2. Economic Systems Chapter 3

3. Why are economic systems needed? Rules of the game! Rules of the game! Standard incentives Standard incentives Understanding of the rewards Understanding of the rewards

4. Economic Systems can allow for _____ A. Specialization A. Specialization B. Comparative / Absolute advantage B. Comparative / Absolute advantage

5. Adam Smith THE WEALTH OF NATIONS (1776) THE WEALTH OF NATIONS (1776) “ bible ” of Capitalism “ bible ” of Capitalism Let the people decide the 3 basic economic questions Let the people decide the 3 basic economic questions Profit and PSYCHIC INCOME will make us work. Profit and PSYCHIC INCOME will make us work.

6. Specialization Adam Smith ’ s PIN EXAMPLE: Adam Smith ’ s PIN EXAMPLE: Specialization leads to increased production Specialization leads to increased production Specialization leads to the need to trade. Specialization leads to the need to trade.

7. Specialization leads to COMPARATIVE ADVANTAGE "If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage. " (Book IV, Section ii, 12) "If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage. " (Book IV, Section ii, 12)

8. Definition: Absolute Advantage A country has an absolute advantage over it trading partners if it is able to produce more of a good or service with the same amount of resources or the same amount of a good or service with fewer resources. A country has an absolute advantage over it trading partners if it is able to produce more of a good or service with the same amount of resources or the same amount of a good or service with fewer resources.

9. Absolute Advantage Orlando has absolute advantage over Lincoln in citrus production. Orlando has absolute advantage over Lincoln in citrus production. Zambia has absolute advantage over the US in copper production. Zambia has absolute advantage over the US in copper production.

10. David Ricardo: Comparative Advantage A country has a comparative advantage in the production of a good or service that it produces at a lower opportunity cost than its trading partners. A country has a comparative advantage in the production of a good or service that it produces at a lower opportunity cost than its trading partners.

11. Ricardo: The tricky road of comparative / absolute advantage Some countries have an absolute advantage in the production of many goods relative to their trading partners. Some countries have an absolute advantage in the production of many goods relative to their trading partners.

12. Ricardo: The tricky road of comparative / absolute advantage Some have an absolute disadvantage. They are inefficient in producing anything, relative to their trading partners Some have an absolute disadvantage. They are inefficient in producing anything, relative to their trading partners

13. RICARDO ’ S … BUT … it is better for a country that is inefficient at producing a good or service to specialize in the production of that good it is least inefficient at, compared with producing other goods. it is better for a country that is inefficient at producing a good or service to specialize in the production of that good it is least inefficient at, compared with producing other goods.

14. HUH????? Country A has an absolute advantage in the production of both maize and wheat. Country A has an absolute advantage in the production of both maize and wheat.

15. HUH??? Country B has an absolute disadvantage. Country B has an absolute disadvantage.

16. HUH?? Due to abundance of raw materials or more productively efficient production techniques, Country A is able to produce more wheat and more maize that Country B. Due to abundance of raw materials or more productively efficient production techniques, Country A is able to produce more wheat and more maize that Country B.

17. HUH???? Perhaps common sense tells us that Country A should produce both goods and export surpluses and Country B neither. Perhaps common sense tells us that Country A should produce both goods and export surpluses and Country B neither.

18. BUT However, when comparative advantage is considered a different story emerges. However, when comparative advantage is considered a different story emerges.

19. CONSIDER THIS: Consider the opportunity cost of Country A producing one more unit of maize. Half a unit of wheat has been foregone. Consider the opportunity cost of Country A producing one more unit of maize. Half a unit of wheat has been foregone.

20. CONSIDER THIS: When country B produces one more unit of maize two units of wheat are foregone. When country B produces one more unit of maize two units of wheat are foregone.

21. REMEMBER: Economics is concerned with the allocation of scarce resources. Economics is concerned with the allocation of scarce resources.

22. If we assume that is true, THEN …. Fewer resources are foregone if Country A concentrates its resources in the production of maize Fewer resources are foregone if Country A concentrates its resources in the production of maize

23. Now consider … the opportunity cost of Country B producing one more unit of wheat. Two units of maize have been foregone. the opportunity cost of Country B producing one more unit of wheat. Two units of maize have been foregone.

24. Now consider … When Country B produces one more unit of wheat only half a unit of maize is foregone. When Country B produces one more unit of wheat only half a unit of maize is foregone.

25. So if that is true …. Fewer resources are foregone if Country B specializes in the production of wheat Fewer resources are foregone if Country B specializes in the production of wheat

26. CONCLUSION OF COMPARATIVE ADVANTAGE In the above case Country A should produce maize and Country B wheat. The surpluses produce should then be traded. In the above case Country A should produce maize and Country B wheat. The surpluses produce should then be traded.

27. Comparative Advantage creates A. Headaches A. Headaches B. Interdependence B. Interdependence C. Coordination problems C. Coordination problems D. Only B and C D. Only B and C

28. Interdependence Makes producers dependent on others for the goods they don ’ t produce. Makes producers dependent on others for the goods they don ’ t produce. Creates PEACE Creates PEACE

29. BUT: Interdependence can create coordination problems Specialization causes interdependence. Specialization causes interdependence. Interdependence requires an economic system to coordinate everyone ’ s various activities. Interdependence requires an economic system to coordinate everyone ’ s various activities.

30. BUT: Interdependence can create coordination problems As specialization and interdependence increase, so does the complexity of coordinating all of the specialized activities of buyers and sellers. As specialization and interdependence increase, so does the complexity of coordinating all of the specialized activities of buyers and sellers.

31. Consider: What countries does the US / Europe have “ troubles ” with? What countries does the US / Europe have “ troubles ” with? How much trade do we have with these countries? How much trade do we have with these countries? North Korea North Korea Iran Iran Middle East Middle East

32. What are the Principal Types of Economic Systems? Market Economies Market Economies Centrally Directed Economies Centrally Directed Economies Traditional Economies Traditional Economies Mixed Economies Mixed Economies

33. Market Economies Also called Also called Capitalism Capitalism Free Enterprise Free Enterprise Private Enterprise Private Enterprise

34. Market Economies: Fundamental Principles Private property rights Private property rights Right to freely trade or sell property Right to freely trade or sell property Pursue self-interest. Pursue self-interest.

35. Centrally Directed Economies AKA AKA Command Economies Command Economies Marxist Economies Marxist Economies Communist Economies Communist Economies

36. Features of Central Planning Decisions made by central planning commission Decisions made by central planning commission Draws up “ master ” plan Draws up “ master ” plan Government employs workers Government employs workers

37. Features of Central Planning Decides what, how and for whom to produce. Decides what, how and for whom to produce. Determines how output is to be distributed Determines how output is to be distributed

38. Features of Traditional Economies Relies on custom and tradition to decide the 3 basic economic questions. Relies on custom and tradition to decide the 3 basic economic questions. Very strong in non- industrialized countries. Very strong in non- industrialized countries. India is not a great example in 2005. India is not a great example in 2005.

39. Mixed Economies AKA: Socialism AKA: Socialism All economies are mixtures of government control and individual motivation. All economies are mixtures of government control and individual motivation.

40. Mixed Ecnomies US: BASICALLY market economy US: BASICALLY market economy SOME government regulation and ownership. SOME government regulation and ownership.

41. Mixed Economies China: In theory, centrally directed China: In theory, centrally directed Some private ownership and sales Some private ownership and sales BRIBES to the govt. in China make it possible for private enterprise to exist. BRIBES to the govt. in China make it possible for private enterprise to exist.

42. Mixed Economies Former Soviet Union Former Soviet Union Economy in transition. Economy in transition. Return of centralization??? Return of centralization??? But under Communist control or the Mafia? But under Communist control or the Mafia?

43. How does a Market System resolve the 3 Basic Economic questions? Markets: Markets: Some are highly organized. Some are highly organized. Information for both seller and buyer: Information for both seller and buyer: Product features Product features Prices Prices Wants and needs Wants and needs Tastes and preferences Tastes and preferences

44. Incentives in Market Economy $$$$$$$$$$$$$ $$$$$$$$$$$$$ Psychic Income Psychic Income

45. Incentives in a Market Economy Price changes give incentives to change current production Price changes give incentives to change current production

46. 2 Types of Markets Product Market Product Market Factor Market Factor Market

47. Product Market Finished goods and services exchanged in product markets Finished goods and services exchanged in product markets

48. Factor Markets Land, labor, capital resources exchanged in the factor markets. Land, labor, capital resources exchanged in the factor markets.

49. Circular Flow of the Economy Resource owners provide land, labor, and capital to business firms. Resource owners provide land, labor, and capital to business firms. Business firms provide finished goods and services to households. Business firms provide finished goods and services to households.

50. Circular Flow of the Economy Firms pay households for factors of production. Firms pay households for factors of production. Rent for land Rent for land Wages and salaries for labor Wages and salaries for labor Interest for financial capital Interest for financial capital

51. Circular Flow Diagram Outer circle shows flow of “ real ” inputs and outputs. Outer circle shows flow of “ real ” inputs and outputs.

52. Circular Flow Model Inner circle shows money payments for imports and outputs. Inner circle shows money payments for imports and outputs.