© 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 2: The Economic Organization of...

Chapter 2:The Economic Organization of SocietyPrepared by:Kevin Richter, Douglas CollegeCharlene Richter, British Columbia Institute of Technology

Introduction

An economic system has to solve three coordination problems:

What, and how much, to produce.

How to produce it.

For whom to produce it.

Introduction

Every economy faces the problem of how to make individuals do what society wants them to do.

Introduction Sometimes the goals of society and

individuals conflict.

An example is the NIMBY (Not In My Back Yard) phenomenon.

NIMBY is a mindset in which individuals approve of a project so long as it is placed somewhere else.

Introduction An economic system must provide the

incentives to do those things that alleviate scarcity—produce more and consume less.

Introduction The two main economic systems of the past

50 years, capitalism and socialism, answer these immense coordination problems differently.

Capitalism (Market Economy) Capitalism is an economic system based

upon private property and the market in which, in principle, individuals decide how, what, and for whom to produce.

Under Capitalism:

Individuals are encouraged to follow their own self-interest, while market forces of supply and demand are relied upon to coordinate those individual pursuits.

Distribution of goods is to each according to his or her ability, effort, or inherited property.

Under Capitalism:

Government must allocate and defend private property rights.

Private property rights – the control a private individual or firm has over an asset or a right.

Reliance on the Market

Markets work through a system of rewards and payments.

In capitalism individuals are encouraged to follow their own self-interest.

Reliance on the Market

Prices coordinate individuals' wants.

If there is not enough of something, its price goes up.

If there is too much, price goes down.

What’s Good About the Market? Most economists believe the market is a

good way to coordinate individuals' needs.

The market is, however, not fair nor is it always efficient.

What’s Good About the Market? The primary debate among economists is

about how markets should be structured, and whether they should be modified and adjusted by government regulation.

Command Economy

Command economy is an economic system that places the ownership of private property in the hand of the state and coordinate all production planning with a central authority.

More often than not, command economy cannot achieve the right allocation of resources.

Mixed Economy

Mixed economy is an economic system that seeks to maximize the welfare of its citizens, while also allowing for the portion of the economy to achieve proper allocation of resources.

It’s a blend of a market and a command economy.

Production Possibilities Model The production possibilities curve shows the

trade-offs among choices we make.

Production Possibility Table

A production possibility table lists the combinations of outputs (products) that can be obtained from a given number of inputs (resources).

Production Possibility Table

Output – an output is simply a result of an activity.

Input – an input is what you what you put into a production process to achieve an output.

Production Possibility Curve

A production possibility curve shows the maximum combination of outputs that can be achieved from a given number of inputs.

It slopes downward from left to right.

58 66 78 94 98History grade

20 hours of history

0 hours of economics

20 hours of economics 0 hours of historyA

Hours of study in history

Grade inhistory

Hours of study in economics

Grade ineconomics

14 13 12 11

10 9 8 7 6 5 4 3 2 1 0

98 96 94 92 90 88 86 84 82 80 78 76 74 72 70 68 66 64 62 60 58

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

40 43 46 49 52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97

The production possibility curve not only represents the opportunity cost concept, it also measures the opportunity cost.

The production possibility curve demonstrates that: There is a limit to what you can achieve, given the

existing institutions, resources, and technology. Every choice made has an opportunity cost—you

can get more of something only by giving up something else.

Increasing Marginal Opportunity Cost The production possibility curve is generally

bowed outward since some resources are better suited for the production of some goods.

Increasing Marginal Opportunity Cost

6543210

X1 2 3 4 5 6 7 8 9

If the slope of the production curve is -2 at A, the

opportunity cost of 1X is 2Y.

Increasing Marginal Opportunity Cost Comparative advantage explains why

opportunity costs increase as the consumption of a good increases.

Some resources are better suited for the production of some goods than to the production of other goods.

Production Possibilities Table

% of resources devoted toproduction of burgers

Number of burgers

% of resources devoted toproduction of DVD’s

Numbers of DVD’s Row

0 20 40 60 80

0 4 7 9 11 12

100 80 60 40 20 0

15 14 12 9 5 0

A B C D E F

Production Possibilities Curve

Burgers4 7 90

Increasing Marginal Opportunity Cost The principle of increasing marginal

opportunity cost states that opportunity costs increase the more you concentrate on an activity.

In order to get more of something, one must give up ever-increasing quantities of something else.

Increasing Marginal Opportunity Cost

Slope is flat at A. Low opportunity cost of

burgers.

Slope is steep at B. High opportunity cost of burgers.

Burgers

Efficiency

In production, we’d like to have productive efficiency – achieving as much output as possible from a given amount of inputs or resources.

Efficiency

Any point within the production possibility curve represents inefficiency.

Inefficiency – getting less output from inputs which, if devoted to some other activity, would produce more output.

Efficiency

Any point outside the production possibility curve represents something unattainable, given present resources and technology.

Efficiency and InefficiencyD

0 2 4 6 8 10

Burgers

BEfficientpoints

Inefficientpoint

Unattainable point, given available technology, resources and labour force

Shifts in the Production Possibility Curve Society can produce more output if:

Technology is improved. More resources are discovered. Economic institutions get better at fulfilling our

wants.

Shifts in the Production Possibility Curve More output is represented by an outward

shift in the production possibility curve.

Neutral Technological Change

B Burgers0

Shifts in the Production Possibility Curve

Biased Technological Change

Burgers

Distribution and Production Efficiency The production possibilities curve focuses on

productive efficiency and ignores distribution.

In our society, more is generally preferred to less and many policies have relatively small distributional effects.

Shifts in the Production Possibility Curve Test your understanding:

A meteor hits the world and destroys half the earth’s natural resources.

Nanotechnology is perfected that lowers the cost of manufactured goods.

Shifts in the Production Possibility Curve Test your understanding:

A new technology is discovered that doubles the speed at which all goods can be produced.

Global warming increases the cost of producing agricultural goods.

(a) (c) (d)(b)

Production Possibility Curve and Economic Systems The production possibility curve presents

choices in a timeless fashion but most choices are dependent on previous choices.

Production Possibility Curve and Economic Systems Sequential decisions can best be seen within

a framework of a decision tree—a visual description of sequential choices.

Production Possibility Curve and Economic Systems All decisions are made in context – what

makes sense in one context may not make sense in another.

Production Possibility Curve and Economic Systems Decisions are contextual.

What the production possibility curve for a particular decision looks like depends on existing institutions.

The analysis can be applied only in the institutional and historical context.

Production Possibility Curve and Tough Choices The production possibility curve represents

tough choices.

Production Possibility Curve and Tough Choices Politicians make promises as though the

production possibility curve did not exist or that the economy can operate outside the economy's production possibility curve.

Production Possibility Curve and Tough Choices Economists continually point out that

seemingly free lunches often involve significant costs thus earning for themselves the nickname, the dismal science.

Comparative Advantage, Specialization, and Trade

The production possibility curve is bowed because individuals specialize in the production of goods for which they have a comparative advantage and trade with others.

Comparative Advantage, Specialization, and Trade The comparative advantage argument used

to explain the bowed-out shape of the production possibilities curve can be used to show how trade makes society better off.

Comparative Advantage, Specialization, and Trade Collaboration and specialization can make

society better off.

Total production can rise.

Comparative Advantage, Specialization, and Trade The outward bow graphically represents the

potential gains from trade.

Gains From Trade

Sunder can either write one economics paper or four creative writing papers in a day.

Ti can either write one creative writing paper or four economics papers in a day.

Gains From Trade

Sunder has a comparative advantage in creating writing and Ti has a comparative advantage in economics.

Gains From Trade

The following table and production possibility curves demonstrate how output increases when two individuals collaborate and specialize in the activity for which each has a comparative advantage.

Gains From Trade

Each individual's PPC is drawn by connecting the number of papers each can write in a day on a graph.

Gains From TradeE

1 2 3 4 5

(b) Sunder

(a) Ti

Creative writing

Gains From Trade

The combined PPC curve is drawn by finding three points and connecting them.

Gains From TradeE

1 2 3 4 5

(c) Combined with trade

(b) Sunder

(a) Ti

Creative writing

Gains From Trade

Point A: This is the combined number of economics papers they both can write in a day.

If economics papers are on the Y axis, it is

point 0,5.

Gains From Trade

Point B: This is the combined number of creative papers they both can write in a day.

If economics papers are on the Y axis, it is point 5,0.

Gains From Trade

Point C: This is where each is focusing on that activity for which he or she has a comparative advantage.

Sunder writes four creative papers and Ti writes four economics papers.

This is the coordinate 4,4.

Gains From Trade

The combined PPC is bowed out because of comparative advantage and specialization.

Division of Labour

Markets allow specialization and the division of labour.

They allow individuals to develop their comparative advantages, thereby increasing the production possibilities of society.

Markets, Specialization, and Growth Markets and specialization have led to

growth.

Markets, Specialization, and Growth The growth in per capita income (constant

1990 dollars) in the past 2 millennia has been astonishing.

This owes largely to the introduction of markets and democracy.

Markets, Specialization, and Growth As people are allowed to compete and

specialize, they get better at what they do, develop new technologies and the market grows ever larger.

Growth in the Past Two Millennia

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$6,000

$5,000

$4,000

$3,000

$2,000

$1,000

2000150010005000

The Economic Organization Of Society

End of Chapter 2

The History of Economic Systems

Chapter 2 Appendix

Evolving Economic Systems

Capitalism and socialism have not existed forever.

Capitalism came into widespread existence in the mid-1700s; socialism came into existence in the early 1900s.

Before capitalism and socialism other forms of economic systems existed:

Feudalism dominated the Western world from about the 8th to the 15th century.

This owes largely to the introduction of markets and democracy.

Evolving Economic Systems Feudalism gave way to mercantilism.

Mercantilism is an economic system in which government determines the what, how, and for whom decisions by doling out the rights to undertake certain economic activities.

Evolving Economic Systems Mercantilism remained the dominant

economic system until the Industrial Revolution.

Industrial revolution – a time when technology and machines rapidly modernized industrial production and mass produced goods replaced handmade goods.

Capitalism evolved from the Industrial Revolution in 1700s.

Industrial revolution led to a decrease in power of small producers and increase in power of capitalists.

The Need for Coordination in an Economic System Every economic system needs coordination.

In his 1776 classic, Wealth of Nations, Adam Smith argued that markets could coordinate the economy without the active involvement of government.

The Need for Coordination in an Economic System Markets coordinate economic activity by

using the price mechanism to direct individuals' self-interest into society's interest.

The Need for Coordination in an Economic System Markets coordinate economic activity by

using the price mechanism to direct individuals' self-interest into society's interest.

Evolutionary Changes Within Systems Both capitalism and socialism are constantly

evolving with changes in social customs, political forces, and the strength of markets.

Evolutionary Changes Within Systems Capitalism evolved into welfare capitalism—

an economic system in which the market operates but government regulates markets significantly.

Evolutionary Changes Within Systems The opposite took place in some socialist

nations in the 1980s—socialism integrated capitalist institutions into its existing institutions.

In the 1990s, most of the former socialist countries have undergone transition to market oriented economies based on private property.

Blurring of the Distinction Between Capitalism and Socialism Recent events point to a blending of

economic systems.

If this trend continues, the 21st century will see the emergence of a single general type of economic structure; it will be a mix of socialist and capitalist institutions.

Feudal Society: Rule of Tradition Feudalism developed in the 8th and 9th

century.

The Lord of the manor was the protector; serfs were working the land.

Feudalism was a tradition based society.

From Feudalism to Mercantilism Mercantilism emerged with the development

of trade and markets in the 15th century.

The power of the society shifted from manors to towns.

From Feudalism to Mercantilism In mercantilism, traders supported the king,

who in turn protected their interests.

The role of government increased during this period.

From Mercantilism to Capitalism Industrialists or capitalists were the business

people who acquired large amounts of money and used it to invest in business.

Craft guild members were artists in their own crafts.

From Mercantilism to Capitalism The economic power base shifted from the

guilds to industrialists.

Coordination of the economy by government was deemed necessary by the craftsmen.

Industrialists considered the market capable of coordination on its own – no government was needed.

From Mercantilism to Capitalism Laissez-faire policy is an economic policy of

leaving coordination of individuals’ wants to be controlled by the market.

Adam Smith’s invisible hand supported the industrialists’ view.

Industrial Revolution

The invisible hand worked; capitalism thrived.

Machine production began to increase enormously in the late 18th century, almost totally replacing hand production.

This phenomenon has been termed the Industrial Revolution.

Industrial Revolution

Eventually, modern economic institutions replaced guilds.

Modern capitalism evolved by the 19th century.

From Capitalism to Socialism

Capitalism was marked by significant economic growth but also by human abuses of the working class who were producing for the elite few.

This led to criticism of the capitalist market economic system.

The best known critic of capitalism was Karl Marx, a German philosopher, economist and sociologist.

Marx developed an analysis of the dynamics of change in economic systems, in the 19th century.

Marx saw an economy marked by tensions between economic classes

The proletariat class – the working class and The capitalist class (businessmen)

The capitalist class made profits by exploiting the working class.

Marx believed that this exploitation would lead to revolt by the proletariat who would overthrow the capitalists.

From Feudalism to Socialism

Contrary to Marx’ predictions, capitalism did not evolve into socialism.

Marx’ socialist ideas took root in feudalist Russia instead.

State socialism was created – a system based on central planning and command.

From Capitalism to Welfare Capitalism? However, evolutionary changes brought

about regulation to protect the working class.

Economic safety net was developed in capitalist economies. Examples are

Public welfare Unemployment insurance

From Feudalism to Socialism

Contrary to Marx’ predictions, capitalism did not evolve into socialism.

Marx’ socialist ideas took root in feudalist Russia instead.

State socialism was created – a system based on central planning and command.

Economic Transition

In the 1990s most Eastern European socialist economies started a path of transition to a market-based economic system.

The History of Economic Systems

End of Chapter 2 Appendix

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