All economic systems must have some way of answering 3 basic questions:
- What goods and services are produced and in what quantities?
- How are they produced?
- Who gets the goods and services that are produced?
There are two extreme systems for answering these questions. In a command economy, the government decides all the answers. In a market economy, the questions get answered through the interaction of buyers and sellers in the market.
command economy:
- government sets prices
- government ownership of resources
market economy:
- freely determined prices
- private ownership of resources
Most actual economies contain a mix of private and government decisionmaking. In the United States, consumer demands determine the answer to the first question. Firms are in business to make profits and profits are made by producing the things that consumers want. Consumer sovereignty refers to the ability of consumers through their purchases to determine what goods and services get produced in a market economy.
Goods and services are produced using the combination of inputs that minimizes costs. If firms do not minimize costs, then they cannot maximize profits.
Income determines the amount of goods and services households obtain. Income is determined by the prices of the resources households own. Those with more valuable resources receive a higher income and, consequently, can purchase more goods and services.
