly, and it can be misguided.

Today, nearly all countries in the world are mixed economies. Obviously, the extent to which the
government intervenes in the economy varies across countries or regions. On the one hand, the
economies of North Korea, Venezuela & Cuba are very close to a planned economy. On the other hand,
the economies of Hong Kong SAR & Singapore are very close to a market economy.

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