COURSE: GENERAL ECONOMICS

ACADEMIC YEAR: 2024/2025

Level: License 1

Module 2: Economic Systems and Models

- Types of Economic Systems:
Traditional Economic,
Command Economic,
Market Economic,
Mixed Economic
- Circular Flow of Economic Activity:
Households,
Businesses,
Government,
Financial Sector
Foreign Sector
- Economic Models and the Ceteris Paribus Assumption
- Activities: Explore different economic systems worldwide through
case studies.

1
 TYPES OF ECONOMIC SYSTEMS
Economic systems are essential frameworks that societies use to
organize the production, distribution, and consumption of goods and
services. There are four primary types of economic systems: traditional,
command, market, and mixed. Each system has distinct characteristics,
advantages, and disadvantages. Below is an overview of each type along
with examples to illustrate their functioning.
1. Traditional Economic System
• Definition: A traditional economic system is based on customs,
traditions, and beliefs that have been passed down through
generations. Production and distribution are guided by long-
standing practices, and there is minimal use of modern technology.
• Characteristics:
o Relies on agriculture, fishing, hunting, or gathering.
o Decisions are made based on customs and traditions.
o Little economic growth or innovation.

• Examples:
In rural communities in some parts of Africa or South Asia,
families may engage in subsistence farming, producing only
enough to meet their needs. Barter systems are common, and
economic activities are deeply rooted in cultural practices.

• The Inuit communities in Canada exemplify a traditional economy

where people rely on hunting, fishing, and gathering for their
livelihoods. Their practices have been passed down through
generations, emphasizing sustainability and community
cooperation.

2
2. Command Economic System
Definition: In a command economic system, the government controls all
major aspects of the economy, including production, distribution, and
prices. The state makes decisions about what to produce, how to
produce, and for whom to produce. Command economy is also known as
socialistic economy. In the recent past, socialism has lost its popularity
and most of the socialist countries are trying free market economies.

Main Features of Command Economy

✓ Collective ownership: All means of production are owned by the
society as a whole, and there is no right to private property.
✓ Central economic planning: Planning for resource allocation is
performed by the controlling authority according to given socio-
economic goals.
✓ Strong government role: Government has complete control over all
economic activities.
✓ Maximum social welfare: Command economy aims at maximizing
social welfare and does not allow the exploitation of labour.
✓ Relative equality of incomes: Private property does not exist in a
command economy, the profit motive is absent, and there are no
opportunities for accumulation of wealth.
All these factors lead to greater equality in income distribution, in
comparison with capitalism.

Examples: The former Soviet Union operated under a command

economy. The government decided what factories would produce and
how goods were distributed. For instance, production quotas were set for
industries like steel or wheat, regardless of actual demand.

Cuba is a prominent example of a command economy where the

government owns most of the means of production and determines
prices and production levels. This system seeks to prioritize social
welfare over individual profit but can lead to inefficiencies and limited
consumer choices.
3
3. Market Economic System or Capitalist economy
Definition: A market economic system is driven by the choices of
individuals and businesses. Decisions about production and pricing are
made based on supply and demand, with minimal government
intervention. This system is also called free market economy or market
system or laissez faire.

Features of Capitalistic Economy

✓ The right to private property: The right to private property is a
fundamental feature of a capitalist economy. As part of that principle,
economic or productive factors such as land, factories, machinery, mines
etc. are under private ownership.
✓ Freedom of choice by consumers: Consumers can buy the goods
and services that suit their tastes and preferences. Producers produce
goods in accordance with the wishes of the consumers. This is known as
the principle of consumer sovereignty.
✓ Profit motive: Entrepreneurs, in their productive activity, are guided
by the motive of profit-making.
✓ Competition: In a capitalist economy, competition exists among
sellers or producers of similar goods to attract customers. Among
buyers, there is competition to obtain goods. Among workers, the
competition is to get jobs. Among employers, it is to get workers and
investment funds.
✓ Price mechanism: All basic economic problems are solved through
the price mechanism.
✓ Minor role of government: The government does not interfere in
day-to-day economic activities and confines itself to defense and
maintenance of law and order.
✓ Self-interest: Each individual is guided by self-interest and motivated
by the desire for economic gain.
✓ Inequalities of income: There is a wide economic gap between the
rich and the poor.

4
✓ Existence of negative externalities: A negative externality is the
harm, cost, or inconvenience suffered by a third party because of actions
by others. In capitalistic economy, decision of firms may result in
negative externalities against another firm or society in general.

Example:
The United States is often cited as a market economy. Entrepreneurs
and companies decide what products to create (e.g., smartphones,
clothing) based on consumer demand. If demand for electric cars rises,
companies like Tesla will increase production to meet that demand.

4. Mixed Economic System

Definition: A mixed economic system combines elements of both
market and command systems. The government plays a role in
regulating certain industries while allowing market forces to operate
freely in others.

Characteristics:
o Balance between public and private ownership.

o Government intervention in essential services like healthcare and

education.
o Market-driven innovation coexists with regulation to protect public
welfare.
o Economic welfare: Economic welfare is the most important
criterion of the success of a mixed economy. The public sector
tries to remove regional imbalances, provides large employment
opportunities and seeks economic welfare through its price policy.
Government control over the private sector leads to economic
welfare of society at large.

o Economic planning: The government uses instruments of

economic planning to achieve coordinated rapid economic
development, making use of both the private and the public sector.
5
 o Price mechanism: The price mechanism operates for goods
produced in the private sector, but not for essential commodities
and goods produced in the public sector. Those prices are defined
and regulated by the government.

o Economic equality: Private property is allowed, but rules exist to

prevent concentration of wealth. Limits are fixed for owning land
and property. Progressive taxation, concessions and subsides are
implemented to achieve economic equality.

Example:
France is a mixed economy. While businesses operate in a free market,
the government regulates industries like healthcare, education, and
transportation to ensure public access and equity. For instance, high-
speed trains (TGV) operate under state influence alongside private
airlines.

Sweden represents also a mixed economy where the government

provides extensive social services like healthcare and education while
the private sector drives most economic activity. This balance aims to
harness the benefits of free markets while ensuring social welfare.

Summary Table
Economic System Key Feature Example
Traditional Based on customs and traditions Tribal communities in Africa
Government control of
Command North Korea, Soviet Union
resources
Market Driven by supply and demand United States, Singapore
Combination of market and
Mixed France, Canada
command

6
 Advantages and Disadvantages of Economic Systems
Economic Advantages Disadvantages
Systems
- Limited Growth: Lack of innovation
- Stability and Predictability:
and technology can hinder economic
Economic roles are well-defined,
development.
leading to social stability. \n -
- Vulnerability: Susceptible to
Cultural Preservation: Maintains
Traditional customs and traditions, fostering environmental changes and external
shocks.
community identity.
- Limited Choices: Few goods and
\- Sustainability: Emphasizes
services available, restricting consumer
resource conservation and
options.
environmental sustainability. \n -
- Resistance to Change: Difficulty
Low Inequality: Resources are
adapting to new ideas or technologies.
often shared more equally among
community members.
- Rapid Decision-Making: The - Lack of Freedom: Individual choices
government can quickly mobilize are restricted, limiting personal
resources to address needs. initiative.
- Can quickly mobilize resources - Lack of innovation due to absence of
in times of crisis. competition.
Command - Equitable Distribution: Aims - Inefficiency: Bureaucratic decision-
to provide basic goods and services making can lead to waste and low-
to all citizens. quality goods. - Inefficiencies from poor
- Reduces inequality by resource allocation.
redistributing wealth. - Limited Incentives: Reduced
- Focus on Social Welfare: motivation for innovation and
Prioritizes collective good over productivity due to lack of competition.
individual profit and - Limited consumer choice.
- Ensures essential goods and
services are provided.
- Consumer Choice: A wide - Inequality and exploitation: Can lead
variety of goods and services to significant disparities in wealth and
available based on demand. access to resources.
- Efficiency: Efficient allocation of - Market Failures: Certain needs may
resources through supply and go unmet, such as public goods or
Market demand. services for the poor.
- Individual - Economic Fluctuations: Subject to
Freedom: Encourages cycles of booms and busts, creating
entrepreneurship and personal uncertainty for individuals and
initiative in economic activities. businesses.
- Encourages innovation and - Vulnerable to economic cycles
entrepreneurship. (booms and busts).
- Wide variety of goods and
services.

7
 - Balanced Approach: Combines - Complexity: Can lead to confusion
advantages of both market and regarding regulations and market
command economies, aiming for dynamics. - Potential for
efficiency while ensuring social Inefficiency: Government intervention
welfare. may sometimes result in bureaucratic
- Flexibility: Can adapt policies inefficiencies.
Mixed based on changing economic - Tax Burden: Higher taxes may be
conditions and societal needs. required to fund social programs, which
- Public Services: Government can be unpopular among citizens.
provides essential services like - Risk of excessive government
healthcare and education while intervention stifling innovation.
allowing market-driven sectors to - Potential conflicts between public and
thrive. private interests.
- Promotes innovation while - Can be complex to manage.
addressing inequalities.

Activity 1
Imagine you are leaders of your country. Which economic system will you choose
and explain why:
1. How they will produce goods.
2. How resources will be distributed.
3. Why they chose that system.
This activity help to think critically about the advantages and disadvantages of
each system in a practical context.

Activity 1: Chose the right answer

1. Which of the following best describes a 2. In a command economic system, who

traditional economic system? primarily makes economic decisions?
a) An economy where decisions are made based a) Individual consumers and businesses
on supply and demand. b) The government or central authority
b) An economy where resources are allocated c) Market forces of supply and demand
through central planning. d) Non-profit organizations
c) An economy that relies on customs, traditions,
and historical precedent.
d) An economy characterized by private
ownership and free markets.

8
3. Which of the following is a key 4. What is a mixed economic system?
characteristic of a market economic system? a) An economy that combines elements
a) Government controls all production and of both market and command systems.
distribution. b) An economy that relies solely on
b) Prices are determined by supply and traditional practices.
demand in free markets. c) An economy that is entirely controlled
c) Economic activities are based on tradition by the government.
and cultural practices. d) An economy where all production is
d) Resources are allocated based on for subsistence only.
government directives.

5. Which of the following is an advantage of a 6. What is one major disadvantage of a

traditional economic system? command economic system?
a) High levels of innovation and change. a) Inefficient resource allocation due to
b) Stability and predictability in economic lack of competition.
roles. b) Overemphasis on individual consumer
c) Efficient allocation of resources through choice.
competition. c) High levels of inequality among
d) Rapid economic growth and development. citizens.
d) Excessive reliance on tradition and
customs.
7. In market economies, what is one potential 8. What is one advantage of a mixed
disadvantage? economic system?
a) Limited consumer choice due to government a) Complete absence of government
control. intervention in the economy.
b) Inequality in wealth distribution among b) Flexibility to adapt to changing
individuals. economic conditions while providing
c) Lack of innovation due to rigid regulations. social welfare programs.
d) Inefficient use of resources due to excessive c) Total control over all aspects of
government intervention. production by private entities.
d) Elimination of competition leading to
stable prices for consumers.

9
 CIRCULAR FLOW OF ECONOMIC ACTIVITY

The circular flow of economic activity is a fundamental model in

economics that illustrates how money, goods, and services move through
an economy. This model helps to understand the interconnections
between different sectors of the economy, including households,
businesses, and the government. Below is an explanation of the circular
flow model, its components, and how it operates.
Components of the Circular Flow Model
1. Households
• Households represent individuals or families who own factors of

production (land, labor, capital, and entrepreneurship).

• They provide these factors to businesses in exchange for income

(rent, wages, interest, and profit).

• Households use their income to buy goods and services from

businesses.
2. Businesses (Firms)
• Businesses produce goods and services to sell in the market.

• They hire factors of production from households and pay them

accordingly.
• The revenue from selling goods and services is used to pay for

production costs and generate profit.

3. Government
• Governments collect taxes from households and businesses.

• They use the revenue to provide public goods and services (e.g.,

roads, education, healthcare, infrastructure) that benefit society as

a whole.
• Governments may also redistribute income through social

programs or subsidies.

10
4. Financial Sector
In more complex models, the financial sector is included, which consists
of banks and other financial institutions. This sector facilitates savings
and investments, allowing households to deposit their savings and
businesses to borrow funds for expansion.
5. Foreign Sector
In an open economy model, the foreign sector is also considered. This
includes imports and exports, where money flows out of the domestic
economy to purchase foreign goods (imports) and flows back in when
foreign consumers buy domestic products (exports).

The Flow of Money and Goods

The circular flow model can be represented visually with arrows
indicating the flow of money and goods/services:
- Money Flow: Money flows from households to businesses when they
purchase goods and services. In return, businesses pay wages and
salaries to households for their labor.
- Goods/Services Flow: Goods and services flow from businesses to
households as they consume products.
- Government Interaction: Taxes collected from both households and
businesses flow into the government, which then spends this money on
public services that benefit both sectors.

Example Scenario
Consider a simple example involving a household named Mussa
1. Income Generation: Mussa works at a company (business) where he
earns a salary.

11
2. Consumption: He uses his salary to buy groceries from a local store
(another business).
3. Business Revenue: The grocery store uses the money earned from
Jonathan to pay its employees (including Mussa's friend) and purchase
more stock.
4. Government Role: Both Mussa's salary and the grocery store's
revenue are taxed by the government, which uses these funds to build
roads or provide public education.
5. Reinvestment: The grocery store may use its profits to expand or
improve its operations.
This cycle continues as long as there are transactions occurring between
these sectors.

12
13
14
Importance of the Circular Flow Model
• Interdependence: Highlights the connection between households,
businesses, and governments.
• Economic Health: Shows how money circulation supports
economic growth.
• Decision-Making: Helps policymakers understand the impact of
taxes, subsidies, or investments on the economy.

The circular flow of economic activity illustrates how various sectors

interact within an economy through continuous exchanges of money,
goods, and services. Understanding this model helps to grasp
fundamental economic concepts such as production, consumption,
income generation, and government intervention in economic
activities. By visualizing these interactions, people can better appreciate
how economies function as interconnected systems.
1. In the circular flow model, which of the 2. What role do businesses play in the
following represents households? circular flow of economic activity?
a) Entities that produce goods and services. a) They receive wages from households in
b) Consumers who provide labor and exchange for goods and services.
purchase goods and services. b) They produce goods and services to sell
c) Government agencies that regulate to households and the government.
economic activity. c) They collect taxes from households for
d) Financial institutions that manage government spending.
savings and investments. d) They provide loans to households for
consumption.
3. How does the government interact 4. What is meant by the "financial sector"
within the circular flow model? in the circular flow model?
a) By solely regulating businesses without a) The part of the economy that focuses on
any financial transactions. producing tangible goods.
b) By collecting taxes from households and b) The institutions that facilitate savings,
businesses, and providing public goods and investments, and loans between households
services. and businesses.
c) By only purchasing goods from foreign c) The government entities responsible for
markets. economic regulation.
d) By eliminating all forms of competition d) The international trade relationships
in the market. between countries.

15
ECONOMIC MODELS AND CETERIS PARIBUS ASSUMPTION
Economic Models often rely on the ceteris paribus assumption, a
foundational concept in economics that facilitates the analysis of
relationships between variables by holding other influencing factors
constant. This Latin phrase translates to "other things being equal" and
is essential for isolating the effects of one variable on another without the
interference of external changes.
Understanding Economic Models
Economic models are simplified representations of reality that help
economists understand and predict economic behaviors and outcomes.
These models can take various forms, including:
- Graphical Models: Visual representations that illustrate relationships
between variables, such as supply and demand curves.
- Mathematical Models: Equations that express relationships
quantitatively, allowing for precise calculations and predictions.
- Verbal Models: Descriptive frameworks that explain economic
concepts in plain language.
In constructing these models, economists often use the ceteris paribus
assumption to simplify complex interactions. By assuming that all other
factors remain unchanged, they can focus on the direct relationship
between two variables, such as price and quantity demanded.

16
 Examples of Economic Models:
Demand and Supply Model: Explains how prices and quantities of
goods are determined in a market.
Circular Flow Model: Demonstrates the flow of money, goods,
services, and resources in an economy.
Production Possibility Frontier (PPF): Shows trade-offs and
opportunity costs in resource allocation.

The Ceteris Paribus Assumption

The ceteris paribus assumption is crucial for several reasons:
1. Isolation of Variables: It allows economists to isolate the impact of
one variable while ignoring others that may also influence the outcome.
For example, when analyzing how a price increase affects demand, one
might assume ceteris paribus to disregard changes in consumer income
or preferences.

2. Simplification of Analysis: Given the complexity of real-world

economies, where multiple variables interact simultaneously, ceteris
paribus simplifies analysis by reducing the number of factors to
consider. This simplification is vital for developing clear and testable
hypotheses.

3. Facilitation of Predictions: By isolating variables, economists can

make predictions about how changes in one area (like tax rates or
interest rates) will affect others (like consumer spending or investment)
under controlled conditions.

17
Examples of Ceteris Paribus in Action
1. Demand and Price:
The law of demand states that as the price of a good increases, the
quantity demanded decreases, ceteris paribus (assuming factors like
income, tastes, and prices of related goods remain constant).
2. Supply and Technology:
An improvement in production technology reduces costs and increases
supply, ceteris paribus (assuming labor, material costs, and demand are
unchanged).
3. Interest Rates and Investment:
Lower interest rates encourage businesses to invest more, ceteris paribus
(assuming stable economic conditions and no policy changes).

Why Is Ceteris Paribus Important?

• Clarity: Helps isolate and study individual economic relationships
without interference from external factors.
• Focus: Makes it easier to identify trends or predict outcomes.
• Limitations: In real-world scenarios, other variables often change,
so conclusions from ceteris paribus analysis may need to be
adjusted.

Limitations of Ceteris Paribus

While useful, the ceteris paribus assumption has limitations:
- Real-World Complexity: In reality, it is challenging to hold all other
variables constant. Economic systems are dynamic and influenced by
numerous interrelated factors that can change simultaneously.

18
- Hypothetical Nature: The assumption often leads to hypothetical
scenarios that may not accurately reflect real-world outcomes. Thus,
while it aids in understanding tendencies and relationships, it does not
provide absolute predictions.

Economic models heavily utilize the ceteris paribus assumption to

simplify analysis and isolate variable relationships. While this approach
has its limitations due to the complexity of real-world economics, it
remains a fundamental tool for economists seeking to understand and
predict economic behavior.

1. What is an economic model? 2. Which of the following is a primary

a) A detailed description of every aspect of purpose of using economic models?
an economy. a) To provide exact predictions without any
b) A simplified representation of complex uncertainty.
economic processes used to analyze and b) To illustrate the complexities of every
predict economic behavior. individual decision in the economy.
c) A historical account of economic events. c) To simplify reality in order to understand
d) A tool for enforcing government relationships between variables and make
regulations. forecasts.
d) To eliminate the need for empirical data
in economics.

3. What does the term "ceteris paribus" 4. Why is the ceteris paribus assumption
mean in economics? important when developing economic
a) All variables are considered models?
simultaneously without any simplifications. a) It allows economists to focus on the
b) Other things being equal or held constant relationship between two specific variables
while analyzing the effect of one variable on without interference from others.
another. b) It guarantees that all predictions made by
c) The assumption that all economic agents the model will be accurate.
behave irrationally. c) It eliminates any need for data collection
d) The idea that markets are always in or empirical testing.
equilibrium. d) It ensures that all economic agents have
perfect information at all times.

19
20