Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Economic Organization Of Society Chapter 2

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Laugher Curve Q. How many Marxists does it take to screw in a light bulb? A. None. The bulb contains within itself the seeds of its own revolution.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Introduction u An economic system must coordinate individuals' wants and desires.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Introduction u An economic system has to solve three coordination problems: l What, and how much, to produce. l How to produce it. l For whom to produce it.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Introduction u Every economy faces the problem of how to make individuals do what society wants them to do.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Introduction u Sometimes the goals of society and individuals conflict. l An example is the NIMBY (Not In My Back Yard) phenomenon. l NIMBY was a 1990s mindset in which individuals approve of a project so long as it is placed somewhere else.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Introduction u One problem every economy faces is what to do with individuals who want to do what "society" does not want them to do.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Introduction u An economic system must give the incentive to do those things that alleviate scarcity—produce more and consume less.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Introduction u The coordination problems faced by society are immense.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Introduction u The two main economic systems of the past 50 years, capitalism and socialism, answer these coordination problems differently.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Capitalism u Capitalism is an economic system based upon private property and the market in which, in principle, individuals decide how, what, and for whom to produce.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Under Capitalism: u Individuals are encouraged to follow their own self-interest, while market forces of supply and demand are relied upon to coordinate those individual pursuits.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Under Capitalism: u Distribution of goods is to each according to his or her ability, effort, or inherited property.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Under Capitalism: u Government must allocate and defend private property rights. l Private property rights – the control a private individual or firm has over and asset or a right.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Reliance on the Market u Markets work through a system of rewards and payments. u Individuals are free to do whatever they want as long as it is legal.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Reliance on the Market u Prices coordinate individuals' wants. l If there is not enough of something, its price goes up. l If there is too much, price goes down.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin What’s Good About the Market? u Most economists believe the market is a good way to coordinate individuals' needs.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin What’s Good About the Market? u The primary debate among economists is about how markets should be structured, and whether they should be modified and adjusted by government regulation.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Socialism u Socialism is, in theory, an economic system based on individuals’ good will toward others, not on their own self- interest. u In principle, society decides what, how, and for whom to produce.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Socialism in Theory u Socialism is an economic system that tries to organize society in the same way as families are organized. u Everyone contributes what they can and get what they need.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Socialism in Theory u If individuals' inherent goodness will not make them consider the general good, government will force them.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Socialism in Practice u Economic systems based on upon people's goodwill have tended to break down.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Socialism in Practice u Socialism in practice is often called Soviet-style socialism. l Soviet-style socialism is an economic system that uses administrative control or central planning to solve the coordination problems what, how, and for whom.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Types of Economic Systems of the Past u Feudalism dominated the Western world from about the 8th to the 15th century. l Feudalism is an economic system in which traditions rule.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Evolving Economic Systems u Feudalism gave way to mechantilism. l Mechantilism is an economic system in which government determines the what, how, and for whom decisions by doling out the rights to undertake certain economic decisions.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Evolving Economic Systems u Mercantilism gave way to the Industrial Revolution. l Industrial revolution – a time when technology and machines rapidly modernized industrial production and mass produced goods replaced handmade goods.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Evolving Economic Systems u Capitalism evolved from the Industrial Revolution.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Evolving Economic Systems u Some economists prefer to call the system that evolved from mercantilism the market economic system—an economic system that relies on markets to coordinate economic activities.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Need for Coordination in an Economic System u Every economic needs coordination – even capitalism.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Need for Coordination in an Economic System u In his 1776 classic, Wealth of Nations, Adam Smith explained how markets could coordinate the economy without the active involvement of government.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Need for Coordination in an Economic System u Markets coordinate economic activity by using the price mechanism to direct individuals' self-interest into society's interest.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Evolutionary Changes Within Systems u Both capitalism and socialism are constantly evolving with changes in social customs, political forces, and the strength of markets.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Evolutionary Changes Within Systems u A purer form of capitalism evolved into welfare capitalism—an economic system in which the market operates but government regulates markets significantly.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Evolutionary Changes Within Systems u The opposite took place in socialist nations—socialism integrated capitalist institutions into its existing institutions.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin A Blurring of the Distinction Between Capitalism and Socialism u Recent events point to a blending of capitalism and socialism.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin A Blurring of the Distinction Between Capitalism and Socialism u If this trend continues, the 21st century will see the emergence of a single general type of economic system, a blended capitalist-socialist system.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin u The choices made by society are often presented in terms of a production possibility curve. The Production Possibilities Curve and Economic Reasoning

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin u The production possibilities curve shows the trade-offs among choices we make. The Production Possibilities Curve and Economic Reasoning

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Production Possibility Table u A production possibility table lists a choice's opportunity costs by summarizing what alternative outputs you can achieve with your inputs.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Production Possibility Table u Three things to know to understand a production possibility table: l Opportunity cost – every decision has a cost in forgone opportunities. l Output – an output is simply a result of an activity. l Input – an input is what you what you put into a production process to achieve an output.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Production Possibility Curve u A production possibility curve measures the maximum combination of outputs that can be achieved from a given number of inputs. u It slopes downward from left to right.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Production Possibility Curve u The production possibility curve not only represents the opportunity cost concept, it also measures the opportunity cost.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Production Possibility Curve u The production possibility curve demonstrates that: l There is a limit to what you can achieve, given the existing institutions, resources, and technology. l Every choice made has an opportunity cost—you can get more of something only by giving up something else.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Economics grade History grade 20 hours of history 0 hours of economics E D C B 20 hours of economics 0 hours of history A Hours of study in history Grade in history Hours of study in economics Grade in economics The Production Possibility Curve

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Increasing Marginal Opportunity Cost u The production possibility curve is generally bowed outward since some resources are better suited for the production of some goods.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Increasing Marginal Opportunity Cost u The concept of comparative advantage explains why opportunity costs increase as the consumption of a good increases. l Some resources are better suited for the production of some goods than to the production of other goods.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Increasing Marginal Opportunity Cost Y Y2Y 1X1X A X If the slope of the production curve is -2 at A, the opportunity cost of 1X is 2Y. 7

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Increasing Marginal Opportunity Cost u The principle of increasing opportunity cost states that opportunity costs increase the more you concentrate on an activity. u In order to get more of something, one must give up ever-increasing quantities of something else.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Increasing Marginal Opportunity Cost % of resources devoted to production of guns Number of guns % of resources devoted to production of butter Pounds of butterRow A B C D E F

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Increasing Marginal Opportunity Cost A Butter Guns gun 5 pounds of butter guns 2 pounds of butter B C D E F guns 1 pound of butter

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Increasing Marginal Opportunity Cost Butter Slope is flat at A. Low opportunity cost of guns. Slope is steep at B. High opportunity cost of guns. Guns B A

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Efficiency u In our production, we would like to have productive efficiency—achieving as much output as possible from a given amount of inputs or resources.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Efficiency u Efficiency involves achieving a goal as cheaply as possible. u Efficiency has meaning only in relation to a specified goal.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Efficiency u Any point within the production possibility curve represents inefficiency—getting less output from inputs which, if devoted to some other activity, would produce more output.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Efficiency u Any point outside the production possibility curve represents something unattainable, given present resources and technology.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Efficiency and Inefficiency Guns Butter CD A B Efficient points Inefficient point Unattainable point, given available technology, resources and labor force

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Shifts in the Production Possibility Curve u Society can produce more output if: l Technology is improved. l More resources are discovered. l Economic institutions get better at fulfilling our wants.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Shifts in the Production Possibility Curve u More output is represented by an outward shift in the production possibility curve.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Neutral Technological Change Butter A B Guns 0 Shifts in the Production Possibility Curve C D

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Biased Technological Change Shifts in the Production Possibility Curve 0 B A Butter Guns C

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Distribution and Production Efficiency u The production possibilities curve focuses on productive efficiency and ignores distribution. u An increase in output that goes to one person and not to anyone else would not necessarily be efficient in some societies.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Distribution and Production Efficiency u U.S.economists often talk about efficiency as if it means productive efficiency and achieving society's goals. u In our society, more is generally preferred to less and many policies have relatively small distributional effects.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Examples of Shifts in the Production Possibility Curve u If more inputs are available for the production of X and Y equally, the PPC shifts out along both X and Y axes. u If fewer inputs are available for the production of X and Y equally, the PPC shifts in along both X and Y axes.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Examples of Shifts in the Production Possibility Curve u If more inputs are available for good X only, the PPC shifts out on the X axis only. u If more inputs are available for good Y only, the PPC shifts out on the Y axis only.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin (a) (c) (d) (b) Examples of Shifts in the Production Possibility Curve

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Production Possibility Curve and Economic Systems u The production possibility curve presents choices in a timeless fashion but most choices are dependent on previous choices made sequentially with a time dimension.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Production Possibility Curve and Economic Systems u Sequential decisions can best be seen within a framework of a decision tree— a visual description of sequential choices.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Production Possibility Curve and Economic Systems u Low-level choices are choices that involves general acceptance of the path one has taken. u Institutional choices are choices that make major institutional changes.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Production Possibility Curve and Economic Systems u Systemic choices are fundamental choices that determine the set of institutional and low-level choices available.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Production Possibility Curve and Economic Systems u All decisions are made in context – what makes sense in one context may not make sense in another.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Production Possibility Curve and Economic Systems u Decisions are contextual. l What the production possibility curve for a particular decision looks like depends on existing institutions l The analysis can be applied only in the institutional and historical context.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin A Decision Tree Low-level decisions Institutional decisions Systemic decisions BA

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Production Possibility Curve and Tough Choices u The production possibility curve represents tough choices.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Production Possibility Curve and Tough Choices u Politicians make promises as though the production possibility curve did not exist or that the economy can operate outside the economy's production possibility curve.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Production Possibility Curve and Tough Choices u Economists continually point out that seemingly free lunches often involve significant costs thus earning for themselves the nickname, the dismal science.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Comparative Advantage, Specialization, and Trade u The production possibility curve becomes bowed out when individuals specialize in the production of goods for which they have a comparative advantage and trade with others.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Comparative Advantage, Specialization, and Trade u The comparative advantage argument used to explain the bowed-out shape of the production possibilities curve can be used to show how trade makes society better off.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Comparative Advantage, Specialization, and Trade u Collaboration and specialization can make society better off. u Total production can rise.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Comparative Advantage, Specialization, and Trade u The outward bow graphically represents the potential gains from trade.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Gains From Trade u Sunder can either write one economics paper or four creative writing papers in a day. u Ti can either write one creative writing paper or four economics papers in a day.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Gains From Trade u Sunder has a comparative advantage in creating writing and Ti has a comparative advantage in economics.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Gains From Trade u The following table and production possibility curves demonstrate how output increases when two individuals collaborate and specialize in the activity for which each has a comparative advantage.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Gains From Trade

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Gains From Trade

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Gains From Trade u Each individual's PPC is drawn by connecting the number of papers each can write in a day on a graph.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Gains From Trade Economics (b) Sunder (a) Ti Creative writing

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Gains From Trade u The combined PPC curve is drawn by finding three points and connecting them.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Gains From Trade Economics (c) Combined with trade (b) Sunder (a) Ti B C A Creative writing

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Gains From Trade u Point A: This is the combined number of economics papers they both can write in a day. u If economics papers are on the Y axis, it is point 0,5.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Gains From Trade u Point B: This is the combined number of creative papers they both can write in a day. u If economics papers are on the Y axis, it is point 5,0.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Gains From Trade u Point C: This is where each is focusing on that activity for which he or she has a comparative advantage. u Sunder writes four creative papers and Ti writes four economics papers. u This is the coordinates 4,4.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Gains From Trade u The combined PPC is bowed out because of Point C – comparative advantage and specialization.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Division of Labor u Markets allow specialization and the division of labor. u They allow individuals to develop their comparative advantages, thereby increasing the production possibilities of society.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Markets, Specialization, and Growth u Markets and specialization have led to growth.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Markets, Specialization, and Growth u The growth in per capita income (constant 1990 dollars) in the past 2 millennia has been astonishing. u This owes largely to the introduction of markets and democracy.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Markets, Specialization, and Growth u As people are allowed to compete and specialize, they get better at what they do, develop new technologies and the market grows ever larger.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Growth in the Past Two Millennia $6,000 $5,000 $4,000 $3,000 $2,000 $1, Per capita income (in 1990 international dollars)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Economic Organization Of Society End of Chapter 2