© 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 2: The Economic Organization of Society Prepared by: Kevin Richter, Douglas College Charlene Richter, British Columbia Institute of Technology

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 2 Introduction An economic system has to solve three coordination problems:  What, and how much, to produce.  How to produce it.  For whom to produce it.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 3 Introduction Every economy faces the problem of how to make individuals do what society wants them to do.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 4 Introduction Sometimes the goals of society and individuals conflict.  An example is the NIMBY (Not In My Back Yard) phenomenon.  NIMBY is a mindset in which individuals approve of a project so long as it is placed somewhere else.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 5 Introduction An economic system must provide the incentives to do those things that alleviate scarcity—produce more and consume less.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 6 Introduction The two main economic systems of the past 50 years, capitalism and socialism, answer these immense coordination problems differently.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 7 Capitalism (Market Economy) 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.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 8 Under Capitalism: Individuals are encouraged to follow their own self-interest, while market forces of supply and demand are relied upon to coordinate those individual pursuits. Distribution of goods is to each according to his or her ability, effort, or inherited property.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 9 Under Capitalism: Government must allocate and defend private property rights. Private property rights – the control a private individual or firm has over an asset or a right.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 10 Reliance on the Market Markets work through a system of rewards and payments. In capitalism individuals are encouraged to follow their own self-interest.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 11 Reliance on the Market Prices coordinate individuals' wants.  If there is not enough of something, its price goes up.  If there is too much, price goes down.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 12 What’s Good About the Market? Most economists believe the market is a good way to coordinate individuals' needs. The market is, however, not fair nor is it always efficient.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 13 What’s Good About the Market? The primary debate among economists is about how markets should be structured, and whether they should be modified and adjusted by government regulation.

Command Economy Command economy is an economic system that places the ownership of private property in the hand of the state and coordinate all production planning with a central authority. More often than not, command economy cannot achieve the right allocation of resources. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 14

Mixed Economy Mixed economy is an economic system that seeks to maximize the welfare of its citizens, while also allowing for the portion of the economy to achieve proper allocation of resources. It’s a blend of a market and a command economy. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 15

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 16 Production Possibilities Model The production possibilities curve shows the trade-offs among choices we make.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 17 Production Possibility Table A production possibility table lists the combinations of outputs (products) that can be obtained from a given number of inputs (resources).

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 18 Production Possibility Table Output – an output is simply a result of an activity. Input – an input is what you what you put into a production process to achieve an output.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 19 Production Possibility Curve A production possibility curve shows the maximum combination of outputs that can be achieved from a given number of inputs. It slopes downward from left to right.

Production Possibility Curve McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 21 Production Possibility Curve The production possibility curve not only represents the opportunity cost concept, it also measures the opportunity cost.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 22 Production Possibility Curve The production possibility curve demonstrates that:  There is a limit to what you can achieve, given the existing institutions, resources, and technology.  Every choice made has an opportunity cost—you can get more of something only by giving up something else.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 23 Increasing Marginal Opportunity Cost The production possibility curve is generally bowed outward since some resources are better suited for the production of some goods.

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 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 25 Increasing Marginal Opportunity Cost Comparative advantage explains why opportunity costs increase as the consumption of a good increases.  Some resources are better suited for the production of some goods than to the production of other goods.

Production Possibilities Table % of resources devoted to production of burgers Number of burgers % of resources devoted to production of DVD’s Numbers of DVD’sRow A B C D E F McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

1211 Production Possibilities Curve A DVD’s Burgers B C D E F McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 28 Increasing Marginal Opportunity Cost The principle of increasing marginal opportunity cost states that opportunity costs increase the more you concentrate on an activity. In order to get more of something, one must give up ever-increasing quantities of something else.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 29 Increasing Marginal Opportunity Cost DVD’s Slope is flat at A. Low opportunity cost of burgers. Slope is steep at B. High opportunity cost of burgers. Burgers B A

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 30 Efficiency In production, we’d like to have productive efficiency – achieving as much output as possible from a given amount of inputs or resources.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 31 Efficiency Any point within the production possibility curve represents inefficiency. Inefficiency – getting less output from inputs which, if devoted to some other activity, would produce more output.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 32 Efficiency Any point outside the production possibility curve represents something unattainable, given present resources and technology.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 33 Efficiency and Inefficiency DVDs Burgers CD A B Efficient points Inefficient point Unattainable point, given available technology, resources and labour force

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 34 Shifts in the Production Possibility Curve Society can produce more output if:  Technology is improved.  More resources are discovered.  Economic institutions get better at fulfilling our wants.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 35 Shifts in the Production Possibility Curve More output is represented by an outward shift in the production possibility curve.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 36 Neutral Technological Change DVDs A B Burgers 0 Shifts in the Production Possibility Curve C D

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 37 Biased Technological Change Shifts in the Production Possibility Curve 0 B A DVDs Burgers C

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 38 Distribution and Production Efficiency The production possibilities curve focuses on productive efficiency and ignores distribution. In our society, more is generally preferred to less and many policies have relatively small distributional effects.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 39 Shifts in the Production Possibility Curve Test your understanding:  A meteor hits the world and destroys half the earth’s natural resources.  Nanotechnology is perfected that lowers the cost of manufactured goods.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 40 Shifts in the Production Possibility Curve Test your understanding:  A new technology is discovered that doubles the speed at which all goods can be produced.  Global warming increases the cost of producing agricultural goods.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 41 (a) (c) (d) (b) Shifts in the Production Possibility Curve

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 42 Production Possibility Curve and Economic Systems The production possibility curve presents choices in a timeless fashion but most choices are dependent on previous choices.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 43 Production Possibility Curve and Economic Systems Sequential decisions can best be seen within a framework of a decision tree—a visual description of sequential choices.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 44 Production Possibility Curve and Economic Systems All decisions are made in context – what makes sense in one context may not make sense in another.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 45 Production Possibility Curve and Economic Systems Decisions are contextual.  What the production possibility curve for a particular decision looks like depends on existing institutions.  The analysis can be applied only in the institutional and historical context.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 46 Production Possibility Curve and Tough Choices The production possibility curve represents tough choices.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 47 Production Possibility Curve and Tough Choices 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.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 48 Production Possibility Curve and Tough Choices Economists continually point out that seemingly free lunches often involve significant costs thus earning for themselves the nickname, the dismal science.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 49 Comparative Advantage, Specialization, and Trade The production possibility curve is bowed because individuals specialize in the production of goods for which they have a comparative advantage and trade with others.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 50 Comparative Advantage, Specialization, and Trade 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.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 51 Comparative Advantage, Specialization, and Trade Collaboration and specialization can make society better off. Total production can rise.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 52 Comparative Advantage, Specialization, and Trade The outward bow graphically represents the potential gains from trade.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 53 Gains From Trade Sunder can either write one economics paper or four creative writing papers in a day. Ti can either write one creative writing paper or four economics papers in a day.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 54 Gains From Trade Sunder has a comparative advantage in creating writing and Ti has a comparative advantage in economics.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 55 Gains From Trade 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.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 56 Gains From Trade

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 57 Gains From Trade

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 58 Gains From Trade Each individual's PPC is drawn by connecting the number of papers each can write in a day on a graph.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 59 Gains From Trade Economics (b) Sunder (a) Ti Creative writing

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 60 Gains From Trade The combined PPC curve is drawn by finding three points and connecting them.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 61 Gains From Trade Economics (c) Combined with trade (b) Sunder (a) Ti B C A Creative writing

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 62 Gains From Trade Point A: This is the combined number of economics papers they both can write in a day. If economics papers are on the Y axis, it is point 0,5.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 63 Gains From Trade Point B: This is the combined number of creative papers they both can write in a day. If economics papers are on the Y axis, it is point 5,0.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 64 Gains From Trade Point C: This is where each is focusing on that activity for which he or she has a comparative advantage. Sunder writes four creative papers and Ti writes four economics papers. This is the coordinate 4,4.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 65 Gains From Trade The combined PPC is bowed out because of comparative advantage and specialization.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 66 Division of Labour Markets allow specialization and the division of labour. They allow individuals to develop their comparative advantages, thereby increasing the production possibilities of society.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 67 Markets, Specialization, and Growth Markets and specialization have led to growth.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 68 Markets, Specialization, and Growth The growth in per capita income (constant 1990 dollars) in the past 2 millennia has been astonishing. This owes largely to the introduction of markets and democracy.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 69 Markets, Specialization, and Growth As people are allowed to compete and specialize, they get better at what they do, develop new technologies and the market grows ever larger.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 70 Growth in the Past Two Millennia col17930_0207.eps $6,000 $5,000 $4,000 $3,000 $2,000 $1, Per capita income (in 1990 international dollars)

© 2006 McGraw-Hill Ryerson Limited. All rights reserved.71 The Economic Organization Of Society End of Chapter 2

© 2006 McGraw-Hill Ryerson Limited. All rights reserved.72 The History of Economic Systems Chapter 2 Appendix

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 73 Evolving Economic Systems Capitalism and socialism have not existed forever. Capitalism came into widespread existence in the mid-1700s; socialism came into existence in the early 1900s.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 74 Evolving Economic Systems Before capitalism and socialism other forms of economic systems existed: Feudalism dominated the Western world from about the 8th to the 15th century. This owes largely to the introduction of markets and democracy.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 75 Evolving Economic Systems Feudalism gave way to mercantilism. Mercantilism is an economic system in which government determines the what, how, and for whom decisions by doling out the rights to undertake certain economic activities.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 76 Evolving Economic Systems Mercantilism remained the dominant economic system until the Industrial Revolution. Industrial revolution – a time when technology and machines rapidly modernized industrial production and mass produced goods replaced handmade goods.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 77 Evolving Economic Systems Capitalism evolved from the Industrial Revolution in 1700s. Industrial revolution led to a decrease in power of small producers and increase in power of capitalists.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 78 The Need for Coordination in an Economic System Every economic system needs coordination. In his 1776 classic, Wealth of Nations, Adam Smith argued that markets could coordinate the economy without the active involvement of government.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 79 The Need for Coordination in an Economic System Markets coordinate economic activity by using the price mechanism to direct individuals' self-interest into society's interest.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 80 The Need for Coordination in an Economic System Markets coordinate economic activity by using the price mechanism to direct individuals' self-interest into society's interest.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 81 Evolutionary Changes Within Systems Both capitalism and socialism are constantly evolving with changes in social customs, political forces, and the strength of markets.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 82 Evolutionary Changes Within Systems Capitalism evolved into welfare capitalism— an economic system in which the market operates but government regulates markets significantly.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 83 Evolutionary Changes Within Systems The opposite took place in some socialist nations in the 1980s—socialism integrated capitalist institutions into its existing institutions. In the 1990s, most of the former socialist countries have undergone transition to market oriented economies based on private property.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 84 Blurring of the Distinction Between Capitalism and Socialism Recent events point to a blending of economic systems. If this trend continues, the 21st century will see the emergence of a single general type of economic structure; it will be a mix of socialist and capitalist institutions.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 85 Feudal Society: Rule of Tradition Feudalism developed in the 8 th and 9 th century. The Lord of the manor was the protector; serfs were working the land. Feudalism was a tradition based society.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 86 From Feudalism to Mercantilism Mercantilism emerged with the development of trade and markets in the 15 th century. The power of the society shifted from manors to towns.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 87 From Feudalism to Mercantilism In mercantilism, traders supported the king, who in turn protected their interests. The role of government increased during this period.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 88 From Mercantilism to Capitalism Industrialists or capitalists were the business people who acquired large amounts of money and used it to invest in business. Craft guild members were artists in their own crafts.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 89 From Mercantilism to Capitalism The economic power base shifted from the guilds to industrialists. Coordination of the economy by government was deemed necessary by the craftsmen. Industrialists considered the market capable of coordination on its own – no government was needed.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 90 From Mercantilism to Capitalism Laissez-faire policy is an economic policy of leaving coordination of individuals’ wants to be controlled by the market. Adam Smith’s invisible hand supported the industrialists’ view.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 91 Industrial Revolution The invisible hand worked; capitalism thrived. Machine production began to increase enormously in the late 18 th century, almost totally replacing hand production. This phenomenon has been termed the Industrial Revolution.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 92 Industrial Revolution Eventually, modern economic institutions replaced guilds. Modern capitalism evolved by the 19 th century.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 93 From Capitalism to Socialism Capitalism was marked by significant economic growth but also by human abuses of the working class who were producing for the elite few. This led to criticism of the capitalist market economic system.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 94 From Capitalism to Socialism The best known critic of capitalism was Karl Marx, a German philosopher, economist and sociologist. Marx developed an analysis of the dynamics of change in economic systems, in the 19 th century.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 95 From Capitalism to Socialism Marx saw an economy marked by tensions between economic classes  The proletariat class – the working class and  The capitalist class (businessmen)

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 96 From Capitalism to Socialism The capitalist class made profits by exploiting the working class. Marx believed that this exploitation would lead to revolt by the proletariat who would overthrow the capitalists.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 97 From Feudalism to Socialism Contrary to Marx’ predictions, capitalism did not evolve into socialism. Marx’ socialist ideas took root in feudalist Russia instead. State socialism was created – a system based on central planning and command.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 98 From Capitalism to Welfare Capitalism? However, evolutionary changes brought about regulation to protect the working class. Economic safety net was developed in capitalist economies. Examples are  Public welfare  Unemployment insurance

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 99 From Feudalism to Socialism Contrary to Marx’ predictions, capitalism did not evolve into socialism. Marx’ socialist ideas took root in feudalist Russia instead. State socialism was created – a system based on central planning and command.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 100 Economic Transition In the 1990s most Eastern European socialist economies started a path of transition to a market-based economic system.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved.101 The History of Economic Systems End of Chapter 2 Appendix