Chapter Two Economic Systems, Resource Allocation and Social WellBeing

1
Chapter TwoEconomic Systems, Resource Allocation
and Social Well-Being

• Chapter Outline
• A Brief Review of Economic History (slides 2-16)
• A Brief Review of the History of Economic Thought
  (slides 17-20)
• Supply and Demand (slides 21-31)
• Resource Allocation Market System vs. Command
  Economy (slides 32-33)

2
A Brief Economic History Lesson

• Every society faces the following three
  questions.
• What is to be produced?
• How will it be produced?
• For whom will it be produced?
• A societys economic system is utilized to
  answer these questions.

3
A Sample of Economic Systems

• Feudalism
• Mercantilism
• Capitalism
• Socialism (Command Economy)
• Mixed Capitalism

4
Feudalism

• An economic system where the three basic
  questions are answered according to tradition.

5
Key Features of Feudalism

• 1. Communities tend to be self- sufficient.
• 2. The primary factors of production are labor
  and land.
• 3. Community is more important than the
  individual.
• 4. Economic growth is typically zero.

6
Mercantilism
An economic system in which the government
determines the allocation of resources by
assigning the rights to certain economic
activities.
7
The Rise of Mercantilism

• 1. The merchant is an anomaly in pre-capitalist
  societies. Merchants are focused on the
  individual, because they owe no allegiance to a
  community.
• 2. As the wealth of merchants increase so does
  their political power.
• 3. What do merchants want? Political unity and
  Monopoly power.
• 4. Society wants what the merchants offer, but
  do not trust the motives of traders.
• 5. The system of mercantilism gives society the
  ability to regulate the merchants and gives the
  merchants the monopoly power they desire.

8
Capitalism

• An economic system based upon private property
  and the market in which, in principle,
  individuals answer the basic questions of the
  economic system.

9
A Philosophical Turn

• At the heart of mercantilism is a belief that
  individuals left to their own devices will not
  produce socially beneficial outcomes. Hence the
  need for government regulation.
• Capitalism arose slowly as the benefits of
  greater individual freedom overcame societies
  skepticism of individual action.

10
Adam Smiths (1723-1790) Three Laws of the Market

• Self interest and competition will cause
• 1. the market price to equal the cost of
  production.
• 2. producers to provide the goods consumers
  demand.
• 3. above normal rates of profit to erode over
  time.

11
The Assumption of Competition

• Characteristics of a perfectly (pure) competitive
  market.
• Large number of buyers and sellers
• Standardized product
• Free entry and exit
• Characteristics of a monopolistic market
• One seller of the good
• Unique product
• Blockaded entry and exit

12
Socialism

• An economic system where the three economic
  questions are primarily addressed by government
  action, not unregulated market forces.

13
Pure Command Economy

• An economy system characterized by state
  ownership of resources and centralized
  decision-making.

14
The Labor Theory of Value and Karl Marx
(1818-1883)

• The Labor Theory of Value The price of a good
  is determined by the cost of production, and the
  cost of production is dictated by the quantity of
  labor utilized.
• The Labor Theory of Value can be found in the
  writings of Adam Smith and David Ricardo
  (1772-1823).
• If labor is the sole producer of value, Marx
  reasoned, then capitalism must result in the
  exploitation of labor.

15
More on Marx

• For Marx, the fundamental conflict in capitalism
  is between labor and capital.
• Marx believed that workers were exploited by the
  owners of capital. Capitalism will end when
  workers own the means of production.
• How will workers acquire the means of production?
  Evolution vs. Revolution

16
Mixed Capitalism

• An economic system where the three economic
  questions are addressed by a mixture of market
  forces and government action.

17
Understanding Market ForcesA Brief Review of the
History of Economic Thought

• The Labor Theory of Value
• Utility Theory
• The Marshallian Cross

18
The Labor Theory of Value, Again

• The Work of David Ricardo
• Every increase of the quantity of labor must
  augment the value of that commodity on which it
  is exercised, and every diminution must lower
  it.
• WHY?
• 1. The price of a good is determined by the cost
  of production.
• 2. The cost of production is dictated by the
  quantity and quality of labor utilized.

19
Utility Theory

• The work of Marx led scholars to find a new
  answer to the question of what determines prices.
• The work of Stanley Jevons, Carl Menger and Leon
  Walras (early 1870s) focused on the role of
  utility, or the satisfaction people derive from
  the consumption of goods and services.
• For these authors, prices changed in response to
  changes in consumer demand.

20
The Issue of Time and the Marshallian Cross

• Alfred Marshall (1842-1924) argued that everyone
  is right (or wrong) depending upon the time
  period one considers.
• In the very short-run, supply is fixed. Therefore
  demand dictates the price.
• In the long-run, where firms have time to enter
  and exit the industry, the price of the good will
  be determined by the cost of production.
• In the short run, firms can alter supply in
  response to price changes. Therefore both supply
  and demand will determine prices. Hence we have
  the Marshallian Cross, or what we call today the
  basic model of supply and demand.

21
Supply and Demand

• 1. Demand
• 2. Supply
• 3. Equilibrium

22
DEMAND

• Quantity demanded the amount of a good that
  buyers are willing and able to purchase.
• Law of Demand the quantity demanded of a good
  will fall when price of the good rises, ceteris
  paribus.
• Ceteris Paribus All else is equal
• See Table 2-1

23
The Demand Curve

• Changes in quantity demand
• Quantity demand changes in response to a change
  in the price of the good.
• This is illustrated by a movement along the
  demand curve
• Changes in demand
• Demand changes in response to a change in any
  other factor besides price.
• This is illustrated by a shifting of the demand
  curve.
• See Figures 2-1 and 2-2

24
What Determines Demand (in addition to the price
of the good)?

• Income of the consumer
• Normal vs. inferior
• Prices of goods related in consumption.
• Substitutes vs. Complements
• Tastes and preferences
• Expectations
• The number of consumers

25
Supply

• Quantity supplied the amount of a good that
  sellers are willing and able to sell.
• Law of supply the quantity supplied of a good
  will rise when the price of the good rises,
  ceteris paribus.
• See Table 2-2

26
The Supply Curve

• Changes in quantity supplied
• Quantity supplied changes in response to a change
  in the price of the good.
• This is illustrated by a movement along the
  supply curve
• Changes in supply
• Supply changes in response to a change in any
  other factor besides price.
• This is illustrated by a shifting of the supply
  curve.
• See Figures 2-3 and 2-4

27
What Determines Supply(in addition to the price
of the good)?

• The cost of production
• The price of goods related in production.
• Sellers expectations.
• Number of sellers.

28
Equilibrium

• Equilibrium Price the price at which the
  sellers of a product wish to sell exactly the
  same amount as the consumers wish to buy.
• Equilibrium quantity the quantity of the
  product that is actually exchanged at the
  equilibrium price.

29
Surplus and Shortage

• Surplus a situation in which quantity supplied
  is greater than quantity demanded.
• Shortage a situation in which quantity demanded
  is greater than quantity supplied.

30
The process of reaching equilibrium

• What if quantity supplied exceeded quantity
  demanded?
• Inventories of producers would accumulate. To
  eliminate excess inventory producers will reduce
  both prices and quantity supplied. This process
  will continue until quantity supplied equals
  quantity demanded.

31
The process of reaching equilibrium, continued

• What if quantity demanded exceeded quantity
  supplied?
• Firms are now able to increase prices without
  losing sales. Consequently prices will rise,
  which will lead a certain number of buyers to
  exit the market. This process continues until
  quantity supplied again equals quantity demanded.

32
Resource AllocationCommand vs. Market

• A market system, assuming competition, can
  achieve Adam Smiths Three Basic Laws without
  government intervention.
• Figure 2-6
• In a command economy, the economic planners must
  simulate the behavior of the market.
• As Hayek noted, the limitations of the human mind
  made such an objective difficult to achieve.
• Figure 2-7, Table 2-3

33
The Problems of Transition

• The pattern High inflation, declining output.
  Why?
• Legal Systems
• The cornerstone of capitalism is private
  property.
• If private property is not defended by law, then
  capitalism will not work.
• Increasing government debt.
• As revenue from government industry declines, how
  can the government pay for the many promised
  services.
• Borrowing and printing money.