The Mixed Economy

Chapter 03

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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Learning Objectives After this chapter you should be able to:

1. List and explain the three questions of economics.

2. Explain the concepts of the profit motive, the price mechanism, competition, & capital.

3. Analyze the circular flow model.

4. Describe and illustrate market failure and externalities.

5. Describe and explain government failure.

6. Discuss the economic role of capital and its importance.

7. Define and describe the “isms”: capitalism, fascism, communism, and socialism.

8. Summarize and explain the decline and fall of the communist system.

9. Discuss the economic transformation of China.

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The Three Questions of Economics

Because scarcity is the central economic problem, an economy cannot produce everything for everybody.

Every economic system therefore must provide mechanisms to answer these 3 questions:

• What shall we produce?• How shall these goods be produced?• For whom shall these goods be produced?

These are questions about how to allocate scarce resources.

• The first two questions involve production.• The third question is about distribution.

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How Capitalism Answers the 3 Economic Questions

What to produce?• The private sector is guided as if by an “invisible hand,” a

metaphor for the way markets operate. • Not central planning! Government does not decide (except

for public goods and services).

How to produce? • Competition among sellers leads to efficiency.

For whom?• Most goods and services are distributed based upon the

ability to pay.• Those who can afford, purchase the goods and services

that they value.

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What the U.S. Economy Produces Has Changed Over Time

These changes result primarily from a hodgepodge of corporateand government officials, as well as individual consumers and taxpayers.

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The Invisible Hand

Adam Smith coined this term.• The invisible hand is a metaphor for an economic guidance system

that leads to desirable economic outcomes. Desirable outcomes are defined as efficient production to

maximize production (on the Production Possibilities Curve). • The invisible hand is made possible by people pursuing their own

self-interest. Businesses pursue profits and consumers pursue satisfaction

of their wants.

The price mechanism guides the Invisible Hand. • Prices send signals to producers and consumers. • When consumers want a product, the price goes up, providing the

incentive to businesses to increase production.

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Competition Competition forces business firms to be as efficient

as possible so they can charge the lowest possible prices. This process answers the question, “How to

produce?” To have real competition, you need many firms in a

particular industry.• You need enough so that no one firm is large enough to have

any influence over price.

When sectors of American industry are not very competitive the price system doesn’t work well.

• The invisible hand becomes less active and more ineffective.• The forces of supply and demand are distorted.

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The U.S. is a Mixed Economy

The United States of America:• Has an imperfectly functioning price system.• It functions in a less than competitive economy.• It is guided by a not too vigorous invisible hand.

Rather than a pure form of capitalism, we use government as well as markets to allocate resources.

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Trust

Capitalism is based on trust. • Lenders expect borrowers to pay back loans.• Buyers and sellers expect contracts to be honored.• Workers expect to be paid by employers.

If we do not trust that these agreements will be honored, the economy will not function.

Self-interest can lead economic actors to behave in a trustworthy manner, so they can continue to do business.

But the legal system reinforces trust by providing consequences for dishonest behavior.

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Equity & Efficiency

Markets can be efficient, without seeming “fair.”• Threat of poverty provides incentives to work hard, leading to

efficiency.• But poverty is due to chance – the initial endowment of resources

you are given at birth – as well as effort.• Too much inequality can be a disincentive to hard work too.

Efficiency can be balanced by equity. Possible solutions?• Should we tax those with higher incomes and redistribute to the

needy? How much and who do we tax? • Should we allocate some goods and services regardless of the

ability to pay? Examples include public schools, public housing, & food stamps.

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Questions for Thought and Discussion Does it make sense that self-interest is enough to

create a well-functioning system? • What rules need to be in place to allow the Invisible Hand to

work its magic?

How were the 3 economic questions answered by hunter-gatherer societies?

Can you think of goods or services that are not allocated according to our ability to pay? What is the reasoning behind these alternative allocation mechanism?

• Why aren’t organs for transplant sold to the highest bidder?

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Modeling a Market Economy without Government: Circular Flow Diagram

Resources are owned by households, who sell them to businessfirms for wages & salaries, rent, interest, and profits.

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The Flow of Goods & Services

Businesses use these resources to produce goods and servicesthat they sell back to households. Households use the income they received from selling their resources.

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The Circular Flow Model

The model has two flows: (1) a flow of money and (2) a flow of resources, goods, and services.

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Economic Role of Government

Government is made up of• Federal government• Fifty state governments• Tens of thousands of local governments

Each level of government • Collects taxes.• Provides services.• Make laws and regulations.

Government alters the outcome of the three questions:• What? How? and For Whom?

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Economic Role of Government (Continued) A mixed market system needs government in order

to function effectively. The government should:

• Protect property rights. Without property rights, the rest will not matter much.

• Provide the infrastructure for a market to function efficiently.

• Ensure that competition flourishes.• See that information flows freely.• Minimize unpleasant side effects of economic activity such

as pollution.

The appropriate size and functions of government depends largely on how well private enterprise does the job of efficiently allocating resources.

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Market Failure

Market failure is when our resources are not allocated efficiently by the private sector using the price mechanism.

• The profit incentives in private markets may yield too many socially undesirable outcomes (oil spills)

• The profit incentives in private markets may yield too few socially desirable outcomes (education).

Types of market failure include: • Externalities and Environmental pollution.• Lack of public goods and services

Another cause of market failure is “monopolies” where large firms crowd out competition.

Government intervenes when markets fail.

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Negative Externalities Negative externalities are external costs.

• “External” means affecting a third party who is not the buyer or the seller.

• Example: You may satisfy your individual want by driving an

inefficient vehicle that pollutes. The seller has a profit motive to sell you the car you

want. The price you pay for the vehicle and gas will cover the

costs of production for the seller and a profit, but not the costs of pollution on other peoples’ health and well-being.

The market price is lower than the true social cost.

Government can discourage negative externalities by taxing them or passing regulations that limit them.

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Two Approaches to Environmental Regulations

Command-and-control regulations: • Government limits market participants choices.

Fuel economy standards for new cars Ban on leaded gasoline

Incentive-based regulations• Government influences market participants choices by making

some options more costly. Taxes on gasoline Emissions rights trading

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Positive Externalities

Positive Externalities are external benefits. Example:

• If you pay someone to paint your house or shovel snow from your sidewalk, your neighbors will benefit.

• If you do not paint your house, it will lower your neighbors’ property values.

• The social value of painting your house may be greater than what you are willing to pay.

Government can encourage positive externalities by subsidizing them or through regulations.

• Local governments may have regulations requiring you to maintain your property and/or sidewalk.

• The federal government subsidizes student loans because society benefits from more college graduates.

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Public Goods and Services

Public goods and services are supplied by government because entrepreneurs could not make a profit by selling them.

Characteristics of public goods and services: • NonexcludableNonexcludable: once it exists, everyone can freely benefit from it.

There is no way to exclude anyone from consuming the goods even if she/he did not pay for them.

Tend to be indivisible or come in large units that cannot be broken into pieces for purchase or sale in the private market

• Non-rivalrousNon-rivalrous: one person’s benefiting does not reduce the amount of it available for others.

Private goods are consumed by an individual. • My ice cream cone cannot be eaten by anyone else!

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Examples of Public Goods and Services1. National defense

2. Court system

3. Police and fire protection

4. Construction and maintenance of infrastructure including streets, highways, bridges, and water and sewer mains

5. Environmental protection

6. Public parks

7. Public schools

8. Public libraries

A public bus is not a public good: • Individuals can be excluded if they do not pay.• Government provides public transportation because it has

positive externalities.

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Government Failure Government can also fail to allocate resources

efficiently and to meet desirable social goals. • Sometimes government is slow and bureaucratic or its

programs continue even when not meeting objectives.

Some examples: • The complex and confusing income tax code creates

inefficient need for professional tax preparers and others to process forms.

• The agriculture price support system was intended to save family farms but most payments go to huge corporate farms.

• The Army Corps of Engineers ignored problems with the New Orleans levees and, when Hurricane Katrina hit, the rescue and recovery efforts were slow and halting.

• Despite a “War on Poverty” since the 1960s and reform in 1996, 39 million Americans, mostly children, are in poverty.

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Questions for Thought and Discussion Give an example of when government might be involved in

answering each of the 3 economic questions: 1. What to produce? 2. How to produce? 3. For whom?

If a factory is polluting and producing its product cheaply, who are the third parties affected by this externality and how are they affected? How might the government approach this problem?

If people are under-purchasing higher education, who are the third parties affected by this positive externality and how are they affected? How might the government approach this problem?

What kinds of regulations affect the market for cigarettes? Why does government regulate this market?

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Capital Capital is the CRUCIALCRUCIAL element in every economic

system.• Remember: capital consist of plant, equipment, & software.

Capital is the key to economic development and raising a country’s standard of living.

• Countries who invest in capital have higher rates of economic growth.

• Capital increases productivity. • Example: U.S. farmer produces 10 – 20 times as much

output as a Nigerian farmer because of the use of tractors, harvesters, and reapers.

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Where does capital come from?

Capital comes from:• Cutting consumption, or • Increasing production.

Examples: • In industrializing Europe, the low wages and barbaric conditions

for factory workers enabled factory owners to invest in better capital.

• In Soviet Union, communist government invested in capital and there were few consumer goods available for purchase.

• After World War II, Japan and Western Europe focused on capital investments rather than consumption.

• But it is difficult for many contemporary developing countries to cut consumption or increase production because people are living at subsistence.

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The “Isms” Capitalism

• There is private ownership of most means of production.• The profit motive moves individuals to produce.• The price system guides production.• The government’s role is kept to a minimum.

Most capitalist countries are political democracies, but the two systems do not always co-exist.

• “The vice of capitalism is that it stands for the unequal sharing of blessings; whereas the virtue of socialism is that it stands for the equal sharing of misery.”

—Winston Churchill

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The “Isms”

Communism:• There is no private property.• At first, the state owns everything. Government planning committees

dictate: What is produced. How it is produced. For whom it is produced.

• Prices no longer send signals about what consumers want. • Eventually, the state would “wither” away and workers would make

economic decisions collectively.

• “The theory of the Communists may be summed up in the single sentence: Abolition of private property.”

Karl Marx & Friedrich Engels

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The “Isms”

Fascism• Also called corporatism because corporate and state power

are merged. • There is private ownership of the means of production, but

strong role for government planning. • Government power is centralized. • Fascism was characterized by a one-party state, militarism,

suppression of economic freedom, and intolerance of political opposition.

Fascists have been virulently anti-communist.

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The “Isms”

Socialism• There is government ownership of some means of production but

most are privately owned. • There is a substantial degree of government planning and

provision of public goods and services. Con: High taxes. Pro: Promises cradle to grave security to protect citizens

from fluctuations of market economies.

Some European countries are democratic socialist systems.

• Soviet Union was sometimes called state socialist instead of communist.

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Internet Joke

Socialism• You have two cows; the state takes one and gives it to

someone else.

Communism• You have two cows; the state takes both of them and gives

you milk.

Fascism• You have two cows; the state takes both of them and sells

you milk.

Capitalism• You have two cows; you sell one and buy a bull.

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Transformation in China

1949–1979• The Chinese economy was dominated by Soviet style central planning.

1979–1984• The government shifted the responsibility of operating huge collective

farms from government bureaucrats to the families that lived on the farms.

The families could lease the land for 15 years. Output above the government quota could be sold. Output jumped 60%.

Late 1970s–early 1980s• Reform began in the industrial sector.

State firms were allowed to sell any surplus output. Family-run enterprises were allowed

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Transformation in China (Continued)

China has become a world-class industrial power. • Exports rose from $5 billion in 1978 to more than $200 billion in

2000.• Up to $1.2 trillion in 2007. • In 2009, China had $227 export surplus to the U.S. • But over 2/3 of its population still lives in rural areas. The standard

of living is still poor. Old communist credo

• “From each according to his ability, to each according to his needs.” New Credo

• “More pay for more work; less pay for less work.” China is basically a capitalist economy with a strong state.

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Questions for Thought and Discussion

How does capital explain productivity differences between countries?

Contrast Marx’s view of the exploitative capitalist with the mainstream economic view of the economic role of the entrepreneur.

What does “the bridge to nowhere” project tell us about the efficient allocation of scarce resources? Is it an example of market failure or government failure?