Chapter Two Economic 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)

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.

A Sample of Economic Systems

1. 2. 3. 4. 5.

Feudalism Mercantilism Capitalism Socialism (Command Economy) Mixed Capitalism

Feudalism

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

Key Features of Feudalism

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

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

The Rise of Mercantilism

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

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

A Philosophical Turn
1.

2.

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.

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.

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

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

Pure Command Economy

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

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

1.

2.

3.

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.

More on Marx
1.

2.

3.

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

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

Understanding Market Forces A Brief Review of the History of Economic Thought

The Labor Theory of Value Utility Theory The Marshallian Cross

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.

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.

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.

Supply and Demand

1. Demand 2. Supply 3. Equilibrium

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

The Demand Curve

1.

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

2.

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.

3.

See Figures 2-1 and 2-2

What Determines Demand

(in addition to the price of the good)?
1.

2.

3.
4. 5.

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

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

The Supply Curve

1.

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

2.

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.

3.

See Figures 2-3 and 2-4

What Determines Supply

(in addition to the price of the good)?
1. 2.

3. 4.

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

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.

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.

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.

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.

Resource Allocation Command 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

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.