Transcript Capital - McGraw Hill Higher Education

The Mixed Economy
Chapter 03
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives

After this chapter you should be able to:
1.
2.
3.
4.
5.
6.
7.
8.
9.
List and explain the three questions of economics.
Explain the concepts of the profit motive, the price
mechanism, competition, & capital.
Analyze the circular flow model.
Describe and illustrate market failure and externalities.
Describe and explain government failure.
Discuss the economic role of capital and its importance.
Define and describe the “isms”: capitalism, fascism,
communism, and socialism.
Summarize and explain the decline and fall of the
communist system.
Discuss the economic transformation of China.
3-2
The Three Questions of Economics
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
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:
•
•
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
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.
•
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The first two questions involve production.
The third question is about distribution.
3-3
How Capitalism Answers the 3 Economic
Questions

What to produce?
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How to produce?
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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).
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.
3-4
What the U.S. Economy Produces Has
Changed Over Time
These changes result primarily from a hodgepodge of corporate
and government officials, as well as individual consumers and
taxpayers.
3-5
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.
•
3-7
The U.S. is a Mixed Economy

The United States of America:
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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.
3-8
Trust

Capitalism is based on trust.
•
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•
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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.”
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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?
•
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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?
3-11
Modeling a Market Economy without
Government: Circular Flow Diagram
Resources are owned by households, who sell them to business
firms for wages & salaries, rent, interest, and profits.
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The Flow of Goods & Services
Businesses use these resources to produce goods and services
that 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.
3-14
Economic Role of Government

Government is made up of
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Each level of government
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Federal government
Fifty state governments
Tens of thousands of local governments
Collects taxes.
Provides services.
Make laws and regulations.
Government alters the outcome of the three questions:
•
What? How? and For Whom?
3-15
Economic Role of Government (Continued)
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
A mixed market system needs government in order
to function effectively.
The government should:
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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.
3-16
Market Failure

Market failure is when our resources are not allocated
efficiently by the private sector using the price
mechanism.
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•

Types of market failure include:
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•
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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).
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.
3-17
Negative Externalities

Negative externalities are external costs.
•
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
“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 wellbeing.
 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:
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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
3-19
Positive Externalities
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
Positive Externalities are external benefits.
Example:
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
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.
•
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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.
3-20
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:
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
Nonexcludable: 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-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 Services
1.
2.
3.
4.
5.
6.
7.
8.
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National defense
Court system
Police and fire protection
Construction and maintenance of infrastructure including
streets, highways, bridges, and water and sewer mains
Environmental protection
Public parks
Public schools
Public libraries
A public bus is not a public good:
•
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Individuals can be excluded if they do not pay.
Government provides public transportation because it has
positive externalities.
3-22
Government Failure

Government can also fail to allocate resources
efficiently and to meet desirable social goals.
•
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Sometimes government is slow and bureaucratic or its
programs continue even when not meeting objectives.
Some examples:
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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?
3-24
Capital

Capital is the CRUCIAL 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.
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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.
3-25
Where does capital come from?

Capital comes from:
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Cutting consumption, or
Increasing production.
Examples:
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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.
3-26
The “Isms”

Capitalism
•
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
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
3-27
The “Isms”

Communism:
•
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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
3-28
The “Isms”

Fascism
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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.
3-29
The “Isms”

Socialism
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
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.
3-30
Internet Joke

Socialism
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
Communism
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You have two cows; the state takes both of them and gives
you milk.
Fascism
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
You have two cows; the state takes one and gives it to
someone else.
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.
3-31
Transformation in China

1949–1979
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
1979–1984
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
The Chinese economy was dominated by Soviet style central
planning.
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
3-32
Transformation in China (Continued)

China has become a world-class industrial power.
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Old communist credo
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“From each according to his ability, to each according to his
needs.”
New Credo
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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.
“More pay for more work; less pay for less work.”
China is basically a capitalist economy with a strong
state.
3-33
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?
3-34