Economic Economic SystemsSystems

Chapter 3Chapter 3

Why are economic Why are economic systems needed?systems needed?

Rules of the Rules of the game!game!

Standard Standard incentivesincentives

Understanding of Understanding of the rewardsthe rewards

Economic Systems can Economic Systems can allow for _____allow for _____

A. SpecializationA. Specialization B. Comparative / B. Comparative /

Absolute Absolute advantageadvantage

Adam SmithAdam Smith

THE WEALTH OF THE WEALTH OF NATIONS (1776)NATIONS (1776) ““bible” of bible” of

CapitalismCapitalism Let the people Let the people

decide the 3 basic decide the 3 basic economic economic questionsquestions

Profit and PSYCHIC Profit and PSYCHIC INCOME will make INCOME will make us work.us work.

SpecializationSpecialization

Adam Smith’s PIN Adam Smith’s PIN EXAMPLE:EXAMPLE: Specialization Specialization

leads to increased leads to increased productionproduction

Specialization Specialization leads to the need leads to the need to trade.to trade.

Specialization leads to Specialization leads to COMPARATIVE COMPARATIVE ADVANTAGEADVANTAGE

"If a foreign country "If a foreign country can supply us with a can supply us with a commodity cheaper commodity cheaper than we ourselves can than we ourselves can make it, better buy it make it, better buy it of them with some part of them with some part of the produce of our of the produce of our own industry, own industry, employed in a way in employed in a way in which we have some which we have some advantage. " (Book IV, advantage. " (Book IV, Section ii, 12) Section ii, 12)

Definition: Absolute Definition: Absolute AdvantageAdvantage

A country has an A country has an absolute advantage absolute advantage over it trading over it trading partners if it is able partners if it is able to produce more of a to produce more of a good or service with good or service with the same amount of the same amount of resources or the resources or the same amount of a same amount of a good or service with good or service with fewer resources.fewer resources.

Absolute AdvantageAbsolute Advantage

Orlando has Orlando has absolute absolute advantage over advantage over Lincoln in citrus Lincoln in citrus production.production.

Zambia has Zambia has absolute absolute advantage over advantage over the US in copper the US in copper production.production.

David Ricardo: David Ricardo: Comparative AdvantageComparative Advantage

A country has a A country has a comparative comparative advantageadvantage in the in the production of a production of a good or service good or service that it produces that it produces at a lower at a lower opportunity cost opportunity cost than its trading than its trading partners. partners.

Ricardo: The tricky road of Ricardo: The tricky road of comparative / absolute comparative / absolute advantageadvantage

Some countries Some countries have an absolute have an absolute advantage in the advantage in the production of production of many goods many goods relative to their relative to their trading partners. trading partners.

Ricardo: The tricky road of Ricardo: The tricky road of comparative / absolute comparative / absolute advantageadvantage

Some have an Some have an absolute absolute disadvantage. disadvantage. They are They are inefficient in inefficient in producing producing anything, relative anything, relative to their trading to their trading partnerspartners

RICARDO’S … BUT …RICARDO’S … BUT …

it is better for a it is better for a country that is country that is inefficient at inefficient at producing a good or producing a good or service to specialize service to specialize in the production of in the production of that good it is least that good it is least inefficient at, inefficient at, compared with compared with producing other producing other goods.goods.

HUH?????HUH?????

Country A has an Country A has an absolute absolute advantage in the advantage in the production of production of both maize and both maize and wheat. wheat.

HUH???HUH???

Country B has an Country B has an absolute absolute disadvantage.disadvantage.

HUH??HUH??

Due to abundance of Due to abundance of raw materials or raw materials or more productively more productively efficient production efficient production techniques, Country techniques, Country A is able to produce A is able to produce more wheat and more wheat and more maize that more maize that Country B. Country B.

HUH????HUH????

Perhaps common Perhaps common sense tells us that sense tells us that Country A should Country A should produce both produce both goods and export goods and export surpluses and surpluses and Country B neither.Country B neither.

BUTBUT

However, when However, when comparative comparative advantage is advantage is considered a considered a different story different story emerges.emerges.

CONSIDER THIS:CONSIDER THIS:

Consider the Consider the opportunity cost opportunity cost of Country A of Country A producing one producing one more unit of more unit of maize. Half a unit maize. Half a unit of wheat has of wheat has been foregone. been foregone.

CONSIDER THIS:CONSIDER THIS:

When country B When country B produces one produces one more unit of more unit of maize two units of maize two units of wheat are wheat are foregone. foregone.

REMEMBER:REMEMBER:

Economics is Economics is concerned with concerned with the allocation of the allocation of scarce resources. scarce resources.

If we assume that is true, If we assume that is true, THEN ….THEN ….

Fewer resources Fewer resources are foregone if are foregone if Country A Country A concentrates its concentrates its resources in the resources in the production of production of maizemaize

Now consider …Now consider …

the opportunity the opportunity cost of Country B cost of Country B producing one producing one more unit of more unit of wheat. Two units wheat. Two units of maize have of maize have been foregone. been foregone.

Now consider …Now consider …

When Country B When Country B produces one produces one more unit of more unit of wheat only half a wheat only half a unit of maize is unit of maize is foregone. foregone.

So if that is true ….So if that is true ….

Fewer resources Fewer resources are foregone if are foregone if Country B Country B specializes in the specializes in the production of production of wheatwheat

CONCLUSION OF CONCLUSION OF COMPARATIVE COMPARATIVE ADVANTAGEADVANTAGE

In the above case In the above case Country A should Country A should produce maize produce maize and Country B and Country B wheat. The wheat. The surpluses produce surpluses produce should then be should then be traded.traded.

Comparative Advantage Comparative Advantage createscreates

A. HeadachesA. Headaches B. B.

InterdependenceInterdependence C. Coordination C. Coordination

problemsproblems D. Only B and CD. Only B and C

InterdependenceInterdependence

Makes producers Makes producers dependent on dependent on others for the others for the goods they don’t goods they don’t produce.produce.

Creates PEACECreates PEACE

BUT: Interdependence can BUT: Interdependence can create coordination create coordination problemsproblems

Specialization Specialization causes causes interdependence.interdependence.

Interdependence Interdependence requires an requires an economic system economic system to coordinate to coordinate everyone’s everyone’s various activities.various activities.

BUT: Interdependence can BUT: Interdependence can create coordination create coordination problemsproblems

As specialization As specialization and and interdependence interdependence increase, so does increase, so does the complexity of the complexity of coordinating all of coordinating all of the specialized the specialized activities of buyers activities of buyers and sellers.and sellers.

Consider:Consider:

What countries What countries does the US / does the US / Europe have Europe have “troubles” with?“troubles” with?

How much trade How much trade do we have with do we have with these countries?these countries? North KoreaNorth Korea IranIran Middle EastMiddle East

What are the Principal What are the Principal Types of Economic Types of Economic Systems?Systems?

Market EconomiesMarket Economies Centrally Directed EconomiesCentrally Directed Economies Traditional EconomiesTraditional Economies Mixed EconomiesMixed Economies

Market EconomiesMarket Economies

Also calledAlso called CapitalismCapitalism Free EnterpriseFree Enterprise Private EnterprisePrivate Enterprise

Market Economies: Market Economies: Fundamental PrinciplesFundamental Principles

Private property Private property rightsrights

Right to freely Right to freely trade or sell trade or sell propertyproperty

Pursue self-Pursue self-interest. interest.

Centrally Directed Centrally Directed EconomiesEconomies

AKAAKA Command Command

EconomiesEconomies Marxist EconomiesMarxist Economies Communist Communist

EconomiesEconomies

Features of Central Features of Central PlanningPlanning

Decisions made Decisions made by central by central planning planning commissioncommission

Draws up Draws up “master” plan“master” plan

Government Government employs workersemploys workers

Features of Central Features of Central PlanningPlanning

Decides what, Decides what, how and for how and for whom to produce.whom to produce.

Determines how Determines how output is to be output is to be distributeddistributed

Features of Traditional Features of Traditional EconomiesEconomies

Relies on custom Relies on custom and tradition to and tradition to decide the 3 basic decide the 3 basic economic economic questions.questions.

Very strong in non-Very strong in non-industrialized industrialized countries.countries. India is India is notnot a great a great

example in 2005.example in 2005.

Mixed EconomiesMixed Economies

AKA: SocialismAKA: Socialism All economies are All economies are

mixtures of mixtures of government government control and control and individual individual motivation.motivation.

Mixed EcnomiesMixed Ecnomies

US: BASICALLY US: BASICALLY market economymarket economy SOME government SOME government

regulation and regulation and ownership.ownership.

Mixed EconomiesMixed Economies

China: In theory, China: In theory, centrally directedcentrally directed Some private Some private

ownership and ownership and salessales

BRIBES to the BRIBES to the govt. in China govt. in China make it possible make it possible for private for private enterprise to exist.enterprise to exist.

Mixed EconomiesMixed Economies

Former Soviet Former Soviet UnionUnion Economy in Economy in

transition.transition. Return of Return of

centralization???centralization??? But under But under

Communist control Communist control or the Mafia?or the Mafia?

How does a Market System How does a Market System resolve the 3 Basic Economic resolve the 3 Basic Economic questions?questions?

Markets:Markets: Some are highly Some are highly

organized.organized. Information for Information for

both seller and both seller and buyer:buyer:

Product featuresProduct features PricesPrices Wants and needsWants and needs Tastes and Tastes and

preferencespreferences

Incentives in Market Incentives in Market EconomyEconomy

$$$$$$$$$$$$$$$$$$$$$$$$$$ Psychic IncomePsychic Income

Incentives in a Market Incentives in a Market EconomyEconomy

Price changes Price changes give incentives to give incentives to change current change current productionproduction

2 Types of Markets2 Types of Markets

Product MarketProduct Market Factor MarketFactor Market

Product MarketProduct Market

Finished goods Finished goods and services and services exchanged in exchanged in product marketsproduct markets

Factor MarketsFactor Markets

Land, labor, Land, labor, capital resources capital resources exchanged in the exchanged in the factor markets.factor markets.

Circular Flow of the Circular Flow of the EconomyEconomy

Resource owners Resource owners provide land, provide land, labor, and capital labor, and capital to business firms.to business firms.

Business firms Business firms provide finished provide finished goods and goods and services to services to households.households.

Circular Flow of the Circular Flow of the EconomyEconomy

Firms pay Firms pay households for households for factors of factors of production.production. Rent for landRent for land Wages and Wages and

salaries for laborsalaries for labor Interest for Interest for

financial capitalfinancial capital

Circular Flow DiagramCircular Flow Diagram

Outer circle Outer circle shows flow of shows flow of “real” inputs and “real” inputs and outputs.outputs.

Circular Flow ModelCircular Flow Model

Inner circle shows Inner circle shows money payments money payments for imports and for imports and outputs.outputs.