Decide S What Goods and Services Will Be Produced

Lecture Outlines

2a - Market Economies and Trade

OUTLINE -- LESSON 2a
Making Choices and Market Economies

MAKING CHOICES - continued

BRIEF OUTLINE: The Necessity of Choice / Making Choices

• Individual's Economizing Problem: The Budget Line (Lesson 1c)
• Society's Economizing Problem: Production Possibilities (Lesson 1d)
• How to Make Choices: Benefit-Cost Analysis (Lesson 1d plus others)
• How Countries Make Economic Choices: Economic Systems (Lesson 2a)
• Capitalism and the Five Fundamental Questions (Lesson 2a)
• The Circular Flow Model of Capitalism (Lesson 2a)
• The Gains from Trade (Lesson 2a)

I. How Countries Make Economic Choices: Pure Capitalism and the Market System (The Market and the 5 Es)

A. Introduction

• Economic Systems
  • A particular set of institutional arrangements and a coordinating mechanism for solving the economizing problem;
  • A method of organizing an economy
• Two main types:
  • Command Economy or socialism
  • Market Economy or Capitalism
  • Economic systems are ways that countries answer the 5 fundamental questions:

    1. What will be produced?
    2. How will goods and services be produced?
    3. Who will get the output?
    4. How will the system accommodate change?
    5. How will the system promote progress?

  • Economic Systems:
    • There are no PURE command economies
    • There are no PURE market economies
    • Instead there is a continuum of different characteristics

      

    • All over the world countries are changing their economies from command economies to market economies
      • this process is called "Structural Adjustment", or sometimes "Globalkization"
  • Economic Systems: Characteristics
    • who owns
    • who decides
      
  • Types of Economic Systems
    • Pure Capitalism
      • also called:
        • market economy
        • competition
        • free enterprise
        • laissez-faire capitalism
    • Command Economy
      • also called
        • socialism
        • state-run economy
        • centrally planned economy
        • communism
      • Examples:
        • North Korea
        • Cuba,
        • Turkmenistan
        • Myanmar
        • Belarus
        • Laos
        • Libya
        • Iran
        • Iraq (until 2003)
  

• All economic systems are Mixed Systems
  

TYPE OF SYSTEM	WHO OWNS?	WHO DECIDES?
Pure Capitalism:	private ownership	the market system
Command Economy:	government ownership	centralized (or gov't) decision-making
Mixed Economy	some private and some government	some private and some government

• The Demise of the Command Systems / Structural Adjustment
  • The Coordination Problem
  • The Incentive Problem
    • http://www.npr.org/blogs/money/2012/01/20/145360447/the-secret-document-that-transformed-china
      • note the important role of INCENTIVES

  • Paul Solman Video: Capitalism vs. Socialism - The Cuban Quandary (YouTube PBS NewsHour 13:56)
    https://www.youtube.com/watch?v=UmI00B2nKFs
    • note the important role of INCENTIVES

  • 

B. So, What is Capitalism? - Capitalist Ideology

• Basic Characteristics:

  CLASS:	TEXTBOOK:
  1. private property 2. freedom of enterprise and choice 3. role of self interest 4. competition 5. markets and prices 6. limited role for government	1. private property 2. freedom of enterprise and choice 3. role of self interest 4. competition 5. markets and prices 6. technology and capital goods 7. specialization 8. use of money 9. active, but limited government

1. private property

• provides an incentive for economic growth
• Paul Solman Video: Private Property (and Pilgrims too)
  [Ch2 http://highered.mcgraw-hill.com/sites/0077337735/student_view0/chapter2/_paul_solman_videos.htm ]

  OPTIONAL: http://www.npr.org/templates/story/story.php?storyId=1565953

  China Considers Private Property Rights on National Public Radio

  All Things Considered, December 22, 2003 · In Beijing, legislators propose an amendment to the Chinese constitution guaranteeing private property rights. The move has great symbolic importance in a country that is nominally communist, but whose people have been buying property and trading stocks for years as the result of economic reforms by Deng Xiaoping. NPR's Rob Gifford reports.

2. markets and prices

• prices GUIDE resources
  • pickups driving to Florida with plywood
  • consumer sovereignty and dollar votes
• prices RATION goods and services
  • high prices after a hurricane encourage people to conserve
• markets and prices affect allocative efficiency

  Quick Quiz:

  TO DECIDE HOW TO USE ITS LIMITED RESOURCES TO SATISFY HUMAN WANTS PURE CAPITALISM RELIES ON:

  A. CENTRAL PLANNING
  B. FREE TRADE
  C. A PRICE SYSTEM
  D. FULL EMPLOYMENT

3. role of self interest

• Introduction: would you rather have government or private business . . . . ? WHY?
  • gas station near a desert
  • your e-mail service
  • 24 hour gas stations
  • other

• Self interest is a powerful force and IF THERE IS COMPETITION IN AN ECONOMY it will result in improving the social good as if there is some "invisible hand" guiding their decisions.
  • "greed" and productive efficiency
  • "greed" and allocative efficiency
  • "greed" and economic growth

4. freedom of enterprise and choice

• definitions
  • Freedom of enterprise means that entrepreneurs and businesses have the freedom to obtain and use resources, to produce products of their choice, and to sell these products in the markets of their choice.
  • Freedom of choice means:
    • Owners of property and money resources can use their resources as they choose.
    • Workers can choose the training, occupations, and job of their choice.
    • Consumers are free to spend their income in such a way as to best satisfy their wants (consumer sovereignty).
• provides the means for "greedy" people to help the economy achieve allocative and productive efficiency, and economic growth

5. competition = capitalism

• what is competition?
  • 1. Large numbers of sellers mean that no single producer or seller can control the price or market supply.

    2. Large number of buyers means that no single consumer or employer can control the price or market demand.

    3. Depending upon market conditions, producers can enter or leave industry easily.

• competition is the "invisible hand"
  • plywood after a hurricane
  • monopolies and inefficiency

6. limited role for government

• What IS the economic role for government? (lessons 5a, 5b, more in macroeconmics)
  • education?
  • highways?
  • defense
  • health care?
  • restaurants?
  • making skis?
• Whenever the government does something we should as "WHY?"
  • Why should we ask "WHY?"
  • Why not let the government do everything?
  • Why not let private businesses do everything?
• Economic goals: 5 Es

• Problems with capitalism:
  • at times even market economies achieve allocative INefficiency:
    • overproduction (too much produced) of goods with negative externalities (lesson 5a)
    • underproduction (too little produced) of goods with positive externalities (lesson 5b)
    • tendency for business to increase monopoly power and produce less to increase profits (lesson 10b)
  • macroeconomic instability (periods of high unemployment and periods of high inflation) (macroeconomics)
  • no mechanism to guarantee equity

C. The Market System at Work

1. The Market and the 5Es

a. Economic Growth

(1) Define
(2) Economic Growth and the characteristics of Capitalism

(a) private property
(s) self interest
(c) freedom of enterprise and choice

(3) market economies tend to have faster growth rates than do command economies

b. Allocative Efficiency: Producing what consumers want

(1) The role of self interest in capitalism provides INCENTIVES to be allocatively efficient.

• more profits = produce more (industry expands)
• losses = produce less (industry shrinks)
• Profits, and losses, are important

(2) Capitalism's use of the market (supply and demand - lessons 3a, 3b, 3c) provides a MEANS to achieve allocative efficiency

• consumer sovereignty and "dollar votes"

(3) Capitalism tends to achieves allocative efficiency (this is why we will study supply and demand in lessons 3a, 3b, 3c)

c. Productive Efficiency: Producing at a minimum cost

(1) The role of self interest (greed?) in capitalism provides INCENTIVES to be productively efficient.

(a) profits = total revenues - total cost
(b) minimizing costs means more profits
(c) minimizing costs is productive efficiency

(2) Capitalism tends to achieve productive efficiency

d. Equity

• Capitalism does not have a mechanism to assure EQUITY. This may be a role of government

e. Full Employment

• Economists disagree over whether capitalism will guarantee FULL EMPLOYMENT.
• studied in macroeconomics

2. Summary:

a. The move toward capitalism has resulted in high rates of ECONOMIC GROWTH in many countries. Profits, private property, and freedom of enterprise and choice promote growth

b. The price mechanism (supply and demand) and the role of self interest provides for an ALLOCATIVELY EFFICIENT use of resources

c. Capitalism provides the incentives (profit) for a PRODUCTIVELY EFFICIENT use of resources

d. Capitalism does not have a mechanism to assure EQUITY. This may be a role of government

e. Economists disagree over whether capitalism will guarantee FULL EMPLOYMENT.

• Some say yes, and if there is unemployment it is usually caused by government interference
  
• Some say no, and at times government involvement is needed to move the economy towards full employment

---

Pure Capitalism and the Market System:
The Market and the 5 Es

Characteristics of a Market Economy (Capitalism)

A. private property
B. markets and prices
C. role of self interest: incentives
D. freedom of enterprise and choice
E. competition

1. large numbers
2. free entry and exit
3. produce standardized products

F. limited role for government

The Market and the 5Es

1. Economic Growth

Capitalist economies tend to have more rapid rates of growth

2. Allocative Efficiency: Producing what consumers want

a. Capitalism and incentives and means

(1) more profits = produce more

(2) losses = produce less

(3) consumer sovereignty and "dollar votes"

b. Capitalism tends to achieves allocative efficiency

3. Productive Efficiency: Producing at a minimum cost

a. Capitalism and incentives

(1) profits = total revenues - total cost

(2) minimizing costs means more profits

b. Capitalism tends to achieve productive efficiency

4. Equity

There is no characteristic of capitalism which will guarantee equity

Often, the government gets involved to help achieve equity

5. Full Employment

Economists disagree over whether capitalism will result in full employment

• Some say yes, and if there is unemployment it is usually caused by government interference
  
• Some say no, and at times government involvement is needed to move the economy towards full employment

II. Capitalism and the Five Fundamental Questions

A. Introduction

1. The five fundamental questions must be answered by all economic systems.

2. The five fundamental questions are:

a. What goods and services will to be produced?
b. How will the goods and services be produced?
c. Who will get the output?
d. How will the system accommodate change?
e. How will the system promote progress?

B. What will be produced? (Allocative Efficiency)

1. In order to be profitable, businesses must respond to consumers' (individuals, other businesses, and the government) wants and desires.

2. Consumer Sovereignty and "dollar votes"

C. How will the goods and services be produced? (Productive Efficiency)

1. The market system encourages and rewards those producers who are achieving least-cost production.

2. The most productively efficient technique will be the one that produces a given amount of output with the smallest input of limited resources.

D. Who will get the output? (Equity)

1. determined by how the income is distributed

2. Products go to those who are willing and able to pay for them.

3. The productivity of the resources, the relative supply of particular resources, and the ownership of the resources will determine the income of individuals and households.

4. The resulting distribution of income may not be the most equitable (fair).

E. How will the system accommodate change?

1. Markets are dynamic - what is efficient today may not be efficient tomorrow as tastes, technology, and resource supplies change.

2. Prices help signal those changes and the market will respond. This guiding function of prices is essential to a well-functioning market system.

3. In the absence of such signals, government or some similar institution would have to decide where resources are allocated, but without knowing what people in society want. the result would most likely be allocatively inefficient.

F. How will the system promote progress?

1. The market system promotes technological improvements and capital accumulation (economic growth).

2. An entrepreneur or firm that introduces a popular new product will be rewarded with increased revenue and profits. (allocative efficiency)

3. New technologies that reduce production costs, and thus product price, will spread throughout the industry as a result of competition. (economic growth)

4. Creative destruction occurs when new products and production methods destroy the market positions of firms that are not able or willing to adjust. NOTE: this is good for society.

III. The Circular Flow Model of Capitalism

The Circular Flow Model

The flow of resources from households to firms and of products from firms to households. These flows are accompanied by reverse flows of money from firms to households and from households to firms.

A. Two Markets

1. product market

A market in which products are sold by firms and bought by households.

a. how much to buy
b. how much to produce

2. resource market

A market in which households sell and firms buy resources or the services of resources.

a. how many to hire
b. how much we earn

B. Two Flows

1. real flow
2. money flow

C. Reversal of Roles
D. Limitations

E. Diagram

IV. Why We Trade: Comparative Advantage

A. INTRODUCTION

Major economic changes have been occurring in the last few decades. Countries all around the world, including the United States are currently engaged in a process of globalization, or structural adjustment. This includes, among other things, moving toward free trade. Globalization and the removal of trade barriers is occurring now and it will continue to occur. In the previous lecture it was mentioned that much of what we hear in the popular press is contrary to what we are going to learn in this course. This is very true when discussing globalization. For example, read the following quotes from the CNN news article: Dobbs: New Congress must show courage [http://www.cnn.com/2006/US/11/28/Dobbs.Nov29/index.html].

Lou Dobbs, CNN News commentator and best-selling author, says:
Dobbs: New Congress must show courage [http://www.cnn.com/2006/US/11/28/Dobbs.Nov29/index.html]

• "But the consequences of faith-based free-trade will be eye-popping in the disaster it wreaks on our economy and working Americans."
• "I hope they (the new Democratic congressional leadership) can acknowledge that so-called free trade has come at an inordinate cost to working men and women in this country. "
• "We've lost three million manufacturing jobs as a result of these so-called free trade agreements that enable corporate America to export plants, production and jobs to cheap foreign labor markets."
• "And yet we persist with our historical ignorance, and we continue to enter poorly negotiated agreements that pose great threats to the U.S. economy and the middle class."

From the Trump campaign website: https://www.donaldjtrump.com/policies/trade

• America has lost nearly one-third of its manufacturing jobs since NAFTA and 50,000 factories since China joined the World Trade Organization. [Economic Policy Institute, April 23, 2015]
• The U.S. trade deficit with the proposed TPP member countries cost over 2 million jobs in 2015. By far the biggest losses occurred in motor vehicles and parts, which lost nearly 740,000 manufacturing jobs. Imagine how many more jobs would be lost if the Trans-Pacific Partnership was actually approved. [Economic Policy Institute, March 3, 2016]
• The Trans-Pacific Partnership will undermine our economy, and it will undermine our independence:

Then read the following quotes taken from our textbook (19th edition):

• p. 96 "Nations specialize and trade for the same reasons as individuals: specialization and exchange results in a greater overall output and income."
• p. 98 "Specialization (i.e. trade) improves global resource allocation. The same total inputs of world resources and technology result in a larger global output."
• p. 405 "Import restrictions alter the composition of employment, but they have little or no effect on the volume of employment."
• p. 101 - "Actually the true benefit created by international trade is the overall increase in output obtained through specialization and exchange.
• p. 403- "the gains that US trade barriers create for protected industries come at the expense of much greater losses for the entire economy. (emphasis added). The result is economic inefficiency, reduced consumption, and lower standards of living."
• p. 403 - Study after study finds that the costs to consumers (of trade restrictions) substantially exceed the gains to producers and government."

"Specialization according to comparative advantage results in a more efficient allocation of the world's resources, and larger outputs ...." (McConnell and Brue 2005, p. 361)

II. REVIEW: Why study International Trade (Specialization, Exchange, and Efficiency)?

A. Productive Efficiency: using resources where best suited ( 5Es )

B. Production Possibilities vs CONSUMPTION Possibilities ( graph )

III. Introduction to Trade

A. Should We Have Free Trade With Other Countries?
B. Why AND Why Not?

• Spend a few minutes writing down your ideas.
• State your opinion and defend it
• also, state arguments that oppose your opinion

C. Many people use anecdotal evidence to oppose freer trade
D. but most economists favor freer trade

IV. The Economic Basis for Specialization and Exchange -- Trade

A. Pre-quiz (yellow page)- Do you think like an economist?
B. Why we specialize and exchange?

1. What would life be like if YOU were self-sufficient?

2. Trade: advantages and disadvantages

a. advantage:

• larger total output / higher living standards
• lower prices

b. disadvantage:

• less independence / more interdependence

3. The basis for specialization and exchange

a. differences in resource endowments
b. differences in preferences
c. differences in productivity (MORE BELOW)

1) define productivity
2) define absolute advantage
3) a good lawyer trades with a good mechanic

d. differences in opportunity costs (MORE BELOW)

1) define opportunity cost
2) define comparative advantage
3) The lawyer/mechanic argument revised

C. Differences in Productivity: Absolute Advantage

1. production possibilities: self sufficiency
2. specialization
3. trading possibilities: more total output

D. Differences in Opportunity Costs: Comparative Advantage

1. production possibilities: self sufficiency
2. specialization

a. comparative advantage
b. calculating opportunity costs

3. trading possibilities: more total output

"Specialization according to comparative advantage results in a more efficient allocation of the world's resources, and larger outputs ...." (McConnell and Brue 2005, p. 361)

4. trade with increasing costs

a. review: law of increasing costs
b. result: specialization is less than 100%

5. terms of trade

a. definition
b. minimum and maximum terms of trade
c. actual terms of trade

Decide S What Goods and Services Will Be Produced

Source: http://www2.harpercollege.edu/mhealy/eco211/lectures/choices/choices.htm

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