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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)

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A Brief Economic History Lesson

Every society faces the following threequestions.

What is to be produced?

How will it be produced?

For whom will it be produced?

A societys economic system is utilized toanswer these questions.

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A Sample of Economic Systems

1. Feudalism

2. Mercantilism

3. Capitalism

4. Socialism (Command Economy)

5. Mixed Capitalism

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Feudalism

An economic system where thethree basic questions areanswered according to tradition.

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Key Features of Feudalism

1. Communities tend to be self-

sufficient.

2. The primary factors of productionare labor and land.

3. Community is more important than

the individual.

4. Economic growth is typically zero.

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Mercantilism

An economic system in which the

government determines the allocation of

resources by assigning the rights to

certain economic activities.

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The Rise of Mercantilism

1. The merchant is an anomaly in pre-capitalistsocieties. Merchants are focused on the individual,because they owe no allegiance to a community.

2. As the wealth of merchants increase so does theirpolitical power.

3. What do merchants want? Political unity andMonopoly power.

4. Society wants what the merchants offer, but do nottrust the motives of traders.

5. The system of mercantilism gives society the ability toregulate the merchants and gives the merchants themonopoly power they desire.

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Capitalism

An economic system based uponprivate property and the market inwhich, in principle, individualsanswer the basic questions of theeconomic system.

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A Philosophical Turn

1. 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.

2. Capitalism arose slowly as the benefits of

greater individual freedom overcamesocieties skepticism of individual action.

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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 erodeover time.

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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

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Socialism

An economic system where thethree economic questions areprimarily addressed bygovernment action, notunregulated market forces.

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Pure Command Economy

An economy system

characterized by state

ownership of resources andcentralized decision-making.

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The Labor Theory of Value and

Karl Marx (1818-1883)

1. The Labor Theory of ValueThe price of agood is determined by the cost of production,and the cost of production is dictated by thequantity of labor utilized.

2. The Labor Theory of Value can be found in thewritings of Adam Smith and David Ricardo(1772-1823).

3. If labor is the sole producer of value, Marxreasoned, then capitalism must result in theexploitation of labor.

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More on Marx

1. For Marx, the fundamental conflict in

capitalism is between labor and capital.

2. Marx believed that workers were

exploited by the owners of capital.

Capitalism will end when workers own

the means of production.

3. How will workers acquire the means of

production? Evolution vs. Revolution

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Mixed Capitalism

An economic system where the

three economic questions are

addressed by a mixture ofmarket forces and government

action.

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Understanding Market Forces

A Brief Review of the History of

Economic Thought

The Labor Theory of Value

Utility Theory

The Marshallian Cross

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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.

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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 ofutility, or the satisfaction people derive from the

consumption of goods and services.

For these authors, prices changed in response to

changes in consumer demand.

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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 demanddictates the price.

In the long-run, where firms have time to enter and exitthe industry, the price of the good will be determined bythe cost of production.

In the short run, firms can alter supply in response to pricechanges. Therefore both supply and demand willdetermine prices. Hence we have the Marshallian Cross,or what we call today the basic model of supply anddemand.

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Supply and Demand

1. Demand

2. Supply

3. Equilibrium

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DEMAND

Quantity demandedthe amount of a good

that buyers are willing and able to

purchase.

Law of Demandthe quantity demanded of

a good will fall when price of the good rises,

ceteris paribus.

Ceteris ParibusAll else is equal

See Table 2-1

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The Demand Curve1. 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 demandcurve

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

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

1. Income of the consumer

Normal vs. inferior

2. Prices of goods related in consumption.

Substitutes vs. Complements3. Tastes and preferences

4. Expectations

5. The number of consumers

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Supply

Quantity suppliedthe amount of a

good that sellers are willing and able

to sell. Law of supplythe quantity supplied

of a good will rise when the price of

the good rises, ceteris paribus. See Table 2-2

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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 supplycurve

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

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

1. The cost of production

2. The price of goods related in

production.

3. Sellers expectations.

4. Number of sellers.

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Equilibrium

Equilibrium Pricethe price at which

the sellers of a product wish to sell

exactly the same amount as the

consumers wish to buy.

Equilibrium quantitythe quantity of

the product that is actually exchanged at

the equilibrium price.

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Surplus and Shortage

Surplusa situation in whichquantity supplied is greater

than quantity demanded.Shortagea situation in which

quantity demanded is greaterthan quantity supplied.

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The process of reaching

equilibriumWhat if quantity supplied exceeded quantity

demanded?

Inventories of producers would accumulate.To eliminate excess inventory producerswill reduce both prices and quantity

supplied. This process will continue untilquantity supplied equals quantitydemanded.

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The process of reaching

equilibrium, continued

What if quantity demanded exceededquantity supplied?

Firms are now able to increase priceswithout losing sales. Consequently priceswill rise, which will lead a certain

number of buyers to exit the market.This process continues until quantitysupplied again equals quantitydemanded.

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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 humanmind made such an objective difficult to achieve.

Figure 2-7, Table 2-3

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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, howcan the government pay for the many promisedservices.

Borrowing and printing money.