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Chapter #l - Foundations of Economics

In April 2018 professional golfer Rickie Fowler finished in second place at The
Masters (one of the four most prestigious tournaments of the year), one stroke
behind winner Patrick Recd. Around the same time a plane crash in Algeria killed
257 people. If Rickie was more upset about the outcome of the Masters than about Fundamental Economic
the Io.ss of life from the accident in Algeria, then it would seemingly suggest that he
A. ts not as good of a person as Patrick Reed.
B . does not care about anyone other than himself. Questions and Gains from
C . Is an irrational individual.
D . is a sail-interested individual. Specialization
In March 2010, when the "Patient Protection and Affordable Care Act" (a.k.a.,
Obamacare) was being finalized by and debated in Congress, Within the previous chapter, economics was defined as the social science that
A. over 40 economists (including Daniel Kahneman, one of the co-recipiants of studies how people make decisions in the face of scarcity, and the resulting impact of
the 2002 Nobel Prize in economics) wrote a letter to President Obama such decisions on society as a whole and the individual members therein. It was noted
supporting the legislation. that as a result of scarcity, decision-makers face tradeoffs (having more of one thing often
B. over 130 economists (including Vernon Smith, one of the co-recipients of the
requires getting by with less of something else). Such ffadeoffs arc particularly important
2002 Nobel Prize in economics) wrote a letter to House Minority Leader Rep. to keep in mind when thinking about the myriad choices that must be made by a society
John Bochnex opposing the legislation.
regarding the use of productive resources.
C. no economist publicly expressed any opinion on the legislation (upholding a The current chapter begins by broadly describing the roles played by households
longstanding tradition within the profession of never getting involved in and firms in the consumption and production of goods/services. Next, the fundamental
public policy debates). questions that a society faces when deciding how to use its scarce productive resources
D . More than one (pcrhapa all) of the above answers is correct.
are identified. From here, the notion of the Production Poss~ilities Frontier (which
provides a graphical depiction of the limits on output that a society faces due to resources
Answer Questions 22 and 23 based upon the information conveyed in the following
being scarce) is described. Finally, a simple model (of a two parson, two commodity
table, which states Ann's Total Benefits from consumption of iced coffee per week
economy) is established and analyzed, in order to illustrate precisely how specialization
(measured in dollars):
in production allows a society to maximize the amount of output which it produces.
Cups of lced 0
Coffee Consumed 1 2 3 4 5 6 7
TotalBenefits T H E T H R E E F U N D A M E N TA L E C O N O M I C Q U E S T I O N S
from Consumption 0 6.50 11.50 15.75 19.50 22.50 24.00 24.50
Societies consist ofpoople. Individual people derive satisfaction from consuming
22. It appears as if Ann has a goods and services - outputs of the production process, such as food, clothing, shelter,
for iced coffee consumption. healthcare, education, and entertainment. At any point in time, a society is endowed with
A . constant marginal benefit
B. increasing marginal benefit a limited amount of productive resources or factors of production - inputs in the
C . diminishing marginal benefit production process, broadly categorized as land, labor, and capital - that can be used to
create different goods or services.
D . negative marginal benefit
There are two primary decision making entities (or institutions) in any economy:
23. If iced coffee costs $3.65 per cup, then Ann should consume __ cups per week. households and firms. Households obtain benefits from consunting goods and services.
A. 0 Firms produce these goods and services. Production refers to the process by which a
B. 4 firm transforms inputs (i.e., factors of production) into an output (i.e., a good or service).
C. 6 Households fulfil an additional role in the economy by providing factors of production to
D. 7 in'ms. For example, a school teacher supplies labor to an elementary school providing
primary education services, and a landowner leases land to a farmer who grows com.
Chapter #2 - Fundamental Economic Questions and Gnins from Specialization Chapter #2- Fundamental Economic Questions and Gains from Specialization

These broad interactions between households and firms are depicted by the Preliminary Thinking about a society's use of its scarce productive resources, three
Circular Flow Diagram in Figure 2. I. fundamental economic questions must be addressed:
The arrow on the right side of Figure 2.1 represents the movement of finished 1. What to produce? [production deed~ion - of all the different combinations of
goods and services from firms to households. Individuals within the households derive goods and services that we could produce, what specific combination will we
benefits from consuming these goods and services (this takes place internally within the produce?]
box labeled "Households"). Members of households provide inputs to the production 2 . How to produce it? [resource use decision - which productive resources will
process to firms. The transfer of these productive resources is depicted by the arrow on be used to produce which goods and services?]
the left side of Figure 2.1. These inputs are then transformed into outputs through the 3 . For whom to produce it? [distributional decision - who gets to censume the
process known as production (which takes place internally within the box labeled goods and services that we have chosen to produce?]
"Firms"). Every society must come up with answers to these three fundamental questions. In many
respects, a society's choice of economic system goes a long way toward determining bow
FigHre 2.1 - Preliminary Circular Flow Diagram these questions are answered in practiceJ
In the United States, the bulk of the answers to the three fundamental economic
questions have historically been determined by the interaction of self-interested decision
makers (both households and firms) in markets. Thinking about the role played by most
Households ] individuals in regards to production and consumption decisions in a modem, market
based economy (like the United States), a general observation emerges: most individuals
specialize in production but generalize in consumption. That is, we tend to focus our
productive activities on a very narrow set of goods, while consuming a much wider array
of goods. Perhaps you provide financial services by working at a bank. You generate
income from this employment, which you then use in the markets for goods and services
to buy all of the different things you enjoy consuming.
But recognize that under such an arrangement you axe relying on others (in many
Factors of Finished cases complete strangers, who are self-interested and don't really care all that much about
production goods and your well-being2) to provide you with nearly all of the goods and services that you
services consume on a daily basis (in many eases, basic necessities such as food, clothing, and
shelter). How is such an arrangement sustainable and ideal? That is, when Uying to
acquire goods for our own consumption, why should we bother interacting with others (as
opposed to producing everything for ourselves)? The short answer is that the trades upon
which the arrangement is supported are each mutually beneficial, because of the fact that
specialization in production allows a society to produce greater amounts of output (than
what could be realized if each person instead produced for only his own consumption).
These three fundamental questions (and the gains in output that can be realized
through SlX',eialization in production) are easily illustrated by considering a simple model
of society in which there is only one productive resource (labor) and two goods to
produce (food and clothing). The production decision amoums to deciding how much
~ 1 F i r m s J j food to produce and how much clothing to produce. The resource use decision amounts
The main purpose of this entire exercise (i.e., the movement of resources between to determining which workers will produce food and which workers will produce
households and finns, along with the related transformation of inputs into outputs by way clothing. The distributional decision amounts to choosing how much food and how much
of the production process) is to create benefits from consumption for individual people. clothing each person in society is ultimately able to consume.
Individual members of households enjoy consuming goods and services. Moreover, this
process will create value for society as long as the households' benefits from consuming
the finished goods and services are greater than their burdens of supplying the factors of
production. i A detailed discussion of what differentiates one economic system from another is provided in Chapter 3,
a Recall the recognition that people are self-interested which was discussed near the end of Chapter 1.
Chapter #2 - Fundamental Economic Questions and Gains from Special~.ation
Chapler #2 - Fundamental Economic Questions and Gains from Specialization

produced. This combination of outputs is illustrated as Point X in Figure 2.2, which is a


THE PRODUCTION POSSIBILITIES FRONTIER combination of 732 units of food and zero units of clothing, and again represents one
point along the PPF.
The scarce nature of productive resources (i.e., any society has only a finite
amount of land, labor, and capital) imposes a constraint on society in terms of what it can To determine the full shape and placement of the PPF, consider gradually
produce and ultimately results in society facing tradeoffs regarding the levels of increasing food production from zero units up to the maximum of 732 units and each step
production of different goods. These observations ere most easily seen by constructing a along the way determining the maximum amount of clothing that could be produced.
Production Possibilities Frontier (PPF), such as the curve illustrated in Figure 2.2. The The only way to puss~ly make more food is to devote more productive resources to food
Production Pnslibmties Frontier is a curve that summarizes the limits of production production. When society is producing at its limits, it must be using all of its available
that a society faces by illustrating the maximum amount of one good that can be productive resources. Thus, starting at such a point, in order to devote more productive
produced for every possible level of production of another good. resources to food production, it is necessary to divert productive resources away from
clothing production. This diversion of resources results in a decrease in the amount of
Figire 2.2- Prodlctlon Possibilin'es Frontier clothing produced. As a result, the PPF must be downward sloping.
When considering alternative uses of a scarce resource, it is helpful to identify
Clothing
and focus on the opportunity cost of using the resource for a paRicular purpose.
'T
Opportunity cost is a generel concept that refers to the cost of giving up the best
alternative that must be foregone in order to do or acquire something. It measures the
820 ........................ value of the next best use of the resources used to undemke (and provides the truest
measure of the cost of engaging in) the activity being considered.
As an example, what is the cost of going to see a movie on a Friday night? Your
immediate response would likely focus on the $10 that you have to pay for the ticket to

1........
39o ...........,of ........ ,~ ....- ~
i i ~
,1
the movies. If you think a bit more, you may recognize sumo additional monetary
outlays that you would make to see the movie (perhaps $8 spent on concessions and $2
spent on gas). So, the total monetary costs are $20. But, in many respects "$20" is a

-
pretty meaningless measure of the cost of seeing the movie. Af~ all if you don't spend
the $20 on your trip to the movies, you will use the money for something else. The
notion of opportunity cost suggests that the tna~ measme of your cest of going to the
movies is obtained by identify what this "something else" is and determining the value
0 i that you place on foresoing this nlt~rnative opportunity.
Further, theax: are other resources (beyond the $20) that you use to see the movie
and, therefore, other foregone oppommities. Perhaps the most obvious is the two hours
0 240 480 621 732 that you spend in the theater watching the movie. If you didn't go to the movies, you
would have spent these two hours doing something else. Again, what you need to do is
Again consider a society with a finite amount of productive resources that identify the next best use of this scarce resource (i.e., your two hours of time), and
produces only food and clothing. If all productive resourees were used to produce determine the value that you place on forgoing this alternative activity.
clothing, then we would necessarily produce zero units of food. Further, this choice Suppose that if you don't go to the movies, you will instead use the $20 to buy a
would result in some finite amount of clothing (suppose 900 units) being produced.3 This new novel over the Internet and you will instead use your two hours of time to exercise at
combination of outputs is illustrated as Point T in Figure 2.2, which is a combination of the gym. The opportunity cost (i.e., the Uue enst) of going to the movies is equal to the
zero units of food and 900 units ofclothing, and represents one point along the PPF. At benefits that you would have instead realized by owning the novel and exercising for two
the other extreme, if all productive resources were instead used to produce food, then hou~ This is the best measure of you cost of going to the movies, since it is what you
zero units of clothing and some finite amount of food (suppose 732 units) would be are actually giving up in order to go to the movies..
Returning to our discussion of the PPF in Figure 2.2, ~ our society is
3 The actual numerical value depends upon nuruemus factors, including how many r~ources the society starting at Point T (at which zero units of food are produced) and is contemplating an
has available, the productive abilities of those resoures~ the technology available for productina, and the inct~tsu in food production up to 240 units, in onier to realize this iucreasu in food
units being used to rm~ure output of clothing. production, we need to dive~ productive resu~ away from clothing production,
Chapter #2 - Fundamental Economic Questions and Gains from Specialization
Chapter #2 - Fundamental Economic Questions and Gains from Specialization

can possibly be produced with the available productive resources and technology. Any
thereby decreasing the amount of clothing produced. Two immediate questions are: point beyond the PPF represents a combination of outputs that is unattainable, in that the
"Which productive resources should be the first ones devoted to food production?''4 and combination cannot possibly be produced (given the limits imposed by the scarcity of
"By how much will we have to decrease clothing production in order to produce these
resources and current technology). In Figure 2.2, Points T, U, V, W, X, and Y are each
240 units of food?"
attainable - each one is a combination of outputs that this society could choose to
Supposing that our available resources differ in regards to their abilities to
produce.6 In contrast, Point Z is unattainable. Given the scarce nature of productive
produce clothing and food (e.g., maybe "Worker A" is good at growing food but not good
resources, there is no way for this society to produce 621 units of food and 820 units of
at making clothing, while "'Worker B" is good at making clothing but not good at
growing food), then the necessary decrease in clothing production depends upon which clothing.
resources we use to produce the initial units of food. The opportunity cost of producing a When addressing the production decision, this society can think of the PPF as a
unit of food is best measured by the number of units of clothing that we must give up in menu of available options. Any point on or below the curve can possibly be chosen. In
order to produce the unit of food (after all, if the resources weren't used to produce food, practice, the society would want to answer the production decision by choosing the
they would instead be used to produce clothing). Resources with different productive combination of goods on this menu which is most valued, given the preferences of its
abilities have different opportunity costs. When increasing food production, we want to members. But, many of the points that are attainable can be ruled out as the best answer
consider all of the available productive resources that could be used to produce the next to the production decision by making a rather weak assumption on preferences. Suppose
unit of food, and choose to use the one which has the lowest valued opportunity cost. that society's preferences are such that having more of either good (with the same amount
Doing so allows us to produce the next unit of food with the smallest possible decrease in of the other good) is more desirable (i.e., "more is better"). For example, start by
clothing production. considering the combination Y = (240,390) (i.e., Point Y, which corresponds to 240
Following this procedure each step along the way as we gradually increase food units of food and 390 units of clothing). It would seem quite reasonable to assume that
production from zero units up to 732 units allows us to determine the full placement and this society would prefer either U = (240,820) (which has the same amount of food but
shape of the PPF. Recognize that at any point along the PPF, the rate at which we must more clothing than Point Y) or W = (621,390) (which has the same amount of clothing
give up clothing in order to produce the next unit of food is directly equal to the
numerical value of the opportunity cost of producing food for the productive resource but more food than Point Y) to Y = (240,390).
that we are diverting away from clothing production toward food production. Thus, By this argument, under the mild assumption that "more is better," any point
when we allocate productive resources in the most effective manner, the PPF becomes below the PPF can be ruled out as the answer to the production decision for this society.
steeper at higher levels of food production (as illustrated in Figure 2.2). Finally, ffwe let For this reason, it is useful to distinguish between attainable points characterized by
productive efficiency versus attainable points characterized by productive inefficiency.
OC ~ denote the opportunity cost of producing food from using "resource j," it follows
A society realizes productive efficiency if it is NOT possible to increase the amount
that when we produce more food by optimally diverting "resourcef' away from clothing produced of any good, without decreasing the amount produced of some other good. At
production and toward food production, the slope of the PPF at this point is - OC ~ (i.e., such output combinations (e.g., Points T, U, V, W, and X in Figure 2.2) the society is
"minus the opportunity cost of producing the good on the horizontal axis for the resource producing at its limits and faces tradeoffs in production. Starting at U = (240,820), is it
being reallocated").5 possible for society to produce an additional 240 units of food, bringing total food output
up to 480 units? Yes, but only if they are willing to get by with (i.e., accept the tradeoff
of having) 820 - 610 = 210 fewer units of clothing.
Interpretation of the Production Possibilities Frontier In contrast, an attainable point is characterized by productive inefficiency if it is
First and foremost, the PPF provides a direct distinction between output possible to increase the amount produced of some good, without decreasing the amount
combinations that are attainable versus ones that axe unattainable. Any point on or below produced of any other good. At such output combinations (e.g., Point Y in Figure 2.2),
the PPF represents a combination of outputs that is attainable, in that the combination the society does not face a txadeoff in production. Starting at Y = (240,390), is it
possible to produce an additional 240 more units of food, raising total production of food
4 Recognize that the answer to this question is part of the resource use decision.
s The "slope" of a curve measures its steepness as the ratio of the change in vertical distance to the change
in horizontal distance (i.e., "rise over run") as we move along the curve. Moving down the PPF in Figure 6 At each point on the PPF (such as Points T. U, V, W, and X), we are producing the maximum mount of
2.2, the "rise" is equal to the dec,zease in clothing production (a negative value), while the "run" is equal to clothing for a chosen quantity of food (or, equivalontly, the maximum amount of food for a chosen quantity
the increase in food production (a positive value). For a reallocadon of resonrees that leads to a one unit of clothing). If we do not use all of our productive resmu,cas or allocate our resources in a tess than ideal
increase in food production, the ratio of these changes in output levels is equal to the previously described way (e.g.. if we produce the initial units of~xl by using the available resom'ce with the highest valued
opportunity cost for producing food. oppommity cost), then we would realize e point below the PPF [such as Point Y).
Chapter #2 - Fundamental Economic Questions and Gains from Specialization
Chapter #2 - Fundamental Economic Questions and Gains from Specialization

food production, his output of food increases by 8 units and his output of clothing
to 480 units? Yes, and even without decreasing the amount of clothing produced. In decreases by 2 units. Thus, Baker's opportunity cost for producing food is oc
B_,- ~, = ÷,
fact, starting at Y = (240,390), this society could increase food production up to 621
since he must decrease his output of clothing by ¼ of a unit for every additional unit of
units (an increase of 381 units) without having to decrease clothing production at all.
This is because a point characterized by productive inefficiency is realized either by not food that he produces. Thus, his PPF is a straight line with a slope of -OCg =-¼,
using all available productive resources or by allocating productive resources in a less illustrating the general insight previously made on the value of the slope of the PPF.
than ideal way. Thus, an increase in the amount produced of some good (with no Finally, if Baker were to spend all five days producing only food, he would produce 40
decrease in the amount produced of any other good) can be realized by either using the units of food and 0 units of clothing. Similarly for Taylor, her PPF has a vertical
idle resources or by assigning resources to productive tasks in a more effective way.
intercept of 0 units of food and 50 units of clothing a slone of - OC r= _~ _ -1 and a
Again, without specific knowledge of the preferences of society (i.e., the relative
value placed on different levels of clothing and different levels of food), we cannot horizontal intercept of 50 units of food and 0 units of clothing (as illustrated in Figure
determine which feasible point is ideal when answering the production decision. But, 2.4).
under the mild assumption that "more is better," any feasible point characterized by
productive inefficiency cannot be best. As a result, when choosing what combination of
outputs to produce, the ideal answer must always be a point along the PPF - that is, one Figure 2.3- individual weekly PPF for Baker
of the attainable points characterized by productive efficiency. Clothing

A S i m p l e Tw o - P e r s o n / Tw o - G o o d E x a m p l e
intercept" => [
"vertical
The precise way in which specialization in production can allow society to
produce greater amounts of output can be illustrated by developing a simple two- Baker produces
person/two-good model of an economy. Consider a society that consists of only two only clothing
people, Baker and Taylor. The only productive resources are the labor of each person.
These two individuals spend their time making food and clothing. Suppose the workers Baker's weekly PPF [
differ in regards to productive abilities. Table 2.1 provides a summary of the output that
can be produced in any given day by each worker. "horizontal
intercept" =>
Table 2.1 - productive abilities for two person~two good society Baker produces
10"4 only food
One day of Baker's labor 8 2
0 Food
One day of Taylor's labor I Units of food
I 0 produced J Units of clothing
1 0 produced I

0
t
40
For example, if Baker spent an entire day producing food, he would make 8 units.
If instead he spent an entire day producing clothing, he would make 2 units. If he spent The ultimate aim is to see how the two individuals can increase their joint output
half a day making clothing and half a day making food, he could produce 4 units of
through specialization in production (i.e., by having workers spend a disproportionate
clothing and 1 unit of food. A similar interpretation of the values in the bottom row
amount of time producing the good which they are "relatively good at producing"). With
provides insight on Taylor's productive options.
this in mind, two immediate questions arise: "Who is better at producing food?" and
Consider the choice of what to produce over the course of a five day workweek.
"Who is better at producing clothing?"
If each individual was producing only for his or her own consumption, the production
Based upon the values reported in Table 2.1, it would seem as if the most natural
possibilities would be summarized by the PPFs illustrated in Figures 2.3 and 2.4.
answers to these questions are that Taylor is better than Baker at producing both food and
If Baker spent all of his time making clothing, over the course of five days he clothing. After all, if each worker spends one day making food, Taylor produces more
would produce 0 units of food and 10 units of clothing (corresponding to the vertical
output than Baker (since 10 is greater than 8), and if each worker spends one day making
intercept in Figure 2.3). If he diverts a single day away from clothing production toward
Chapter #2 - Fundamental Economic Questions and Gains from Specialization
Chapter #2 - Fundamental Economic Questions and Gains from Specialization

food (since if the labor is not used to produce food, it would instead be used to produce
clothing, Taylor produces more output than Baker (since I0 is greater than 2). These clothing). This is precisely the previously discussed notion of opportunity cost. As noted
observations are recognitions of the facts that Taylor possesses an absolute advantage in
above, Baker's opportunity cost for producing food is OC rs= ¼ and Taylor's opportunity
the production of food and an absolute advantage in the production of clothing.
cost for producing food is ocr= 1. Thus, the cost of having Baker produce the next unit
Figure ~4-individual weekly PPF for Taylor of food is ¼ of a unit of clothing, whereas the cost of having Taylor produce the next unit
Clothing of food is I unit of clothing. So, "Who can produce food at a lower cost?" Clearly, the
"vertical
intercept" => answer is Baker, since giving up ¼ of a unit of clothing is less costly than giving up I
Taylor produces unit of clothing. This is simply an observation of the fact that Baker possesses a
only clothing comparative advantage in the production of food.
In general, consider a situation in which there arc two potential producers of two
< / different goods. Focusing on the production of either one of the two goods, the
50" ~N,~ opportunity cost of producing the good provides a measure of how many units of the
//~ Taylor's weekly PPF ] other good must be given up in order to produce one more unit of the good under
consideration. The first producer possesses a comparative advantage in the production
\ / I . b o .Jz. /It Taui nyt n tp rao d ulc e sI
ercept" =>
l o ro
of the good if her opportunity cost of producing the good is lower than the opportunity
nylfood cost of the second worker for producing the same good. The worker who possesses the
comparative advantage can produce an additional unit of the good while incurring a
smaller decrease in production of the other good. Again, in the present example Baker
has a comparative advantage in food production, since the decrease in clothing
Food production which must be incurred to produce an additional unit of food is smaller for

t
50
Baker (¼ of a unit of clothing) than it would be for Taylor (1 unit of clothing).
Shifting attention to the production of clothing, recognize that Baker's
opportunity cost for producing clothing is OC $c=$~- = 4 and Taylor's opportunity cost for
In general, consider a situation in which there are two potential producers of a producing clothing is OCT c-~-
1 0 _ 1. Since Taylor's opportunity cost for producing

good. Suppose that each producer is given n common amount of inputs, and wc observe clothing is less than Baker's opportunity cost for producing clothing, it follows that
who can make more total output with the given inputs. The first producer possesses an Taylor possesses a comparative advantage in the production of clothing.
absolute advantage in the production of the good if she can produce more output than Note the way in which Baker's opportunity cost for producing clothing is relatad
the second producer with the same amount of inputs. For the present example, which 1
worker has an absolute advantage in the production of food? The answer is Taylor, since to his opportunity cost for producing food: OC ~= OC-----~r. That is, his oppon'unity cost
when using one day of labor, Taylor can produce more food (I0 units) than Baker (8
units). Similarly, Taylor has an absolute advantage in clothing production, since when for producing clothing is equal to the reciprocal (or multiplicative inverse) of his
using one day of labor, Taylor can produce more clothing (l 0 units) than Baker (2 units). opportunity cost for producing food. This relation arises because the value of Baker's
But, since Taylor possesses an absolute advantage in the production of both food opportunity cost for producing clothing is equal to the decrease in output of food divided
and clothing, it follows that this notion cannot provide much insight on how productive by the increase in output of clothing which results from diverting his time away from
resources should be used. After all, if Taylor is beRcr at producing both food and food production toward clothing production. Similarly, Baker's opportunity cost for
clothing, which activity should she focus on, and, further, how should Baker use his producing food is equal to the decrease in output of clothing divided by the increase in
labor7 With this in mind, is there a more insightful way to answer the questions of "Who output of food which results from diverting his time away from clothing production
is better at producing food?" and "Who is better at producing clothing?" Recognize that toward food production. In either case, we are considering a re.allocation of the same
these questions can be sfightly rephrased as "Who can produce food at a lower cost?" and productive resoerces, the only difference being the direction of the change (i.e., assay
"who can produce clothing at n lower cost?" from food production toward clothing production in the fomler case, away from clothing
Focusing first on the production of food, the true cost of producing a unit of food production toward food production in the latter case). The reciprocal relation between
is best measured by the number of units of clothing that must be forgone to produce the Baker's two oppor~mity costs is a direct consequence. In fact, this is a general relation
Chapter #2- Fundamental Economic Questions and Gains from Specialization
Chapter #2 - Fundamental Economic Questions and Gains from Specialization

resources actually increases the amount produced of each good: food output increases by
that must hold for any "worker I" dividing his labor between the production of "good 1" 3 units (Baker's increased output of 8 units is 3 units greater than Taylor's decreased
output of 5 units) and clothing output increases by 3 un/ts (Taylor's increased output of 5
and "good 2": OC ~= ~ (or equivalently OC I1= ).
units is 3 units greater than Baker's decreased output of 2 units).
Further, because this reciprocal relation holds for each worker, it immediately This example illustrates the driving force behind the Law of Comparative
follows that in any two-person/two-good setting, if one worker has a comparative Advantage, which states that when increasing the production era good, a society should
advantage in producing one of the goods, then the other worker must have a comparative do so by using the available productive resource with the lowest opportunity cost (i.e., the
advantage in producing the other good. For example, suppose you do not know any of one which has the comparative advantage at producing the good). The Law of
the numerical values in Table 2.1, but are told that Baker has a comparative advantage in Comparative Advantage was first described by the English economist David Rinardo in
the production of food, What are the consequences of knowing this (in light of the 1817. It is a truly profound insight. When challenged by the Polish mathematician
reciprocal relation which must hold for each worker's two opportunity costs)7 Stanislaw Ulam to give an example of a proposition fi'om the social sciences that is both
If Baker has a comparative advantage in the production of food, then (by true and non-trivial, the economist Paul Samuelson cited this result, stating: "The
1 Ricardian Theory of Comparative Advantage...That it is logically true need not be
definition) OC~ < OCr. If we multiply both sides of this inequality by ~ and
argued before a mathematician; that is not trivial is attested by the thousands of important
I 1 and intelligent men who have never been able to grasp the doctrine for themselves or to
1 1
believe it after it was explained to them."s
ocr, it becomes ~ < ~--~-ra. By the reciprocal relation we know OCr = OC"-'-f
By always applying the Law of Comparative Advantage, a society is able to
and O
c C- mOC~
_ 1 . .". . Thus,
..~ the inequality can be expressed as OCr < OCt, which (by guarantee that for any chosen level of production of "good I" the maximum possible
amount of"good 2" is produced. This approach to allocating productive resources can be
definition) implies that Taylor has a comparative advantage in the production of clothing. illustrated by fully constructing the societal weekly PPF (with specialization) for the two
Specialization in production allows a society to produce greater amounts of output person economy consisting of Baker and Taylor (i.e., a PPF which ilhisWates the joint or
by essentially exploiting differences in opportunity costs between productive resources. collective productive possibilities of the two individuals). This PPF is illustrated in
When deciding how to effectively allocate different productive resources to various tasks, Figure 2.4. If all five days of each workers time is devoted to producing clothing, then in
differences in absolute abilities (i.e., total output levels) are not important, but rather total 60 units of clothing ((5)(2) = 10 by Baker and (5)(10) = 50 by Taylor) and zero
differences in comparative abilities (i.e., relative tradeoffs in output levels) are what units of food are produced. This is illustrated by Point G in Figure 2.5.
matter. Starting at Point G, which worker should be used to produce the first unit of food?
To illustrate how the two individuals can increase their joint output by Recognize that society has essentially two options: have Taylor produce the first unit of
specialization in production, assume that without specialization Baker is spending at least food (in which case clothing output would decrease by oct= 1 unit) or have Baker
one day per week making clothing and Taylor is spending at least half a day per week
making food.~ Recall that Baker has a comparative advantage in the production of fund produce the first unit of food (in which case clothing output would decrease by OC ~= ¼

(i.e., OCen < OCr) and Taylor has a comparative advantage in the production of clothing of a unit). Clearly, the better choice (consistent with the Law of Comparative Advantage)
is to have Baker produce the first unit of food. Further, so long as either worker has some
(i.e., OCcr < OCff). Thus, we would want Baker to spend more time producing food time that could be diverted toward food production, we would always want to have Baker
(and less time producing clothing) and Taylor to spend more time producing clothing produce the next unit of food. As a result, starting at this vertical intercept the societal
(and less time producing food). PPF is a straight line with a slope of - OC ~= -¼ (since Baker is the worker whose time
How would the joint output of the two workers change if Baker were to increase
is being switched away from clothing production toward food production). But, at some
his time spent making food by one day (thereby decreasing his time spent making
point we will have switched all of Baker's time over to food production. When Baker
clothing by one day) and Taylor were to increase her time spent making clothing by half
spends five days producing food and Taylor spends five days making clothing, together
a day (thereby decreasing her time spent making food by halfa day).'? As a result of this
reallocation of time, Baker would produce 8 more units of food and 2 fewer units of they produce 40 units of food (all produced by Baker) and 50 units of clothing (all
produced by Taylor). This leads to Point H in Figure 2.5.
clothing, while Taylor would produce 5 more units of clothing and 5 fewer units of fuod.
But, focusing on the collective output of the two workers, this reallocation of productive
s $amuelson p 'The Way of an Econormst. m Samuelsca, p. A.. Internauonal Economtc Relauons:
Even if these assumptions me not satisfied, specialization can lead to an increase in joint output so inng as Proceedings of the Third Congrns$ of that International Economic Association, London: Macmillan. 1969.
Baker is producing positive amount of clothing and Taylor is producing a positive amount of food to start. page 9,
Chapter #2 - Fundamental Economic Questions and Gains from Specialization Chapter #2 - Fundamental Economic Questions and Gains from Specialization

If Baker wcrc producing only for his own consumption, the best hc could do is spend one
Figure 2.$ - weekly PPF for Baker and Taylor (with specialization) day making food and four days making clothing. He would then produce and consume 8
units of each good. Similarly, if producing only for her own consumption, the best that
C....
mmmg[ "vertical intercept" => [ [ "kink" => Baker produces Taylor could do is equal divide her five day workweek between clothing production and
food production, producing and consuming 25 units of each. The collective output of the

]~
I | both Baker and Taylor 1~ onlyfood, while Taylor
produce only clothing [[ produces only clothing two workers consists of 33 units of each good (illustrated by Point K in Figure 2.5),
which lies below the joint PPF)°
5 0 + 1 0 = 6 0 ~ When specializing in production, the efficient point with equal amounts of food
J ~ u n i t s o f
~ food and 0 units ofclothing, and clothing is realized by having Baker spend all five days making food (thereby
I G ~ . H l c " "
50"1- ........... ~ ' z , , / [ while Taylor produces 5 units producing (5X8) = 40 units of food and zero units of clothing) and having Taylor spend
[ of food and 45 units of clothing half a day making food and four and a half days making clothing (thereby producing
4 5 - = ~ . . . . . . . . . .K. . . . . ~ (.5)(10) = 5 units of food and (4.5)(10) = 45 units of clothing). When allocating their
I ~ I 'no
,L rizontal
-- 1 33 ........... ~ I time in this fashion, in total they produce 45 units of each good, putting them at Point I in
Productive ~ ] intercept" =>
[ .,~1 ~ Figure 2.5. That is, specialization in production allowed them to produce 12 additional
inefficiency / / ' ~ ~ ] both Baker and units of food and 12 additional units of clothing.
- - i ,
(perhaps from "no [
specialization")/ " ~
/I onlyfood
j / ~ Taylor produce Now suppnsc that on top of this specialization, the two workers trade with each
i other. As an example, if Taylor gives Baker 13 units of clothing in exchange for 27 units
of food, then Taylor is ultimately left with 32 units of food (the 5 units she produced, plus
the 27 units she received from Baker) and 32 units of clothing (the 45 units she produced,
minus the 13 units she gave to Baker). Clearly Taylor is better offbeing able to consume
33 40 45 90=50+40 32 units of each good as opposed to only 25 units of each good (which was the best she
could do when producing only for her own consumption).
Under this arrangement, Baker is ultimately left with 13 units of food (the 40 he
At this point, is it possible to produce even more food? Yes, but the society no produced, minus the 27 he gave Taylor) and 13 units of clothing (the zero he produced,
longer has the luxury of using Baker's labor (i.e., the resource with the lower opportunity plus the 13 he received from Taylor). So, after specialization and trade, Baker is also
cost). They must now have Taylor produce any additional food (i.e., they must use a better off than he would have been if he instead produced only for his own consumption
resource with a higher valued opportunity cost). As a result, the PPF becomes more (being able to consume 13 units of each good, as opposed to only 8 units of each good))I
negatively sloped (the slope is now equal to -ocr=-l), reflecting the fact that a Thus, through specialization in production, this two person society is able to
greater decrease in clothing production is now necessary to produce an additional unit of produce more of each good than would bc possible if each person produced only for his
food. Recognize that the PPF becomes more negatively sloped as a direct consequence or her own consumption. Further, once we allow trade following this specialization, each
of correctly applying the Law of Comparative Advantage? Finally, if all five days of individual is able to realize higher levels of consumption, compared to what they could
each workers time is devoted to producing food, then 90 units of food ((5X8) = 40 by achieve if they did not interact with the other person. That is, as a result of specialization
and trade, not only is society as a whole better off (in terms of being able to produce
Baker and (5)(10)= 50 by Taylor) and zero units of clothing arc produced. This
more total output), but further, each individual member of society is better off(in terms
corresponds to Point J in Figure 2.5.
Further, after more of each good is produced through specialization, the total
output of society can be distributed to consumers in such a way so as to make all l0 Recognize how these choices by Baker and Taylor provide answers to the three fundamental economic
individuals better off than they would be when producing only for their own questions. Production Decision: the society produces 33 units of each good. Resource Use Decision:
consumption. We can illustrate this point more easily by making a simplifying Baker spends one day making food and four days making clothing, while Taylor spends two and a half days
making each good. Distributional Decision: Baker consumes 8 units of each good. v,'hile Taylor consumes
assumption about the preferences of our two consumers. For the sake of argument, let's 25 units ofeach good.
suppose that each person always wants to consume an equal amount of food and clothing. tt Again, these choices provide a set of answers to the three fundamental economic questions.
~: the society produces 45 units of each good. Resource Use Decision: Baker spends five days
making food and zero days making clothing, while Taylor spends halfa day making food and four and a
In an ¢¢ooomy with many different productive resources (each with a diffe~nt valued opportunity cost for half days making clothing. Distributional Decision: Baker consumes 13 units of each good, while Taylor
producing food), this would result in PPF which approximates a smooth curve that is bowed-out from the consumes 32 units of each good.
origin, similar to that pictured in Figure 2.2.
Chapter #2 - Fundamental Economic Questions and Gains from Specialization
Chapter #2 - Fundamental Economic Questions and Gains from Specialization

of being able to consume greater quantifies of the goods, thereby realizing greater C H A P T E R # 2 M U LT I P L E C H O I C E Q U E S T I O N S
benefits from consumption).
The importance of these gains in output from specialization in production cannot I. When interpreting a Production Possibilities Frontier, which of the following
be understated. They provide the basis for why individuals within a society should statements is true?
bother interacting with others when it comes to producing goods and services for A. "All Attainable combinations of output are characterized by Productive
consumption, As this example illustrates, specialization, division of labor, and trade can Efficiency."
be a "win-win situation" for all members of society. B. "A combination of goods is characterized by Productive Inefficiency if it
cannot possibly be produced with the currently available resources and
technology."
C. "A combination of goods is Unattainable if it cannot possibly be produced
with the currently available resources and technology."
D . None of the above answers are correct,

2, Which of the following is one of the "Three Basic Economic Questions" that every
society must address?
A. "How can we reduce our carbonfoo~rinf?.'"
B. "Which productive resources should be used for the production of which
goods?"
C. "How can we guarantee that all people have access to bealthcare?"
D . More than one (perhaps all) of the above is one of the "Three Basic Economic
Questions" that every society must address.

3. Evan and Liam spend each workday assembling bicycles and fixing computers.
Evan can assemble 24 bicycles in a single day, while Liam can assemble 18
bicycles in a single day. Based upon this information alone, we know that
A. Evan possesses a Comparative Advantage in assembling bicycles.
B. Evan possesses an Absolute Advantage in assembling bicycles.
C. Liam possesses an Absolute Advantage in fixing computers.
D . More than one (perhaps all) of the above answers is correct.

4. Production refers to
A. the consumption ofgoods/servines.
B. the creation of additional scarce resources/inputs.
C. inputs, which can be broadly categorized as land, labor, and capital.
D. the process by which inputs are transformed into outputs.

5. Consider a society consisting of only three people: Amy, Bill, and Carrie. Amy and
Bill spend all day producing clothing and food. At the end of each day they bring
their output to Carrie, who then divides it between the three individuals. The "basic
eeonormc question" that Carrie is answering for this society is the
A. Resource Use Decision.
B . Production Decision.
C . Distributional Decision.
D . Choice of Incentives.
Chapter #2 - Fundamental Economic Questions and Gains from Specialization
Chapter 02 - Fundamental Economic Questions and Gains from Specialization

are the decision making entities whose primary objective is to obtain


6. is a general concept that refers to the cost of giving up the benefits from consuming goods and services.
best alternative that must be foregone in order to do or acquire something. A. Politicians
A. A Property Right B. Households
B. Comparative Advantage C. Firms
C, The Resource Use Decision D. Entrepreneurs
D. Opportunity Cost
1 I. The Preliminary Circular Flow Diagram illustrates the
For Questions 7 through 9, consider a society facing the Production Possibih'tles Curve
A. movement of economic resources (i.e., factors of production and finished
illustrated below: goods/services) between households and firms.
Corn B. transfer of money between households and firms.
C. the limits of production that a society faces, by identifying the maximum
amount of one good that can be produced for every possible level of
1,000 ~.~. production of another good.
8 ~ . . . ~ . ~ . . . . . . . . . . D. gains in output that can be realized when individuals focus their efforts on
producing the goods for which they possess a comparative advantage.

12. A.C. and Zack produce surfboards and hair gel. A.C.'s opportunity cost of
producing a surfboard is lower than Zack's opportunity cost of producing a
surfboard. The suggests that they can increase their total
Tanks output of these two goods if A.C. focuses his production on surfboards while Zack
0 ~ focuses his production on hair gel.
0 300 320 420 600 A. Law of Absolute Advantage
B. Law of Comparative Advantage
7. Which of the following combinations of output is "feasible but characterized by C . Cost-Benefit Principle
productive inefficiency'? D . Incentive Principle
A. "A" (300 Tanks and 375 bushels of Corn).
B. "B" (420 Tanks and 800 bushels of Corn). 13. "Vinny's Sports Pub" is Jessica's favorite restaurant. After recently joining their
C . "C" (420 Tanks and 1,000 bushels of Corn). frequent diner club for free, she got a coupon by e-mail which can be redeemed for
D . More than one (perhaps all) of the above answers is correct. either a free order of Buffalo wings or a free slice of pizza. Last night she used the
coupon to get a flee slice of pizza. Her Opportcnity Cost of the slice of pizza is
8. Starting at Point "B" (i.e., 420 Tanks and 800 bushels of Corn), if this society A, zero, since she received the code for free.
wanted to produce 180 more Tanks, then B. the maximum amount of money she would have been willing to pay for the
A. they could not increase their output of Corn, but they also would not have to slice of pizza if she did not have the coupon.
decrease their output of Corn at all. C, the regular menu price of a slice of pizza.
B. they could also increase their output of Corn by 200 bushels. D, the value she places on an order of Buffalo wings.
C. they would have to decrease their output of Corn by at least 300 bushels.
D. they would no longer be able to produce any Corn whatsoever. 14. The provides a guide for allocating scarce productive resources to
various uses, which states that when increasing the production of a good, a society
9. If this society wanted to produce 650 bushels of Corn, then their maximum output should use the nvallable productive resource with the lowest opportunity cost.
of Tanks would be A. Opportunity Cost Principle
A. exactly 420 Tanks. B. Economic Distribution Principle
B. more than 420 but fewer than 600 Tanks. C, Law of Absolute Advantage
C. exactly 600 Tanks. D, Law of Comparative Advantage
D. more than 600 Tanks.
Chapter #2 - Fundamental Economic Questions and Gains from Specialization

15. An output combination is characterized by Productive Efficiency if


A. it cannot possibly be produced (given the limits imposed by the scarcity of
resources and current technology).
B. it is possible to produce the output combination, and further it is not possible Economic Systems:
to increase the amount produced of any good without decreasing the amount
produced of some other good.
C. it is possible to produce the output combination, and further it is possible to
Capitalism versus
increase the amount produced of some good without decreasing the amount
produced of any other good. Socialism
D. one single worker possesses a comparative advantage in producing every good
that is a part of the output combination.
In the modem world (for our purposes roughly from 1700 to the present) there has
16. Erika produces clothing and food. In a single day she can produce either 100 units been competition between several different economic systems. The two that survived
of clothing or 25 units of food. It follows that her Opportunity Cost for producing a into the 20`h century were Socialism and Capitalism, the ideas of which are still
unit of food is units of clothing. contending with each other to the present day. An economic system refers to the rules
A. (25X 100) = 2,500. and methods put in place by a society to answer the three fundamental economic
B. 100-25=75. questions of "What to produce?," "How to produce it?," and "For whom to produce it?"
C. 100+25=4. (recall the discussion of these questions from Chapter 2).
D. 25 + 100 ='A. In many respects, an economic system can be thought of as the institutions and
social arrangements established by a society to answer these three fundamental economic
questions. In most modern societies, there are four broad institutions that are ofutmnst
importance for determining the answers to these questions: households, firms,
government, and markets. As was noted in Chapter 2, the two primary decision-making
institutions in any economy are households and fares. A market can be defined as the
collection of all potential buyers and all potential sellers of a good or service. In many
societies, nearly all of the interactions between households and finns takes place within
markets.
With regards to the functioning of an economy, the fourth important institution is
government. In this context, government refers to a decision-making institution with the
legal authority to impose restrictions or mandates on the behavior of other decision-
makers, in other words, the ability to use legal coercion. In a modem economy,
government plays a critical role in defining and enforcing property rights. It is necessary
for government to undertake these actions in order to create a solid foundation upon
which markets can operate. Additionally, government plays a key role by regulating the
behavior of businesses (e.g., mandating product characteristics, such as the automobile
safety features discussed in Chapter 1), providing some goods and services (e.g.,
education or healtheare), and redistributing income (either directly by way of transfer
payments, such as food stamps or welfare, or indirectly through the tax code). By such
actions, government imposes constraints or restrictions on the behavior of decision-
makers, thereby directly altering the costs and benefits of different actions and indirectly
influencing how households and firms interact with each other in markets.
Recognize that there is a drastic difference in the power or authority that the
decision making entity of government (or the state) has when compared to that of a
household or business. As described by the German philosopher and political economist
Chapter #3 - Economic Systems: Capitalism versus Socialism Chapter #3 - Economic Systems." Capitalism versus Socialism

Max Weber in his famous lecture "Politics as a Vocation," the government or the state plays, and movies as diverse as Tennyson's King Arthur to "Monty Python and the Holy
differs from other decision malting entities in that it alone has established "the monopoly Grail." Feudalism took centuries to collapse, but the collapse accelerated during what we
of the legitimate use of physical force within a given territory.''~ Consequently, if a now call the Industrial Revolution which become visible in the 18a~ century and picks up
member of household or a business wants you to do something, they have to in some steam in the 19a' century in Europe and North America. While the roots of Capitalism
non-coercive way make doing it worth your while. In stark contrast, if government wants can be traced all the way back to the Renaissance in the advanced trading city states of
you to do something, they could choose to threaten you with penalties that are ultimately Italy, we will pick up the story with Adam Smith who wrote An Inquiry into the Nature
backed by a threat of the use of force, encompassing physical harm or incarceration. and Causes of the Wealth of Nations in 1776 (hereafter The Wealth of Nations).2
From this discussion, we can see how each of these four different institutions Socialism, on the other hand, grew out of a reaction to the problems of
plays an important role in determining society's answers to the three fundamental industrialization with many famous thinkers leading the way. We will focus on the
economic questions. Again, it is a society's economic system that in essence specifies works of the most famous and ultimately influential of Capitalism's critics, Karl Marx.
the "rules" that must be followed and the roles which are played by households, firms, Among his most famous works are The Communist Manifesto, written with Freidrich
and government (and any other relevant decision makers, such as labor organizations and Engels in 1848, and Capital." Critique of Political Economy, Volume 1 written in 1867.
non-guvemmental organizations) when interacting with each other in markets. In all of his works on economics Marx analyzed and criticized capitalism in the most
severe terms and proposed an alternative known as communism. For our purposes at this
point of the discussion we will treat socialism and communism as synonyms since they
C A P I TA L I S M V E R S U S S O C I A L I S M agree far more than they differ.
In the diagram below we put socialism on the "left" and capitalism on the "right."
The primary aim of the present discussion is to distinguish between the two In European and American usage, people who oppose capitalism are politically to the
dominant economic systems of socialism and capitalism. Other systems coexist with "left" of those who support capitalism (or, equivalently, those who oppose socialism are
these two in the world but do not contend for dominance on the world stage. Historically, politically to the "fight" of those who support socialism), in addition to the main titles of
the most basic of all economic systems is the Traditional System which can be seen in the respective systems, socialism and capitalism also have many synonyms in current
subsistence agriculture and fishing as well as in nomadic herders and others. These usage which are listed below. You may be familiar with many of them since the debate
methods still exist side by side with more modem organizational forms in many lesser between capitalism and socialism has been going on quite loudly for some time.
developed countries, but have all but died out in Europe, the large coastal cities in the Far
East, North America, most of Latin America, and in the larger cities of Africa and the Socialism i | Capitalism
Middle East. In this chapter we will spend our time describing and analyzing socialism
Communism Free-Market System
and capitalism since they are the only remaining alternatives that economically advanced Command System Free Enterprise
societies really consider as alternatives. Such an examination falls within the realm of Centrally Planned System
comparative economic systems, which is the subfield of economics that compares and Decentralized System
Laissez Faire
contrasts the structure and the performance of different types of economic organization
(i.e., different economic systems). Each synonym brings out different aspects of each system in more detail, but we will use
The fundamental defining characteristic of any economic system is an socialism and capitalism as the main labels for the ideas embodied in all of these terms.
identification of who is allowed to own and decide how to use the available productive What are the dominant characteristics of each system that clearly identify their
resources or factors of production - the inputs such as factories, farms, stores, trucks,
differences? For most of the present discussion, we will be using the terms socialism and
and equipment used to produce goods and services. At any point in time a society has a capitalism in their purest, theoretical sense, not as practiced in any real country. With
certain, scarce amount of these factors. this in mind, we can differentiate between these two systems by identifying who is
Capitalism, the first alternative to be examined, grew out of and replaced allowed to own the factors of production.
Feudalism in Europe over an extended time period. Feudalism is the system of
aristocratic and hereditary ownership of landed estates and titles of nobility where society
is divided between the nobles at the top and the serfs or peasants at the bottom. The Socialism is an economic system based on Government ownership of the factors
of production. The government (on behalf of society) owns all of the productive
nobility owned all of the land and gained their possess/un of it either by conquest or
resources and operates all of the businesses and, therefore, determines the answers
inheritance. This system is both glorified and lampooned in our culture in poetry, books,
to the fundamental economic questions by deciding what goods to make, what
J An English translation of Weber's "Politics as a Vocation" is available at htto://anthrotyos-lah.net/wt~/wr~-
content/uz~loads/20 l ]//2/Weber-Politics-as-a- Vocation.pall. 2 The full text of The Wealth of Nations is available at: http. ',it~vwe~-(mhh org?ibrdr3 "Smith ~sml;:~:htrnl.
Chapter #3 - Economic Systems: Capitalism versus Socialism Chapter #3 - Economic Systems: Capitalism versus Socialism

prices to charge, who gets access to the goods, and who gets denied access to the instance, if you own 50 acres of land, who gets to decide if corn or cotton is planted on it
goods. this year, or if the land is left fallow, or ira subdivision or apartment complex is built on
it? Private ownership implies that the owner gets to make that decision exclusively, and
Capitalism is an economic system based on private ownership of the factors of the community as a whole does not get to vote on how the property is used. Let's
production. Private individuals own all of the productive resources and operate examine another example. You own a car and a school break is coming up. Your friends
all of the businesses. This ownership is referred to as Private Property. Private want to go to the mountains in it and you want to go to the beach. Who gets to decide
ownership of a company can be by a single individual like in a sole where the car goes? You do, as the owner, even if your friends outnumber you. This
proprietorship, or with other like-minded individuals such as in a partnership or fight of control also extends to any income you derive from the property you own. For
corporation. In all these cases there is an identifiable, limited group of people example, you own a house and rent it out to Mr. Miller for $1,000 per month. Your
who are the owners. This is in distinction to state ownership where conceptually neighbor Mrs. Jones claims that she should get to keep the rent from the house. Who
the whole society owns the property. {For example, Michael Dell and his may rightfully claim the rent payments? In capitalism you, as the owner, have that right.
stockholders own Dell Computer Company, but you and I do not, while What if in addition to the rent you collected you make $100,000 in salary, but Mrs.
Yellowstone National Park and the Post Office belong to all Americans.) Just as Jones' hours at work were just reduced and she will make only $20,000 this year. Which
in socialism, the "owner" of the enterprise gets to make the decisions of what of you now has the fight to collect the rent from your rental house: you or your neighbor?
product to produce, what price to charge, who gets access to the goods, and who In capitalism, you, as the owner, still have the right, since ownership has not changed.
gets denied access to the goods. This is because ownership carries certain rights Clearly, the defining issue for capitalism and Private Property Rights is ownership, not
and responsibilities. need or some other criteria.
Right to Acquire or Transfer Ownership of Property. If ownership gives
In order to understand each system more fully we are now going to examine in more people such powerful control over the use of, and the income from, property, how did
detail the underpinnings of each system. Since the capitalist system came fn'st and the people get to own the property to begin with? While the concept of property clearly
socialist system started as a criticism of capitalism we will start with an analysis of exists in the Bible and in other ancient civilization's documents, the modem concept of
capitalism. Private Property as a right in the English speaking world is most forcefully put forward
by the philosopher John Locke in his Second Treatise on Government (originally
published in 1690. All references to the version edited by C.B. McPherson, Hackett
C A P I TA L I S M A N D P R I VAT E O W N E R S H I P O F P R O P E R T Y Publishing, 1980.) in this treatise he bases the justification for ownership of all property
as being an extension of self-ownership. In his chapter, On Slavery, he makes the
Private Property or Property Rights are understood by the philosophers of argument that everyone owns themselves by natural right and that no one else may treat
capitalism as a subset of, or a part of, the overarching concept of individual rights or another human being as property, nor may a person even voluntarily sell themselves into
human rights, commonly known as Natural Rights. Not all philosophers who have slavery. A person's freedom is considered an inalienable right or a right that is inherent
studied private property agree that people have a right to their property equal to their in a person and cannot be removed from them even if they want to get rid of it (you may
right to their human rights or civil rights. We will explore this disagreement as the recognize this concept from the Deelamtinn of Independence). This right of self-
chapter progresses, but for now we will explore the pro-capitalist position first, and then ownership is so well established in the modern world and is contested by no respected
the criticism of that position which culminates in the development of socialism and authorities, so we will not attempt to further justify it. This self-ownership then gives
communism. you all of the fight of control over yourself that an owner has over a car or farm or any
What is private property and what does ownership of property give you the other thing that he owns. From this right Locke derives all other property rights.
"'right'' to do? Private Ownership, the key concept within a system of Private Property, How do you get from the ownership of yourself to the ownership of 50 acres of
consists of three interlocking sets of rights which collectively go by the name Property land or a car or any other external thing? In his chapter, Of Property, he poses the
Rights. Ownership consists of the right to: following thought experiment: if you, who own yourself, were wandering through a
1. Control or decide how to use property forest an-owned by anyone and you gathered up wild acorns or apples, who would own
2. Acquire or transfer ownership of property them? If you came back to your band of hunter-gatherers and Fred says to you, "give me
3. Seek restitution for damages to property my acorns," how would you respond? Locke assumes everyone would agree that you
Let's consider each of these in turn. owned the acorns and Fred has no right to them. You could give him some or all of them
Right to Control or decide how to use property. When you claim to own a if you choose, but it is your right to control the acorns and apples because they are your
piece of propar~ you are claiming the exclusive fight to con~'ol or use the property. For property. What made them exclusively your property? Locke says it was when you
Chapter #3 - Economic Systems: Capitalism versus Socialism Chapter #3 - Economic Systems: Capitalism versus Socialism

such a system is to protect an individual's private properly rights. You can however,
"...bestowed your labor upon it..." (paragraph 30, Of Praperty, page 20) that it become
enter into a voluntary agreement with the Gareia family. For instance you can work out a
yours. It was un-owned before, but now that you have done the work you have "mixed
yourself into the good" and it is now yours by right. So, the concept is that if a person rent-to-own plan where you propose taking over all of the work on the farm for the next
who clearly owns himself labors on some un-owned thing, then that thing becomes his, 20 years while giving Mr. Garcia the money the farm earned and at the end of the period
you become the new owner. If Garcia is elderly and cannot work the land anymore he
and all others have no fight to demand the thing from him. By logical extension he
might just be interested, and then you have a deal. As long as yon hold up your end of
claims that a fisherman owns his catch, that a hunter his game, a housewife the water she
draws from a well, etc. the bargain and commit no fraud by shirking your duty to Garcia you will become the
Locke goes on to describe how a person comes to own a piece of land as private new rightful owner. If someone came along after you finally worked offyour obligation
property by the same argument. At one time there was no owner of the trackless forests to Garcia could this new person claim that he has as much right to the land as you do,
and grasslands of the world, but if a pioneer family went out into the un-owned since neither of yon was the original owner? Clearly not. Your agreement or conWact
wilderness and cut down the trees, tilled the land, planted crops, and built a house, who with Garcia, who rightfully owned the farm, transfers his fight to you. Now you rightly
would deny that they "owned" the property7 Could anyone that comes along later, after own the farm, and all other persons must respect your right, just as they respected
all of the work was done, claim equal fights to the crop or to make decisions on what to Gareia's original ownership right.
plant? John Locke said no. From this beginning, all of the physical things of this world What other ways are there to transfer the rightful ownership of, or the property
were appropriated over time until all of the land and everything on it could in principle be right in, the farm to others? You could instead offer Garcia enough money that he would
private property. Now, this scheme still leaves some things conceptually outside of the rather have your money than keep his farm. He can now move to town and pay for his
private property system. It is difficult to define personal ownership of things that have no own retirement out of the cash you gave him. This agreement, voluntarily agreed to by
fixed or permanent location or that cannot be easily contained (e.g., the air, an ocean, or a both sides, makes the transfer of the land to you morally right. You now have all oftbe
river). Even today, such resources remain ommon property, which is property owned rights to claim ownership that Garcia had. Lastly, Garcia could freely give it to you.
simultaneously by everyone in society. Why would he do this? You may be a close relative like a son or daughter, and he could
Most private property that is owned or accumulated today is not accumulated by name you in his will. After he dies you now have all of the rights to the property that he
Locke's original method of applying labor to un-owned things, simply because there are had. If another person comes up and claims that they should have the property how do
few or no nn-owned things to get (fishermen are one exception since they capture un- we decide who should get it? In the above example, the voluntary decision of the rightful
owned fish from an nn-owned ocean or river). So how does one gain a property right in a property owner to do with his property as he wishes makes the person to whom he wills it
car, a business, a house, or a farm if all of the property is already owned by someone (the inheritor) the morally legitimate owner. If Gareia has no children, or dislikes them
else? Most property is accumulated in modem times through voluntary agreements for whatever reason, and voluntarily gives the property to his church or other charity,
known as contracts. We are all familiar with contracts when we buy a car or house, and who now legitimately owns the farm? The son or daughter, or the church or charity? I
we read about football players signing contracts with teams and the like. However, a am sure that by now you see the logic of capitalism, and understand that the church or
contract is really nothing more than a voluntary agreement between two parties to charity is now the rightful owner because it received the farm from a voluntary grant by
voluntarily exchange one thing for another without force or fraud being employed. Most the legitimate owner.
contracts are verbal agreements, but as things get more complicated or the dollar amounts This concept of individual control of property is very modem. Only a few
get large we switch to written agreements, often drawn up by lawyers, to protect the hundred years ago, under what is known as the Feudal System, land was inherited by the
interests of the parties to the agreement. eldest male son or relative by law (you can see an example of this in the PBS period
The process by which property ownership can be transferred is easily illustrated drama, Downton Abbey, where a family has only daughters who cannot inherit their
by way of example. Suppose the Garcia family was the first to enter into a valley after father's estate). If we now imagine a well-governed society with a functioning police and
coming over the mountain pass, and they have spent several years improving the raw land court system to enforce these rules of rightful acquisition and rightful transfer, then
into a comfortable farm. You and your family now enter into the valley too, and you conceptually you can imagine a world in which all present owners of property are the
admire Garcia's farm. There is raw land full of trees available for you to turn into a farm, rightful owners. They now have all the rights of control that the original owners who
but you would rather not do all of that work that the Garcia family did. You like the long ago applied their labor to original pieces of un-owned property had.
Garcia farm and you want if for yourself. May you rightly take it from them against their Right to Seek Restitution for Damages to Property. What do you do if the
will? If your family has 10 members and the Garcia family only has 5, can you sit down momUy correct procedures were not followed to acquire property? Those using force or
with them and have a vote and rightly vote them off the farm like some episode of the TV fraud to acquire property from others do not rightfully own that property, and therefore
show Survivor?. Neither of these options exists within a Capitalist system since have no right to control it, profit from it, or give or sell it to others including their family
ownership in this ease is clear and one of the unambiguous duties of a government in me,nbers. Government may rightly interfere with a person's claim to hold these rights
Chapter #3 - Economic Systems: Capitalism versus Socialism Chapter #3 - Economic Systems." Capitalism versus Socialism

over a piece of property if it can be shown that the acquisition was unjust or wrongly In all of these cases the underlying issue can by conceptually reduced to a dispute over
acquired. As mentioned above, a just or fair capitalist society has (or needs to have) property rights.3 Who owns the property in question, and/or is there a valid agreement to
some method of providing some kind of relief to those who have been wronged by others. transfer property between people? Once these questions are answered then the court
What kind of injuries to a person's property rights gives that person the right to knows who deserves the property or who deserves restitution and who should pay whom.
restitution or to rectification of the wrong? Let's work through some examples. Remember the example of the rental house and your poorer neighbor demanding
the right to collect the rent rather than you? According to proponents of Capitalism, who
Someone texting while driving doesn't see that you have come to a stop sign until should the judge award the rent payments too? Clearly, judges have no authority to alter
it is too late and they hit your car, destroying it. In this case they have damaged the existing property rights or award them to whom they think deserves them. They are
your property which you have exclusive rights over, and therefore justice like referees at a football game. If one team is winning by 35 points can a referee
demands that they pay restitution for the damages. You are not entitled to make a arbitrarily give out 15 yard penalties to the team that is winning or arbitrarily add points
profit on the deal, only to get your property restored to its value before the to the score of the team that is losing in order to make the game "fair'? In the capitalist
accident. If however, you entered into an agreement with the owner of a monster conception of property rights neither judges, nor legislators, nor even the President has
truck show to use your car as a prop for the trucks to crush, are you entitled to the authority to give the rent check to your neighbor if you rightly own the property. This
restitution? Clearly not since your voluntary agreement gave the show owners the would be true even if your income was $1,000,000 per year and your neighbor's was $0.
right to destroy your vehicle (usually in return for money). The primary issue is Your property rights would trump the feelings of others as a matter of moral right. You
not the destroyed car itself, but whether the result was agreed to and whether your could of course give some income to your neighbor as charity, but they could not demand
property rights were violated. it by right.
The study of history shows that most holdings of property throughout time have
Your spouse goes into the hospital for routine surgery, but the doctor was drunk not followed the procedures of morally correct original acquisition or morally correct
and botched the operation killing the patient. How do property rights enter into voluntary transfer to new owners as outlined above. We won't go into the details of all of
this txagedy? Well, who "owns" the body of the person who was killed? That the wars of conquest, frauds, and other forms of coercion that history provides us, but
person obviously does (based upon what John Locke said about serf-ownership in there are a few that are germane to an American audience.
his discussion on slavery). The doctor has no right to take the life away, so the Did the slave owners rightfully own their slaves? When they were set free aRer
dead person has had their property damaged. Since they aren't able to sue the the Civil War was restitution owed them? lfso, by whom: the former slave owners, the
doctor for restitution themselves, their spouse does on the reasonable theory that now defunct Confederate government, or the U.S. government that fought to liberate the
spouses inherit fi'om each other on death. So the surviving spouse sues the doctor slaves (this issue is often discussed in American History courses in the chapter on
for restitution for the value of the life that was taken. Now of course a person's Reconstruction)? When pioneer families crossed the Appalachian Mountains and settled
life is a very difficult thing to value, but in principle a property rights system and farmed Indian lands, did they become the rightful owners? When the U.S.
would treat wrongful death as ultimately a property rights issue. Government gave away 160 acre tracts of conquered Indian land to Americans who
would go live on it and improve it in the famous Homestead Act of 1862 (see the movie
A building contt'actor agrees to install fancy marble in your bathroom but installs "Far and Away" starring Tom Cruise and Nicole Kidman for a cinematic treatment of the
cheap tile instead. Here the issue is failure to live up to a contract which is an !ssue), did those families come to rightfully own it? A Mexican-American, who legally
exchange of property rights and part of the section on transfers discussed above. mumgrated to the U.S. 10 years ago, buys a farm in Kansas from the great grandson of
The homeowner is obligating himself to pay the agreed price and the contractor is the original homesteader and pays good money for it. Does he legitimately own the land,
morally obligated to deliver what was promised. There is now a violation of or could an American Indian descendent living in California claim rightful ownership of
property rights and the homeowner can sue the contractor. the Mexican-American's farm? These are very difficult and contentious issues because
they are about conflicting moral claims to property. Add in all of the more common
A bank lends money to a car dealer so that the car dealer can put cars on the lot crimes, frauds, and other forms of coercinn and you have a difficult knot to untangle.
for sale. The car dealer refuses (for whatever reason) to pay the interest and Modern societies have dealt with many of these issues by invoking the principle
principle on the loan, so the bank sues the dealer for restitution. The bank may of a Statute of Limitations, whose principles go all the way back to Roman Law (see
end up getting a court order for repossession of the cars if necessary to retrieve Cormun, Calvin W., Limitation of Actions, Boston: Little, Brown, 1991), that sets a time
the money lent. limit on how long a person may wait before making a legal claim. The principle here is

J For a fuller discussion of these issues related to the principle of rectification, see: Nozick, R. Anarchy.
State and Utopia, Basic Books. 1974, pages 152-153.
Chapter #3 - Economic Systems: Capitalism versus Socialism Chapter #3 -Economic Systems: Capitalism versus Socialism

not to prevent a person from making a just claim, but to prevent a miscarriage of justice For example my freedom of religion is my absolute fight to believe in any
due to "...fraudulent and stale claims from arising utter all evidence has been lost or after relig on 1 choose or create, or not to believe in any religion at all. The only time anyone,
the facts have become obscure through the passage of time..."4 As you can see, the including the government, may interfere in the exercise of this right is ill use my religion
principle is not to sweep injustice under the rug, but to prevent further injustice fi'om to interfere with someone else's rights For instance, I could not legitimately start a
happening. Whether this principle is strong enough to convince you to let bygones be religion that requires sacrificing maidens, since every maiden has an inalienable right to
bygones is of course open to question. her own life. My right to my religion now comes into conflict with the maiden's equal
In principle, a fair and just capitalist system, operating through a legal system that right to life. However, I do not lose my fight to my religion if the right is negatively
rigorously protects people's property rights, could lead over a period of time to all defined. A negative right is understood as possessing the right to freely do with your
privately owned property being justly owned as a right and deserving of the own property that which you wish, while respecting the equal rights of others to do with
government's protection. This, in a nutshell, is the way that individual capitalists or other their property that which they wish. If the maiden does not wish to participate in your
property owners see their property holdings in a properly functioning capitalist system. sacrificial rituals then you have no fight to make her. When rights are defined in this
As you can see, there is not much room for government action if one adopts the negative sense they cannot ever truly come into conflict with each other, and everyone in
moral principles outlined above. Most welfare programs could not exist, Social Security the world can have the exact same rights as everyone else.
as currently designed would violate people's rights, government subsidies of everyone If the moral and intellectual principles outlined above are true, then the Capitalist
from farmers, college students, the elderly, and banks would have to end. If carried to its System is actually a very morally consistent one that participates in the great Human
logical ends capitalism is only what Nozick calls the minimal state or Night Watchman Rights tradition that most ofns are familiar with. This makes the defense of capitalism a
State, where the government operates only a police force, a court system, a prison system, moral enterprise and not just a defense of privilege in the eyes of proponents.
and the military,s This would be a minimal government indeed! All other activities
handled by government today would have to be handled by private charities, private
schools, churches, and other voluntary associations. Everyone gets whatever they own,
such as clothes, cars, houses, and food, by entering into voluntary bargains with others. S O C I A L I S M A N D S TAT E O W N E R S H I P O F P R O P E R T Y
Whatever income you get from this process is rightly yours and no one, including the
government, may take if from you without your permission. Issues like income Socialists, as you might imagine, totally reject the capitalist's understanding of
private property as nothing but a sophisticated defense of privilege, exploitation, and
inequality do not arise since everyone is the legitimate owner of their income and
oppression of the weak by the strong. Their aim is Social Justice, a conception of justice
property, however high or low. The only exception to this principle would be if the
that transcends the capitalists' conception of natural rights (which includes individual
inequality can be shown to have arisen from a violation of one person's property rights property, contract, and restitution). Advocates of Social Justice instead strive for equality
by someone else.
of outcomes and solidarity (i.e., brotherhood or cohesion) between the members of
society. The denunciation of the Capitalist System can be summed up best in this
popularization of the words of Marx and Engels, "Workers of the World, Unite. You
PROPERTY RIGHTS AS A HUMAN RIGHT have nothing to lose but your Chains!"6
What was the source of these "chains" that Marx wanted to destroy? It was the
In pure capitalism this right to control the property you own is inviolable and is Private Property of the business owning class. Marx divided the world conceptually into
considered part of your human rights, shnilar to your right to freedom of religion or the Bourgeoisie the business owners, and the Proletariat, the working class. By the
speech. In each of these rights you as an individual retain the right to make certain 1840's the industrial factory system in the U.S+ and Western Europe was already a major
decisions that no one else, including the government, may legitimately interfere with. All employer of workers. In the previous century manufacturing took place in small
of these rights (property rights, freedom of religion, freedom of speech, etc.) are workshops controlled by an owner/craftsman who worked alongside his handful of hired
understood to be negative in nature. Negative rights specify obligations of others not to workers and apprentices. By the 1840s, modem factories were of a much larger scale,
interfere in your exercise of your rights. It is also understood that everyone else in the requiring large amounts of financing to purchase and employing hundreds if not
world has these same rights naturally (this is the foundation of Natural Rights) and that
thousands of workers. As capitalism progressed, a new class of very wealthy men who
no individual or government may legitimately interfere in the exercise of these rights. made their fortunes in business emerged who were neither members of the feudal
These rights can only be interfered with, or are only limited, when they come in conflict
aristocracy nor the working class. Marx named the owners of these factories Capitalists
with the equal rights of another.

+ See: htto://le~al-dictionart,.thefreedictionarv.com/Stamte+of+Limitalio~v.
s Nozick. IL Anarchy, State and Utopia, Basic Books, 1974, pages 26-28.
e See endnote 5 on Page 67 ofbtm.'//marxists.ortt/archive/ma~vAL~orks/dpwnload/t~dtTManifesto,f.tr.
Chapter #3 -Economic Systems: Capitalism versus Socialism Chapter #3 - Economic Systems." Capitalism versus Socialism

since they owned the business capital, which is the technical name for all of the Smith. To him they were nothing but a cover for greed and exploitation. This leads to
buildings, equipment, inventories, and money invested in a business enterprise. two totally different conceptions of the proper role of the State or Government.
Marx believed that the relationship between the workers and capitalists was In a pure capitalist society the state is to act merely as a "night-watchman"
inherently exploitive. He believed that most of the improvements in productivity arising protecting the already existing property fights of the people and interfering as little as
from the new factory system should accrue to the workers who produced the goods, not possible. People are left free to make their own decisions, enter into their own
to the capitalists who simply owned the factories. He considered mere ownership as non- agreements, create their own businesses, churches, charities, etc., and generally conduct
productive and that in claiming the income derived from the factory for himself, the their own affairs with their own property flee from government interference as long us no
capitalist was clothing naked aggression and greed in the mantle of morality and human force or fraud was used. The government, as "night-watchman," merely protects these
rights. This made Marx furious, as can be seen in his scathing denunciations of the rights and oversees these agreements, by providing a police force, a court system, and a
capitalists in all of his writings. Of course, the capitalists (who called themselves military.
Entrepreneurs, meaning one who undertakes a project), responded that the factory In a pure socialist system the government would make almost all important
would never have existed in the first place if they did not take the risk of investing in the decisions, since all property is owned by the government. It is a/most impossible to
enterprise, managing it wisely, and finding the markets to sell the goods in. They imagine anything a person could do on their own initiative/fall property belongs to the
believed that their large incomes were fair compensation for the tasks they did and the government. How do you start your own church? All of the land and buildings belong to
risks they took. Marx would have none of that, and this disagreement kicks offone of the the government, all printing presses to print Bibles, Korans, or other holy books are
most far reaching and bloody debates in history, as entire countries lined up on either side owned by the government, all of the paper you would print them on belongs to the
of this controversy. government, all of the newspapers and TV stations on wh/ch you would like to run
If one agrees with Marx regarding worker exploitation by the capitalists, what is advertisements to attract members belong to the government, all of the computers, the
the logical next step? In the Communist Manifesto, Marx proposed revolution. The intemet, and websites that you would like to use are also owned by the government.
purpose of the revolution would be to set up a government to seize both the business Without the government's express support and perra/ssion how would you prooeed~
property and wrongly accumulated personal property of the Bourgeoisie, thereby We could go through other examples, but the general point should be clear; no
destroying the Capitalists. All properW would be collective property that is owned and individual initiative is possible in a pure socialist state, nor is it welcome. From the
operated by the state. In Marx's own ringing words, "The monopoly of capital becomes
socialist's point of view, if you let individuals do their own thing you run the risk that
a fetter upon the mode of production... This integument is burst asunder. The knell of some of the more aggressive and intelligent ones will set up organizations that will
capitalist private property sounds. The expropriators are expropriated.''7 exploit others, and ending this supposed exploitat/on is the express purpose of socialism
The purpose of the government seizing the factories and other property of the
and communism.
capitalists is to re-direct both income and production to satisfy the needs of the
proletariat, whom socialists believe created the goods in the fast place. A more equal
distribution of income could be imposed and society could choose to provide everyone
with goods such as housing, food, clothing, shelter, and medical care, irrespective of a PRACTICAL DIFFERENCES
person's productive ab/lity. This idea is best expressed in the famous Socialist phrase, B E T W E E N C A P I TA L I S M A N D S O C I A L I S M
"from each according to his ability, to each according to his need." (Louis Blanc in, "The
Organization of Work," 183 9) The discussion thus far has focused on the eth/cal underpinnings of property
Following this government seizure of productive resources, a Dictatorship of the ownership as a basis for justifying a system of capitalism or socialism. The defining
Proletariat would be set up in the form of the Communist Party which would adm/nister difference between these two systems is the answer to the question of who owns the
and control the factories and farms that had been collectivized, or brought under common means of production: under capitalism, the means of production are owned by
ownership, until the proletariat could be properly educated and indoctrinated in social/st individuals, whereas under socialism, the means of production are owned by the state.
thinking. Marx believed that people were naturally good and ultimately would not be While this distinction is important to note and conceptually straightforward, it has
motivated by selfish or greedy desires once the capitalist system was destroyed. In the its limitations. First, as noted by Egon Neuberger, "An insistence on using the single
long-run Marx expected the state (or the government) to simply fade away after it was no criterion of property relationships would force us to lump the Uhited States, France,
longer needed. Denmark, and Nazi Germany under capitalism, and the Soviet Union, Communist China,
Marx completely rejected the claims to private property rights as outlined by John Yugoslavia, and Albania under socialism. This would make for some uncomfortable
Locke and the claims of beneficial outcomes of private enterprise as outlined by Adam

s This examp e was adapted from Capitalism and Freedom, by Milton Friedman. Univermty of Chicago
See the Communist Manifesto: hltp.'/Al~vw.marxists.ore/archive/marx~,orks/1867.c l/ch32.htn!.
Press, 1962 and 1982, Chicago, pgs. 16 and 17. and modified by the authors.
Chapter #3 - Economic Systems: Capitalism versus Socialism Chapter #3 - Economic Systems: Capitalism versus Socialism

bedfellows indeed.''9 Numerous scholars in the field of comparative economic systems you to engage in transactions that arc not of this nature. Even if you do not think that the
have suggested that it is perhaps more insightful to focus on and identify who has the transportation infrastructure funded in part by your income taxes is a good deal, you
decision-making power in regards to the use of resources, which may or may not coincide cannot simply choose to not pay your taxes. If you did so, you would be subject to stiff
with who has the nominal ownership claim. Neuberger justifies this position by stating, fines and, ultimately, imprisonment for tax evasion.
"...ownership rights, in themselves, signify very little. They may mean anything from Second, profit seeking entrepreneurs will ultimately respond to the signals which
complete control over the owned object to virtually no control at all. For example, they are sent by consumers via their purchasing decisions. If cnnsumers are willing to pay a
may range from the almost absolute control you have in the decision to save or spend the very high price (in excess of production costs) for plug-in electric hybrid vehicles, then a
dollar in your wallet to the almost zero control a child of three has over the same dollar profit seeking firm will choose to increase production of such goods. This is done by
deposited in his name by his parents in a saving bank."l° We now briefly focus on the essentially diverting productive resources away from other uses (e.g, the production of
practical, operational differences between capitalism and socialism, in order to highlight gas guzzling SUVs), toward the production of plug-in electric hybrid vehicles. This
important distinction regarding how the two systems function. results in more plug-in electric hybrid vehicles being produced and also more productive
In a capitalist system, the bulk of economic decisions are made (and the three resources being devoted to the production of plug-in hybrid electric vehicles. That is, in
economic questions are answered) by individual decision makers interacting with each the capitalist system (in which decisions are made based upon individual choice in free
other in markets. Capitalism relies upon individual choice in markets to answer the three markets) the price system additionally plays an important role in addressing the
fundamental questions (of "What to produce?," "How to produce it?," and "For whom to production decision (i.e., the fundamental question of "What to produce?") and the
produce it?"). Mainstream economic theory supposes that when making decisions in the resource use decision (i.e., the fundamental question of "How to produce it?").
marketplace, most consumers and fL, Tns behave as rational, self-interested decision- Third, based upon the insights thus far, we see that in a free market system, the
makers. From here, many important insights emerge, three of which are discussed below. answers to the three fundamental economic questions are determined indirectly by the
First, when addressing the distributional decision (i.e., when answering of "For innumerable individual decisions made by every member of society regarding the use of
whom to produce it?") capitalism relies heavily upon consumer sovereignty. Consumer the economic resources (both productive resources and monetary resources) which he
sovereignty refers to the freedom for an individual to choose to purchase (or to choose to himself owns. When making each of these decisions, the individual is guided by his own
not purchase) a good or services at a price determined in a free, unfettered market. For self-interest. However, the end result of this seemingly chaotic, decentralized process is
example, in 2015 Chevrolet sold 15,393 Chevy Volts (a plug-in electric hybird vehicle) often a set of outcomes that is good or desirable for society as a whole.
in the United States.H How did we, as a society, decide who got these cars? We These points are perhaps best illustrated by quoting from The Wealth of Nations,
essentially relied upon individual choice in markets, based upon consumer sovereignty. in which Adam Smith wrote, "It is not from the benevolence of the butcher, the brewer,
The suggested retail price of a base level Chevy Volt was $33,995. Each household in or the baker, that we expect our dinner, but from their regard to their own interest. We
the United States exercised its consumer sovereignty and chose to either buy or not buy a address ourselves, not to their humanity, but to their self-love, and never talk to them of
Chevy Volt at this price. From here we can begin to see how price acts as a rationing our own necessities but of their advantage."12 When a fn'm in the marketplace provides
mechanism, a point that will be further explained within the discussion of Demand and us with something that we value, their motive is profit. But, in order for us to be willing
Supply in Chapter 4. Which 15,393 people get to drive these new vehicles? The 15,393 to give up our scarce money for their good, they need to be offering us something that we
who essentially said, "Yes, at a price of $33,995 I'd like to have a Chevy Volt." value. Thus, voluntary trades in free markets arc "win-win situations," in that both the
Returning to Max Weber's observation that only the government or state is able to seller and the buyer are better off as a result of the trade. As a consequence, a savvy
use (or legitimately claim to use) physical force as an ultimate influence on behavior, this entrepreneur will always be mindful of creating something of value for the consumer
notion of consumer sovereignty highlights the practical difference between the power of (after all, it's in his self-interest to do so).
business compared to the power of government. How does Chevrolet get you to purchase As a final consequence, the collective behavior of self-interested decision makers
a Chevy Volt? By giving you something that you want, as a consequence of making the in markets guides us toward a set of outcomes for which the total benefits from economic
attributes of the car very desirable and the price of the ear reasonably low. No matter activity for society as a whole are as large as possible, Adam Smith described these
how big and powerful a private business is, when you are allowed to exercise your unseen forces (i.e., the self-interest of rational individual decision-makers) which lead
consumer sovereignty, you can always walk away from a transaction if you do not like society to an outcome in which maximal value is created from the use of productive
what you are getting or how much you have to pay. In contrast, government can force resources as the "Invisible Hand." Smith stated:

9 Neubesger, Egon, "Classifying Economic Systems," in Morels Bonmtein (ed.) Comparative Economic
Systems: Models and Cases, 6~ edition, Richard D. Irwin, Inc., 1989, page 18.
no Ibid., page 19. n Sm th, A., l'he Weahb of Nations book l, chapter 2. paragraph 2,
|l See: http://en.wikipedia.or~Arikl/Chevrolel Foh. htto: 'A¢~ar.econlib, orv~7ibrarwSmith/sm WNI.htmlCt.. ,

57
: ,
Chapter #3 - Economic Systems: Capitalism versus Socialism
Chapter #3 - Economic Systems: Capitalism versus Socialism

subsidizing desired actions and penalizing undesirable actions. Under Indicative


"As every individual, therefore, endeavours as much as he can both to employ his
Planning, the government guides the behavior of individuals in regards to economic
capital in the support of domestic industry, and so to direct that industry that its
decisions by establishing policies which alter costs and benefits of different courses of
produce may be of the greatest value; every individual necessarily labours to
action. Proponents of Indicative Planning intend it as a complement to (and improvement
render the annual revenue of the society as great as he can....by directing that
upon) markets, as opposed to a replacement for markets. Alec Hove describes indicative
industry in such a manner as its produce may be of the greatest value, he intends
planning as "when the state uses influence, subsidies, grants, [and] taxes [to influence
only his own gain, and he is in this, as in many other cases, led by an invisible
economic decisions], but does not compel.''15
hand to promote an end which was no part of his intention...By pursuing his own
interest he frequently promotes that of the society more effectually than when he In practice, such indicative planning may entail the establishment of guidelines,
really intends to promote it.''.3 regulations, and measurable targets, jointly formulated by government and industry.
Both France and Japan openly operated under such systems during the second half of the
As will be further discussed in Chapter 5 (using the framework of the model of Supply twentieth century. In France, this system of "focusing, prioritizing, and pointing the
and Demand), Adam Smith's notion of the Invisible Hand suggests that in many cases way" was dubbed PlanificationJ6 In Japan, the agency charged with such efforts was the
free market forces result in the efficient amount of a good - that is, the amount which "'Ministry of International Trade and Industry" (MILD, which has been described as "the
maximizes total benefits for society - being produced and consumed. This observation command center for the noncommand Japanese economy.''z7
provides a strong, practical argument for favoring the system of capitalism. In stark
contrast to capitalist systems (which rely upon individual decisions in free markets),
socialist systems rely heavily upon planning. The term "planning'° can be used to broadly DIFFERENT TYPES OF ECONOMIC INCENTIVES
describe any system in which the government plays a key role in determining (either
directly or indirectly) the answers to the three fundamental economic questions. From the discussion above, we can begin to see that the different systems of
Returning to the philosophical foundations of socialism, recall that Marx viewed capitalism and socialism rely upon different types of incentives. As suggested by the
government seizure of productive resources as the first step away from capitalism. discussion of the Incentive Principle, an incentive refers to a change in a cost or a benefit
Ultimately, Marx expected that the state or government could simply fade to the which can cause a person to alter his behavior. There are three different broad types of
background and cease to exist, at which point all productive resources would be owned incentives: material rewards, moral suasion, and coercion. Material rewards refer to
collectively or communally by all members of society. But, Marx conceded that in the monetary rewards or direct increases in consumption from engaging in an activity.
interhn, government would have to play a very heavy-handed role. Capitalist systems rely very heavily upon (but not exclusively upon) material rewards.
Following the seizure of private property by the state a Central Planning system When a fn'm invests a great amount of resources on research and development in order to
would be established to administer all of the thousands of factories, businesses, and farms bring a new product to market, they are likely doing so because of the material reward of
operating when the revolution came. This system would operate similarly to how the profit. Similarly, when a worker gives up 40 hours of her scarce time per work, she is
military operates, where the senior generals in the Pentagon plan out what the soldiers do likely doing so primarily because of the material reward of income that her employer is
and what they will be paid. Then orders, or commands, are issued by a Command giving her in return.
System to get everyone doing what they are supposed to do. In the Communist Manifezto Moral suasion describes attempts to convince individuals to behave in a certain
Marx even used the phrase "Industrial Armies" that the state would form to work in the manner because doing so is the fight thing to do. Sociafist systems likely rely upon moral
factories and on the farms,la Such Command Planning, under which the government suasion to a greater extent than do capitalist systems. However, the behavior of people
directly controls nearly all economic activity, with almost all production taking place living in capitalist systems can sometimes be influenced by such considerations. If you
within enterprises owned and operated by the state, is one form that planning can take. choose to throw an empty water bottle in the recycling bin instead of the trash can, why
This was the system that was essentially in place in the former Soviet Union. are you doing so.'? Recognize, that especially in tight-knit social units, moral suasion can
However, the government need not go to rids extreme to have a significant impact be quite powerful, particularly in the short term. Think about what would motivate a
on the answers to the three fundamental economic questions. Recall the Incentive soldier on the battlefield to expose himself to enemy fire in order to rescue a fellow
Principle discussed in Chapter 1, which recognized that people will often alter their warrior who has been wounded.
behavior in response to changes in costs or benefits. This suggests that, far short of
mandating what people must do, government could guide the actions of people by t5 Nove, A., "Planned Economy," in John EatwcLI, Mun-ay Milgate, and P©tcr Ne~wman (eds.) The New
Palgrave: a Dictionary of Economics, MacMillan. 1987, page 879.
13 Smith, A., The Wealth of Nations, book IV, chapter 2, paragraph 9, 16 See: Yergin, D. and J. Stanislaw, ~The Conmumding Heights: the Battle for the World Economy," Simon
hul~.'/A~econlib.org/lib~r~,/~mith/smWNl3.html#11<2.9. and Schuster, 2002, page I I.
14 See Page 26 of http..I/mar, r~ts.orr, larchitw./marxA~'ork.vldo~lload/pdf/Mantf~to~df. 17 Ibid., page 145.
Chapter #3 - Economic Systems." Capitalism versus Socialism
Chapter #3 -Economic @stems: Capitalism versus Socialism

role in directly supplying (through State Universities) and subsidizing (through low
Coercion is the use or threat of force or incarceration in order to obtain interest rate student loans) higher education. Government is similarly the sole provider of
compliance. Once again, recall Max Weber's observation that only the state (and not mail delivery (the U.S. Postal Service is a legally established monopoly).
households or businesses) can legitimately contemplate using physical force as an Finally, even in many countries that appear to be capitalist, the government plays
incentive on behavior. With this in mind, it is not surprising to observe that the countries a key role by in many areas, such as:
which have ever implemented anything close to the conceptual notion of pure socialism influencing behavior through the tax code (e.g., sales tax rates are higher on
as described by Karl Marx (e.g., the former Soviet Union and present day North Korea)
cigarettes than on apples, interest paid on qualifying mortgages and student
have been totalitarian regimes which regularly relied upon coercion. In these countries loans is tax deductible),
people were often incarcerated in forced labor camps for reasons that would seem
providing a "social safety net" for low income individuals (e.g., in the United
unthinkable to anyone living in a free society. Between 1934 and 1953, approximately States, the federal government has provided healthcare services for low
18.75 million people spent time in the gnlags (i.e., forced labor concentration camps) in
income households through Medicaid since the 1960s),
the former Soviet Union.Is One of these 18.75 million people was Vassily Romashkin,
redistributing income2j (often via progressive taxation, under which high
whose "crime against the state was to check out the wrong library book from the public
h'brery.''|9 income individuals pay a greater percentage of their income in taxes, as is the
case under the U.S. Federal Income Tax), and
regulating the behavior of businesses (e.g., mandating product characteristics,
as in the case of the automobile safety regulations discussed in Chapter 1).
THE MIXED ECONOMY As a result, in practice the answers to the three fundamental economic questions are
answered by a mix of individual decisions in flee markets, along with government
Returning to the example of the production and purchase of 15,393 Chevy Volts intervention and guidance. That is, any system that at first glance appears to be capitalist
in the U.S. during 2015, in light of the discussion of different types of incentives, the likely has some elements of socialism.
consumers of these items were likely influenced by a mix of material rewards and moral
Similarly, any system that seemingly appears to be socialist probably has some
suasion (again illustrating how a capitalist system relies on more than just material elements of capitalism. A mixed economy refers to an economic system in which most
incentives). Further, we suggested that these transactions reflected the exercise of factors of production are owned and controlled by individuals, while some factors of
consumer sovereignty in flee markets. While this observation has a great deal of merit, it production are owned and controlled by the state. That is, a mixed economy contains
should also be recognized that government is playing a significant role in these some elements of capitalism and some elements of socialism. From the discussion
transactions. Each buyer of a Chevy Volt in 2015 was eligible to receive up to $7,500 in above, we see that the United States is in fact a mixed economy. Further, many
the form of a Federal Income Tax Credit.2° The presence of this tax break, which economies in Europe that are commonly referred to as socialist - such as Sweden and
effectively reduces the $33,995 price by over 22% for a consumer who is able to claim France - are best described as mixed economies.2-2
the full credit, reveals that we are not simply letting free market forces decide how many Thus, instead of thinking of capitalism and socialism as "two bins" (with every
Chevy Volts will be produced. In fact, this government policy seems to perfectly fit Alec country having to be placed in one bin or the other, based upon its economic system), it is
Nove's description of indicative planning. instructive to think of there being a continuum between socialism and capitalism. With
The point to recognize is that even a country that seemingly operates under a
this in.mind, it becomes relevant to try to determine where along this continuum different
system of flee market capitalism likely has some elements of planning, some government countries are at any point in time. For example, which country is presently closer to pure
ownership and control of productive resources, and some direct production of goods and socialism, the United States or the United Kingdom? Similarly, we may want to
services by government. For example, in the United States the government is the primary determine how the economic system of a country has evolved over time. For instance,
supplier of education up through the secondary or high school level, and also plays a key was the United States closer to pure capitalism in 2000 or in 1945?
Broadly, most developed countries around the world experienced a two-part
ts This figure is from: EIlman, M. "Soviet Repression Statistics: Some Comments," Europe-Asia Studies, evolution in regards to their economic system during the 20~ century. At the start of the
Vol. 54, No. 7 (2002), pages 1151-1172. As noted by the author, as a measun~ of the number ofpaople 20~ century, government played a relatively limited role, with most countries relying
who spent time in the gulag, this figure is subject to multiple biases, both upward and downwerd. For
example, it overatatcs the number, since some people were sent to the gulag, released after a time, and
subsequently sent back to the gulag. On the other hand, it understates the true number, since it takes no 21 A brief discussion oftbe philosophical arguments in favor of income redisuibution, along with an
account of people in the gulag before 1934 or at~.-r 1953. ove~lew of"social safety net" programs in the U.S., is presented in Chapter 12.
z9 See the video segment "The Ghosts of Noriisk" ("Commanding Heights: the Bittle for the World z2 In practice a Mixed Economy is "characterized by strong direct government involvement in the
Economy," (2003) episode 2, chapter 2), which can be viewed on-line at: ¢conomy...plus an expansive welfare state." See: Yergin, D. and J. Stanislaw, "The Commanding Heights:
hap:/Av~¢.ob.~.oro/wQbh/¢ommandin~heivhts/~haredA'ideoA~'mn/mini ,02 02 220.html. the Battle for the World Economy," Simon and Schuster, 2002, page 3.
2o See "Purchasers of ping-in cars will get tax credits": htm://www.msnbc, m.~n.com/Id/2/462414.
Chapter #3 - Economic Systems: Capitalism versus Socialism

Economic Freedom
Chapter #3 - Economic @stemS: Capitalism versus Socialism ~" Individual freedom and choice is essential for capitalism. As such, we start by
focusing on the results of the Frasier Institute's "Economic Freedom of the World" study,
--, economic questions. Then, from 7 .~ ~mdv is t)redicated upon a suppo,,sition that there are fo~
as re erred m Table 3.1~ Thl~ ":'---,~-oedom' "oersunal choice,' "voluntary exchange,'
e s s e ~ i a l f o u n d a t | o n s o t e c o n o m y , = , , . . . . ts ,,:s
primarily upono2ma0sket~°u~nhS~h~r T;Tt0hs,r~mfUo~da~inn?~So~cmJe::Cadwaay ~:tercj~li:°.mcr "open markets," and "clearly defined and enforced property ngu
roughly the .l:".v ---norav ~ That is, there wa. ~ the 20th century, the econorm
ovemment n the ..~v ~ fin the last two decaoes o!, ,,, with a greater tel ance on For each country in the study the degree of economic freedom is first determined
g - - - - i a l i s m F i n a l l y, d u g . . . . . . . d the cap ta.o.-, - --
towam so,., ' -,-.:.~ moved back to'~,o, in five major dimensions: Size of Government; Legal System and Property Rights; Sound
systems in manY coUnuJ~ -" Money; Freedom to Trade Internationally; and Regulation. In each dimension, a score
markets an a lesser role for gov.emment'nom first popularized in Western Euro,~ bu~2~ between a low of zero to a high of ten (with a higher value corresponding to greater
economic freedom) is determined. An aggregate index value (also ranging between zero
by simply averaging these scores across the five dimens,ons.
and ten) is then computed
compromise between the extre P -
Alec Hove, "a strong case can be made for the proposition that a mix of the two is The results of this exercise for the 159 countries included in the most recent
essential in anY modem society''25 As such, this intermediate system will include the study, which ranks countries in terms of econo._rm_ c fi'eedom mr20115° 7:c~on~oo~lied ~eTdoblme
best of both worlds according to its advocates but the worst of bothissues worldsthat must beto
according 3.1. As noted by the authors, a country acmeves a mg,w .....
its critics. We will ultimately explore inr socia
more detail the practical
ist systems if their supporters are to when its government creates "an infrastructure for voluntary exchange" and safeguards
"individuals and their property from aggressors," along with not enacting policies which
dealt with by either cap:tah~es~a~r~ality
imolement their ideas ann ma r .,.o~o in the world
~¢tlifferent oi oot.~ sy a .
In exaann:ng.th
asDccts "restrict personal choice, interfere with voluntary exchange, and limit entry into
]
wewill emphasize both the successes anu tat~ ....... up your own mind as markets.,,29 Consequently, those countries with larger index values can be thought of as
the end, given that we live in a demOCracy, you will have to make having systems closer to capitalism.
to which system or which possible blend of systems is best for our country. You will As reported in Table 3.1, the four counU'ies with the greatest amount of economic
then have to work towards making the appropriate changes in our economic, moral, and freedom are Hong Kong (with an EFWI of 8.97), Singapore (8.81), New Zealand (8.48),
political systems. and Switzerland (8.44). In fact, these four countries have occupied these four positions
(in this particular order) in each release of this annual study since 2005. While there has
been relative stability at the very top of the ranking in recent years, there has been a
MEASRUES OF A SOCIETY'S ECONOMIC SYSTEM
significant amount of movement further down the list. As will be discussed in greater
detail below, between 2004 and 2010 the United States dropped from a tie for 3'~ place
We conclude the present chapter by discussing attempts to measure or observe a
down to 18e place in the ranking, climbing back up to a tie for 11th in 2015.
coantzy's economic system in terms of the continuum between capitalism and socialism. Over this same time-period of 2004 through 2015, other countries had much more
Within this discussion we focus on structural measures which attempt to gauge the
institutions, rules, or structure of a society's economic system-2s Because there are many dramatic changes in their amount of economic freedom, both upward and downward.
diffel~nt dimensions that determine the economic system of a society, there will not be Between these two years, I 1 countries moved up 20 or more places in the ranking, with
rsall a ed upon and accepted measure of where an economic system biggest upward movers being: Rwanda (up 80 spots from 11 ph to 3 I~; Romania (up
one single, umve ~y gre --:.m: .... d canitalism. r Thus, we must attempt to look at ,:thnc~,~ e,-~m 78t~ to 18th~' Georgia (up 48 spots from 56th to 8th); Mauritius (up. 44 spots
is on the continuum octwcen s~.~,o,- ~ ~ °e"-.s~"~"~,~ .~ ,,.~'~i~. Renublic fun 39 soots from 101s' to 62m). In the
multiple proxy measures.
other direction, 13 countries moved down 30 or more places, with the biggest downward
movers being: Greece (down 77 spots from 39t~ to 116t~); Argentina (down 74 spots from
. ~t~t ,~ ts5th~. Trinidad and Tobago (down 59 spots from 47t~ to 106t~); Oman (down 57
23The exact start date and end date for this period during which . the role of government increased differs
from cot.may to cottony. But, these dates identify the apprordmate start and end date of this transltton for S~l~Ots~fro'm 38~ to 95th); Iron (do~vn 55 spots from 95t~ to 150t~); and Iceland (down 55
the relevant ounmes. . _ , :_ ,..t...,~ 9 of this textbook vrovides a spots from 9t~ to 64~).
The section titled "The Transition to a Market economy m ~,~v~, -. .
preliminary discussion of several important issues that must be addressed when an economy is going
through such a transition from planning to markets. ~ The full report ("Economic Freedom of the World: 2017 Annual Report" by J. Gwarmey, R. Lawson,
Nove,A., -planned Economy,~ in John Eatwell, Murray Milgate, and peter Newman (eds.)The . New
. . .
palgrave:aDictionaryofEconomics, MacMUinn, 1987, page884. and J. Hall), which measures economic freedom across countries in 2015. is available at:
htt~:/A~|~v.fr¢~ver~n.~titute.~r¢~ites/defau~t/~es/e~`~n~mw-fn~ed~m~f-the~" x~r~d-- O l .pd[.
From a pragmatic perspective, we may also care to observe outcome based measures, in gain insight mto :s Ibid.. page I.
how a society's economic system actually performs.Toward this end, a discussion of Gross Domestic :9 Ibid., page 2,
Product is pr~cnted in Chapter 7 and a measure of monroe equahty/mcquahty (the Gmz cocflicJent) Js
developed in Chapter 12.
Chapter #3 - Economic Systems: Capitalism versus Socialism Chapter #3 - Economic Systems: Capitalism versus Socialism
Table 3,1 - Economic Freedom of the World, 2015

rank ewaatry EFW! raak o u n t r y EFW! rank ceantry


! Hong Kong EFWI
8.97 5 4 Bahamas 7.30 107 Nepal 6.49 Returning attention to the 2015 rankings, of the 159 countries included in the
2 Singapore 8.81 54 Hondm'u 7.30 108 Barbadoa
3 New Zealand 8.48 6.47 study Venezuela is the only one with an EFWI below 4.00 (more precisely, 2.92). An
5 4 Hungary 7.30 109 Guyaua
4 Switzerland 6.45 additional 5 countries have an index value below 5.00, including Argentina (4.88),
8.44 54 lutly 7.30 110 M ~ 6.44
5 Ireland 8.19 5 4 Jamaica Algeria (4.84), and the Central Aft/can Republic (4.62). Other countries with an index
7.30 I I l Papua New Guinea 6.42
6 United Kingdom 8.05 5 9 Nicaragua 7.28 112 China value below 6.00 include: Pakistan (5.93), Brazil (5.75), Zimbabwe (5.61), and the
7 Mauritius 8.04 6.40
6 O Uganda 7.25 112 Colombia Ukraine (5.38). Near the middle of the ranking are countries such as: France (52~d, with
8 Georgia 8.01 6.40
61 Gambia, The 7.24
9 Australia 114 Azerbaijan 6.38 an EFWI of 7.33), Italy (54~, with an EFWI of 7.30), Kenya (70zh, with an EFW] of
7.99 6 2 Iceland 7.23
10 Estonia 114 Nigeria 6.38
7.95 6 3 Cambodia 7.11), Mexico (76*, with an EFWI of 6.95), India (95~, with an EFWI of 6.63), Russia
11 Canada 7.21 116 Greece
7.94 6 3 Dominican Rep. 6.36 ( 100a', with an EFWI of 6.60), and China ( 112th, with an EFWI of 6.40). Finally, tbe top
7.21 117 Bangladesh
11 United States 7.94 6.32
6 5 Malaysia 7.19 117 Tunisia quartile of countries includes: the United Kingdom (6*, with an EFWI of 8.05), Australia
13 Lithuania 7.92 66 6.32
14 Cyprus 7.18 119 Vielmlm (9th, with an EFWI of 7.99), Chile (15th, with an EFWI of 7.77), Germany (23rd, with an
7.79 6 7 Macedonia 6.30
7.17 120 Mamceo
15 Chile 7.77 6.29 EFWI of 7.69), and South Korea (32", with an EFWI of 7.54).
6 8 Uruguay 7.16 120 Th~r-Leste
15 Denmark 7.77 6.29 As noled above, between 2004 and 2010 the United States dropped from a tie for
6 9 El Salvador 7.13 122 Saudi Arabia
17 Finland 7.75 6.24 3'd place down to 18~ place in the ranking, with a slight rebound since moving hack up to
7 0 Bhutua 7.11
17 Latvia 123 Yemen, Rep~lic 6.17
7.75 7 0 Kenya a tie for 11~ in 2015. Table 3-2 provides a smnma~ of the change in economic fieedom
7.11 t24 Seangal
19 Netherlands 7.74 7 2 Croatia 6.16
7.02 125 Bumndi which has occurred in the United States between 2000 and 2015. It is worth noting that
2 0 Romania 7.72 6.08
7 3 Indonesia 7.00 126 Bolivia
21 Malta 6.03 during these years there was a slight inc~ase in the average level of economic freedom
7.70 7 3 Sinvenia
21 Taiwua 7.00 127 Pan, fan 5.93 globally, with the mean EFWI value for all countries included in the study increasing
7.70 7 5 Laos
2 3 Germany 6.98 128 ~ 5.92
7.69 7 6 Mexico from 6.67 in 2004, up to 6.76 in 2010, and up to 6.80 in 2015. Thus, the decrease in
6.95 129 Marl 5.90
2 3 Guatemala 7.69 7 7 Tanzania 6.92 130 C6te d'Ivoire economic freedom in the United States between 2004 and 2015 goes against to global
2 5 Norway 5.88
7.67 7 8 Lebanon 6.91 trend during this time.
2 6 Austria 130 Ecuador 5.88
7.66 7 8 Paraguay
2 7 Sweden 6.91 132 Burkina Faso 5.87
7.65 8 0 Kyrgy2 Republic 6.89 133 Malawi 5.86
2 8 Luxembourg 7.63 81 Tuflcey Table 3.2- Decline of Economic Freedom in the United States between 2000 and 2015
6.82 134 Sierra Leone 5.78
2 9 Arm~ia 7.60 8 2 Liberia 6.80 135 B4min 5.77
30 Panama 7.59 8 2 Tajikistan yaw 2000 2002 2004 2005 2006 2007
6.80 136 Gabon 5.76
31 Rwanda 7.57 8 4 Swaziland E.FWl
6.79 137 Brazil 5.75 8.5 8-2 8-2 8.1 8,04 8.06 7.96
3 2 Albania 7.54 8 5 Montenegro Value
6.77 137 Guinea 5.75
3 2 South Korea 7.54 8 6 Bnmei Damssnlam 3'e tied 3'd fed 3'd fled 5* tied 8e' 6* 6*
6.76 139 Niger
3 4 Portugal 7.53 5.74 m.O~ik.aal of 130 of 141 of 141 of 141 of 141
8 6 Nama'bin 6.76 140 Egypt ... ~ of 123 o fl 2 3
3 5 Costa Rica 5.73
7.52 8 8 Se~'bin 6.75 141 Tngo
3 6 Spain 5.70 2009 2010 2011 2012 2013 2014 2015
7.51 8 8 Thailand 6.75 year I
142 G n l n e a - B ~ 5.65
3 7 Untd. Arab Emirates 7.5O 8 8 Zambia 6.75 glrWlI 7.73 7.81 7.73 7.75 7.94
143 Mozambique 5.62 7.60 7.69
3 8 Lqael 7.49 91 Fiji 6.68 144 Zimbabwe 5.61
3 9 Japan 7.47 9 2 Suriname O~ 10~ 18" 17" 12" 16" 16" 11~
6.67 145 Mala-inmia 5.56
3 9 Jordan 7.47 p=~ki~_~ of 141 of 144 of 152 of 152 o fl 5 7 of 159 o fl 5 9
9 3 Cape Verde 6.66 146 Ethiopia
3 9 Philippines 5.53
7.47 94 St'i l.amka 6.65 147 Congo, De~L Rep. of
4 2 Czech Republic 5.45
7.46 9 5 India 6.63 148 Angola The decline in the EFWI value and ranking of the United States betwcen 2004 and
4 3 Belgium 7.44 5-40
9 5 South Afiica 6.63 149 Ukraine
4 3 Peru 5.38 2010 was a result of decreased economic fi'¢edom in all five of the major dimensions
7.44 9 7 Kuwait 6.62 150 Iran
4 5 Mongolia 5.31 (i.e,., Size of Government; Legal System and Proggt"W Rights; Sound Money; Freedom to
7.43 9 7 Oman 6.62 151 Chad
4 5 Qmar 5-26
7.43 9 9 Bosnin & Herzeg. 6.61 Trade Internationally;, and Regulation). The rebound in economic freedom in the United
151 Myanmar 5.26
4 7 Seychelles 7.42 100 Russia 6.60 153 Syria Statos botwecn 2010 and 2015 is due almost exclusively to increased freedom in the
4 8 Bulgaria 5.22
7.39 101 Lesocho 6.58 154 Lybia
49 Bahrain 4.95 dimension of Regnlation. Sub-scores in Size of Government, Legal System and Property
7.38 102 Moldova 6.56 155 Argentina
5 0 Botswana 4.88 Rights, and Sound Money wexe virtually unchanged between 2010 and 2015, while
7.37 103 Ghana 6.53 156 Algeria
51 Poland 4.84 F ~ e d o m t o Tr a d e I n t e m a t i o n a U y d e c l i n e d e v e n f u r t h e r d u r i n g t h e s e m o s t r e c e n t fi v e
7.34 103 Haiti 6.53 157 ~ Republic of
5 2 France 4.81
7.33 105 Belize 6.50 years. In contrast, the United States' summary score in the dimension of Regulation
5 3 S|ovak Republic 158 Ceamd Afi-icaa Rep~ 4.62
7.31 105 Tnnldad& Tobago 6.50 159 Venezuela 2.92
SOURCE: Economic Freedom of the World: 2017 Annual Report. Available at:
httr~s./Acww frg~eri~titute.or~/sites/default//iles/economi¢.freedom.of.the.~tv~rld.20/7,~=lf.
64
Chapter #3 - Economic Systems: Capitalism versus Socialism Chapter #3 - Economic Systems: Capitalism versus Socialism
b h , . i ~ c v.

increased from 8.14 to 8.71, due primarily to decreased government regulation of credit Table 3.3 - International Property Rights lnd~r, 2017
markets.
rank ¢oumtry IPRI rank country IPRI rank country IPRI
1 New Zealand 8.633 4 4 Botswana 6.126 8 7 Ethiopia 4.718
Property Rights 2 Finland 8.626 4 5 Costa Rica 6.060 88 Georgia 4.707
3 Sweden 8.608 4 6 Jamaica 6.010 8 9 Gabon
The definition of property rights is also instrumental in defining a society's 4 Switzerland 4.694
8.561 4 7 Slovenia 5.994 9 0 Mainwi
economic system. The "Property Rights Alliance" releases an annual report, the 4.670
5 Norway 8.533 4 8 Hungary 5.99'. 91 Macedonia
*'International Property Rights Index" (IPRI) measuring the degree to which private 6 Luxemburg 8.459 4 9 Italy
4.655
5.979 92 Bnmei Damssalam 4.632
property rights (both physical property rights and intellectual property rights) are 7 Singapore 8.358 5 0 Lithuania 5.918 93 Ecuador 4.627
protected within different countries.30 The results of the study (reported in Table 3.3) 8 Japea 8.327 51 Panama 5.798 9 4 Mozambique 4.625
9 Netherlands 8.296 5 2 China 5.712 95 C6te d'lvoire
state an IPRI value for 127 different countries. The IPRI value can conceptually range 4.587
10 Australia 8.244 5 3 Ghana 5.646 9 6 Benin
from zero to ten (with a higher value corresponding to more secure property rights) and is 4.583
I I Canada 8.179 5 4 India 5.564 9 7 Argentina 4.568
computed as an average of scores on three different dimensions - "legal and political 12 Denmark 5 5 Trinidad & Tobago
8.158 5.503 98 Sierra Leone 4.523
environment," "physical property rights," and "intellectual property rights.,,31 13 United Kingdom 8.129 5 6 Morocco 5.500 9 9 Into 4.521
New Zealand has the highest IPRI value (8.633), while the Republic of Yemen 14 United States 8.074 5 7 Cyprus 5.447 I00 Paraguay 4.478
15 Austria 8.012 5 8 Brazil 5.434 I01 Egypt 4.433
has the lowest value (2.728). The other countries with IPRI values above 8.5 (rounding
16 Germany 7.959 5 9 Sri Lank 5.390 102 Kazakhstan 4.432
out the "Top 5") are Finland, Sweden, Switzerland, and Norway. Countries with ]PRI 17 Ireland 7.872 6 0 Greece 5.389 103 Lebanon 4.331
values above 6.5 (placing them in the "Top 33" out of 127 countries) include Singapore, 18 Belgium 7.839 61 Kuwait 5.380 104 Cameroon 4.294
Australia, the United States, Hung Kong, Chile, and Rwanda. Near the middle of the 19 Hong Kong 7.786 6 2 Colombia 5.354 105 Montenegro 4.192
ranking are China (52~), India (54th), Brazil (58'~), Greece (60~h), Mex/co (67th), and 2 0 Iceland 7.700 6 3 Latvia 5.341 106 Algeaia 4.160
21 United Arab Emitatas 7.483 6 4 Philippines 5.331 107 Armenia 4.126
Turkey (78th). Near the bottom (i.e., least secure property rights) are Egypt (101a),
2 2 Qatar 7.348 6 5 Peru 5.217 108 Mauritania 4.091
Algeria (106e~), Russia (11 lth), Zimbabwe (120th), and Venezuela (126th). 2 3 France 7.336 6 6 Thailand 5.215 109 Madagascar 4.064
The results of this study are important, since property rights not only go a long 2 4 Tniwan 7.268 6 7 Mexico 5.194 110 Serbia 4.044
way toward revealing a society's economic system, but are also of critical importance for 25 Estonia 7.199 6 8 Indonesia 5.167 111 Russia 4.043
fostering economic growth and development. Secure property rights are a necessary 2 6 South Africa 7.000 6 9 Uganda 5.102 112 Nicaragua 3.990
2 7 Israel 6.974 7 0 Tunisia 5.081 113 Bolivia 3.971
condition for individuals to have incentives to produce gunds/services, develop new 2 8 Chile 6.926 71 Guatemala 5.077 114 Nigeria 3.950
technologies, and invest in privately owned capital. In the absence of secure property 2 9 Malta 6.881 7 2 Tanzania 5.051 115 Azerbaijan 3.946
rights the incentives for individuals to engage in productive economic activity are greatly 3 0 Czech Republic 6.860 7 3 Romania 5.042 116 Bomia & Herzeg. 3.917
reduced. 31 Portugal 6.848 7 4 El Salvador 4.945 117 Chad 3.891
3 2 Malaysia 6.610 7 5 Senegal 4.942 118 Albania 3.822
3 3 Rwanda 6.508 7 6 Nepal 4.941 119 Congo. Dem. Rep. of 3.818
3 4 South Korea 6.495 7 7 Vietnam 4.930 120 Zimbabwe 3.760
Legal and Regulatory Environment 3 5 Spain 6.422 7 8 Turkey 4.925 121 Pakistan 3.474
F i n a l l y, r e c a l l t h e i m p o r t a n t r o l e t h a t g o v e r n m e n t p l a y s i n e s t a b l i s h i n g a n d 3 6 Uragoay 6.412 7 9 Zambia 4.917 122 Bunmdi 3.430
enforcing laws and regulations. In order for markets to function effectively such laws 3 7 Sloekin 6396 8 0 Hondures 4.902 123 Ukraine 3.424
3 8 Manrifns 6.315 81 Liberia 4.893 124 Moldoea 3.178
and regulations should be easy to understand, evenly enforced, and able to be followed at
3 9 Oman 6.280 8 2 Kenya 4.856 125 Bangladesh 3.117
low cost. If this is not the case markets will not be able to operate effectively. That is, 40 Jordan 6.266 4.823 3.057
83 Dominican Rep. 126 Venezuela
for a free market system to provide efficient and equitable outcomes, the system should 41 Poland 6.253 8 4 Mnii 4.814 127 Yemen, Republic 2.72.8
not be plagued by high levels of corruption or an overly burdensome bureaucracy. For 4 2 Bahrain 6.157 8 5 Bulgaria 4.813
instance, during the time of Russia's rapid transition away from socialism in the 1990s, 4 3 Sandi Arabia 6.133 8 6 Croatia 4.754
the ownership of many large enterprises was transferred from the state to private
SOURCE: 2017 lnumaafiooal Pmpealy Rights Index. Available at:
hn~x:/A~r.internationalnrovernvieht~index.orrifull.revort.
For an overview of this index, see: http ://internationalproDerta,ri~ht~index org~ The full
repo~ can be
accessed at: htttTs:/Awnv.internationalnrotTert~,ri~htsindex.or~/futl.report. " "
~zS
ee htfp.?:/At~t~ .Intcrnatlono/17rolTertvrivht, vtndex.orff/counlr3,/bnited.slotes.~.~" for breakdown of how
the U.S. was assessed overall and in each distinct dimension.
Chapter #3 - Economic Systems: Capitalism versus Socialism
Chapter #3 - Economic Systems." Capitalism versus Socialism

'able .1
individuals through what became known as "loans-for-shares" deals. These deals provide Table 3.4 - Rankings on the Ease of Doing Business, 2017
examples of a particular type of corruption known as "crony capitalism," in that the
government often favored insiders with connections. One of the more egregious rank country DTF tank ¢eulltry DTF raak emln|ry
I New Zealand DTF rank
examples was the acquisition of Norilsk Nickel (an enterprise with annual revenues of 86.55 49 Mexico 72.27 97 Guatemala 61.t8 145 Nigeria
2 Singapore 84.57 50 Bulgaria 71.91 98 Dorninica 52.03
$1.5 billion) by Vledimir Potanin for only $180 million.32 3 Denmark 84.06 51 Croatia 71.70 99
60.96 146 Gamb~ "[he 51,92
Dominican Rep. 60.93 147 Pakman
4 South Korea 51.65
Furthermore, an overly burdensome bureaucracy can stifle market activity. 5
83.92 52 Belgium 71.69 I00 India 60.76 148 Burkilm Ftso 51.54
Hang Kong 83.44 53 Cyprus 71.63 101 Fiji
Perhaps the most extreme example of such a situation is the system which evolved in 6 Uniled States 82.54 54 lsrlel
60.74 149 Marshall lslamh
J1,45
71.42 102 Tnnidsd & Tobago 60.68 150 Mlalrltatha
India during the second half of the 20th century, which became known as the "Permit 7 United Kingdom 82.22 55 Chile 71~2 Jordan 50.88
103 6058 151 Be~in 50.47
8 Noway 82.16 56 Bmnei Damsslm. 70.60 104 Lcsotho
Raj." This system consisted of "a complex, irrational, almost incomprehensible system 9 Georgia 82.04 57
60.42 152 Belivla 50.18
Azerbaljan 70.19 105 Nepal 59.95 153 Guinea 49.80
of controls and licenses," under which "everything needed (government) approval and a 10 Sweden 81.27 58 Peru 69.45 106 Namibia 59.94 154 DJibouu 49_~
II Macedonia 81.18 59 Colombia 69.41 107 Antigual & Barbuds 59.63
stamp."33 Regulations impose costs on and create obstacles for businesses which can 155 Minronesia 48.99
12 Esthnia 80.80 60 Turkey 69.14 108 Paraguay 59.18 156 Togo 4&~l
discourage firms from developing new products, entering new markets, and even starting 13 Finland 80.37 61 Costa Plea 69.13 109 Papua New Guinea 59.04 157 Kiribati 48.74
14 Australia 80.14 62 Mongolia 69.03 110 Malawi
up in the first place. Ira business chooses not to undertake one of these actions because 15 Talwan 80.07
58.94 158 Comoms 4&52
63 Luxembourg 69.01 111 Sri Lanka 58.86 159 Zimbabwe 48.47
of excessive regulatory costs (as opposed to other economic considerations), then 16 Lithuania 79.87 64 Puerto Rico 68.85 I]2 Swaziland 58.82 160 Sitma Leone 48,18
17 Ireland 79.51 65 Alb~ia 68.70 113 Philippines 58.74 161 EthJopla
consumers, employees, and the business owners are all worse offas a result. 18 C~eda 79.29 66 Bahrain 68.13 I14 West Bank & Gaza
47.77
58.68 162 Madagascar 47.67
For insights on current bureaucratic costs in different countries we can look at the 19 Latvia 79.26 67 Greece 68.02 115 Ho~dunts 58.46 163 Came~ou 47.23
20 Germany 79.00 68 Vietnam 67.93 116 Solomon Islands 58.13 164 B~umfi
results of a study by the World Bank Group which provides an ordered ranking of 190 21 UnL Arab Emir. 78.73 69 Morocco 67.91 117 Argentina
46~2
58.11 165 Sunnarae 46.87
countries around the world in terms of their "Ease of Doing Business" (as reported in 22 Ausma 78+54 70 Jamaica 67.27 118 Ecuador 57.83 166 AIgc'~t 46.71
23 Iceland 78.50 71 Omen 67.20 119 Bahamas, The 57.47 167 C~bo~
Table 3.41.34 This ranking accounts for bureaucratic costs (in both time and money) 46.19
24 Malaysia 78.43 72 Indonesia 66,47 120 Ghana 57.24 168 h~q ~+s7
across ten different dimensions: Dealing with Construction Permits; Getting Electricity; 25 Mauritius 77.54 73 El Salvador 66.42 121 Belize 57.11 169 7~1o Tom~ & Pi~ci~ 44.84
26 Thail~d 77A4 74 Ozbekistan 66.33 122 Uganda 56.94 170 Sudan 44,46
Registering Property; Getting Credit; Protecting Minority Investors; Paying Taxes; 27 Poland 77.30 75 Bhutan 66.27 123 Tajiklstan 56.86 171 Myanmar 44.21
Enforcing Contracts; Trading Across Borders; Resolving Insolvency; and Starting a 28 Spain 77.02 76 Ukraine 65.75 124 Iron 56.48 172 Liberia 43,55
29 Poaugal 76.84 77 K yrgyz Republic 65.70 125 Brawl 56.45 173 Equalofial Gttin~ 41.66
Business)5 For each country, a "Distance to Frontier" (DTF) score is computed which 30 Czech Republic 76.27 78 China 65.29 126 Guy~ 56.28 174 Syria 41.55
"captures the gap betWeen an economy's performance and a measure of best practice" 31 France 76.13 79 Panama 65.27 127 Cabo Verde 56.24 175 Angola 41+49
32 Netherlands 76.03 80 Kenya 65,15 128 Egypt
across all countries in the study.36 New Zealand has the highest DTF score (86.55), 33 Switzerland 75.92 81 BoLswana 64.94
56.22 176 Gttinea-Bissau 41.45
129 St. Vincent & Gin. 55.72 177 Banglad¢ah 40~9
revealing the greatest ease of conducting business; Somalia has the lowest DTF score 34 Japan 75.68 82 South Africa 64.89 130 Palan 55.58 178 Tirnor-Laste 40.62
35 Rttssia 75.50 83 Qatar 64.86 131 Nic~goa 5539 179 Congo. Rap. of
(19.98), reflecting the largest burdens to conducting business. 39.57
36 Kazakhstan 75.44 84 Malta 64.72 132 Barbados 55,20 180 Chad 38.30
Other countries with low costs of complying with bureaucracy and government 37 Slo~ia 75.42 85 Zambia 64.50 133 Lebam~ 54.67 181 Haiti 38.24
38 Belnms 75.06 86 Bosnia & Hel2eg. 64.20 134 SL Kitts & Nevis 54.52 182 C~go, Dam. Rap. 37.65
regulations include Singapore (2nd), Hang Kong (5th), the United States (6th), Australia 39 Slovah Republic 74,90 87 Samoa 63.89 135 Cambodia 54A7 183 Afghantstan 36.19
(14th), Canada (lgm), and Germany (20th). In contrast, bureaucratic and regulatory costs 40 Kc~ovo 78.49 88 Tanisia 63.58 136 Maldives 54.42 184 Central African Rap. 34.86
41 Rwanda 72.40 89 Tonga 63.43 137 Tanzania 54.04 185 Libya
are very high in countries such as Madagascar (162~), Chad (180th), the Democratic 33.21
42 Mooumegro 73.18 90 Vlmuatu 63.08 138 Mozamhiquc 54.00 186 Yemet~ Republic 33.00
Republic of the Congo (182~a), and Venezuela (188t~). Countries near the middle of the 43 Serbia 73.13 91 St. Lucia 62.88 139 Cbte d'lvolre 53.71 187 South Sudan 32.86
44 Moldo~'a 73.00 92 Saudi Arabia 62.50 140 Seeegal 53.06 188 Veneraela 30,87
ranking include China (78th), Uruguay (94th), India (100th), Argentina (117th), and Brazil 45 Romania 72.87 93 San Marino 62A7 14t Lao PDR 53.01 189 EriUe.a 22.87
(125th). 46 Ibtly 72.70 94 Uruguay 61,99 142 Oreneda 52.94 190 Somalia 19.98
47 ~ i a 72~1 95 Seychcnes 61.41 143 Mall 52.92
48 Hungoly 72.39 96 Kuwait 61.23 144 Niger 52.34

)2 See" " ' SOURCE: Doing Business 2018: Reforming tO Create Jobs. Available at:
. Yergm, D. and J. Stamslaw, "The Commanding- Heaghts:
, the Battle for the World Economy," Simon
and Schuster, 2002, page 299. httD:/A¢ww.d~in~business-~r~/-/media/WBG/D~im:B"siness/D~c1mwnts/Anmla~-ReP~rts/Eng~ish/DB2~8~
33 Ibid., pages 213-14. FulI-ReoorLo~.

The full report ("Domg Business 2018: Reforming to Create Jobs") is avadable on-line at:
Ease of doing business should not be misunderstood to mean a lack of
~ n p . . ~ A ~ w w. d ~ i n J ? b u s i n e s s ~ r ~ / - - / m e d i a / W B G f D ~ i n e B ~ s i n e s s / D ~ u m e n t s / - 4 n ~ a ~ R e t ~ r ~ . ~ E n ~ i s h / ~ 2 ~
Full-Reoort.pdf. government regulation or an absence of government intervention in markets. Rather it
~ T h t ~ r m n-u n o n, t y .m. P r ,o t e c t i n g .M i n o r i t y I n v e s t o r s " r e f e r s t o i n d i v d u o s w t h a s m a l l o w n e r s h i p
should be thought of as a gauge of the degree to which government actions do or do not
claim in business (as opposed t "majority ownership share") - that is, it does not mean minority in the impose significant costs on (and thereby potentially alter the decisions of) businesses.
sense of rscial or socioeconomic status.
~ Ibid, page 5.
Ideally governments should be striving for efficient regulations (which may be needed to
Chapter #3 - Economic Systems: Capitalism versus Socialism Chapter #3 - Economic ,~stems: Capitalism versus Socialism

protect consumers, shareholders, other firms, and the public interest) while imposing Somalia is ranked in the "Bottom 20" in six of the ten dimensions and in the "Bottom
minintal costs on the businesses being regulated. Half" in every single dimension
To gain further insight into the various characteristics of bureaucratic and In contrast, many countries near the middle of the ranking have scores in the
regulatory costs, Table 3.5 provides a breakdown of the relative ranking in each of the ten different dimensions which vary considerably. As an example, China is in this position
dimensions included in the Ease of Doing Business study for fourteen different countries. (ranked 78~ overall, near the middle) by virtue of having veW low costs in some
Information is also provided on the number of procedures, number of days, and monetary dimensions (e.g., ranked 5th in Enforcing Contracts), moderate costs in other dimensions
cost (as a percentage of per capita income) of starting a new business in each of these (e.g., ranked 97~ in Trading Across Borders and 98'~ in Getting Electricity), but very high
countries. The fourteen countries listed in Table 3.5 include those with the overall costs in other dimensions (e.g., ranked 172'~ in Dealing with Construction Permits).
highest and lowest ranking (New Zealand and Somalia), the United States, plus eleven The final three columns in Table 3.5 state the number of procedures, number of
other countries at varying positions along the overall ranking. days, and monetary cost (as a percentage of per capita income) necessary to start a new
business in each of these countries. These figures begin to illustrate the practical
Table 3. 5- Different Dimensions of the Ease of Doing Business In Select Countries
differences which entrepreneurs face in different countries. To start a business in the
United States six procedures must be followed, taking roughly 5.6 days and costing about
1.1% of the annual per capita income in the country. New Zealand has the lowest costs
of sta.,'ting a business - only one procedure must be followed, which can take as little as
half a day and costs a mere 0.3% of the annual per capita income in the country. In stark
contrast, to start a business in Venezuela (ranked 190~ in this dimension) 20 procedures
must be followed, taking at least 230 days and costing 351.6% of the annual per capita
income in the country. Clearly, entrepreneurs are able to more easily respond to
economic incentives in the business climate in New Zealand compared to Venezuela.

Summary
Examining the results of the "Economic Freedom of the World" study,
" ~ - ~ 3 6 1 6 3 6 3 49 6 51fi "International Property Rights Index" report, and the ranking of the "Ease of Doing
Business" collectively, we can identify the countries with the most market oriented and
least market oriented economic systems.37 The countries that are probably closest to pure
- ~ " ~ 6 5 1 3 1 2 9 57 37 4 12.S capitalism are Hew Zealand and Singapore, followed by Hong Kong. Additionally,
- ~ - ~ 1 3 0 I 5 I 9 7 5fi o~t "7 2j~'~ Australia, Canada, and Denmark are in the "Top 10%" across all three rankings. Eight
- ~ - ~ ~ 3 1;6 11,5 2918 i more couna'ies are in the "Top 10%" on two of the lists and in the "Top 20%" on one of
Brazil - $ ~ 05 ] the lists: Estonia, Norway, Sweden, Switzerland, the United Kingdom, and the United
States. Countries that a~ in the "Middle Third" of all three rankings include El Salvador,
i ~ ? ~ ! 8 9 1 4 7 1 8 7 1 6 5 190 India, Indonesia, and Kuwait; countries that are in the "Bottom Third" of all three
~ o m a l , a / 8 6 I _ ~ _ 1 ~ 1 9 0 11 0 f r o 1 6 8 20 230 3~
187 9 rankings include Algeria, Bolivia, Egypt, and Zimbabwe. Finally, countries such as
70 2i
Chad, the Democratic Republic of the Congo, and Venezuela appear to have the least
market oriented economic systems, by virtue of placing in the "Bottom 10%" on all three
are _ F_~,ra Table 3.5 We.Can observe ~at those countries at the very top of the ranking
typlcauy in that poslnon because they tend to perform extremely well in several lists,
dimensions and at least reasonably well in all dimensions. For example, New Zealand is
ranked in the "Top 3" in five of the ten dimensions and is ranked outside of the "Top 40"
in only one single dimension. Similarly+ Singapore is ranked in the "Top 12" in five of
the ten dimensions and is ranked outside of the "Top 30" in only one single dimension.
At the other exlxeme, those countries at the very bottom of the ranking perform very
poorly in many dimensions and do not particularly excel in any dimension, For example,
~) Unfo~unatoly, ~ the ~tive of I~ining insights, the countries that are p~ently cl~icst to pu~
socialism (e.g., Cuba and North Korea) are not evca included in any of these makings,
Chapter #3 - Economic Systems: Capitalism versus Socialism Chapter #3 - Economic Systems: Capitalism versus Socialism

C H A P T E R # 3 M U LT I P L E C H O I C E Q U E S T I O N S 7. One of the three primary types of "economic incentives" is "moral suasion," which
could be described as
1. is an economic system in which the means of production are A. the use or threat of force or incarceration to obtain compliance.
privately owned and operated for a profit. B. the use of monetary rewards or direct increases in consumption which result
A. Capitalism from engaging in an activity.
B. Communism C. attempts to convince individuals to behave in a certain manner because doing
C. Feudalism so is "the right thing to do."
D. Socialism D. the use of torture or other "enhanced interrogation techniques" in order to
elicit information from someone.
2. Which of the following countries currently has an economic system which would be
best described as "Pure Socialism"? 8. refers to the freedom of an individual to choose to purchase (or to
A. Sweden. choose to not purchase) a good or service at a price determined in a free market.
B. China. A. The Invisible Hand
C. India. B. Command Planning
D. None of the above answers are correct. C. Consumer Sovereignty
D. Indicative Planning
3. observed that the government or the state differs from other
decision making entities in that it alone has established "the monopoly of the 9. While playing baseball in their front yard, Wally and his little brother break the
legitimate use of physical force within a given territory." windshield of Ward's car. Wally and his brother concede that it is fight for them to
A. Karl Marx cover the costs of repairing the broken windshield. In taking this position, they are
B. Egun Neuberger recognizing that Ward has a in regards to his car windshield.
C . Max Weber A. right to control
D . Adam Smith B. right to restitution
C. fight to transfer
4. Which of the following is a basic characteristic of Capitalism? D. fight to consumer sovereignty
A. Private ownership of property is illegal.
B. Economic decisions occur in markets. For Question 10, consider the continuum between the economic systems of PRre
C. Income is distributed on the basis of "need." Socialism and Pare Capitalism illustrated below.
D. Government owns the factors ofproductinn.

5. specify/specifics obligations of others not to interfere in your


exercise ofyour rights.
A. Positive Rights
B. Negative Rights
C. Control Rights
D. Social Justice

6. Consider the costs of complying with bureaucratic regulations to economic decision


makers in China, Singapore, and Venezuela. According to the results of the "Ease 10. Along the continuum illustrated above the economy of the United States currently
of Doing Business" study, of these three countries, such costs are: would most accurately lie at
A. lowest in China and highest in Singapore. A. Point A
B. lowest in China and highest in Venezuela. B. Point B
C. lowest in Singapore and highest in Venezuela. C, Point C
D. lowest in Venezuela and highest in China. D. Point D
Chapter #3 - Economic SystemS: Capitalism versus Socialism

fu'st said "From each according to his ability, to each according


Chapter #3 - Economic SystemS: Capgalism versUS Socialism 17.
~ his
to - - nee
- - .- ' - "
A. Adam Smith
B. Karl Marx
I I. In the writings of Karl Marx, the ,,bourgeoisie" rcfencd 1o the C. Louis Blanc
and the ,,proletariat" ref~d to the ..~~-" D. Max Weber
A . business owners; working class.
B. unskilled workers, entrepreneurS. 1 8 . T h e present economic system of the ~United
, w h i l Kingdom
e t h e p r ewould
sent e
bec omost
n o m accurately
ic system of
C. government planners; tax collectors. described as
D . colonialists; nobility. most accurately described as pure Socialism.
S p . a l n ~ e
12. aOn September
$100,000 4, 2009,
reward former California
for anyone who could Governor
provideArnold Schwarzenegger
information leading to offered
the arrest a Mixed Economy; would also be most accurately described as a Mixed
B.
EconOmy.
and conviction of arsonists who set a wildfire in southern California which claimed C. pure Capitalism; would be most accurately described as Pure Socialism.
the lives of two fireflghters. In this situation, Gov. Schwarzenegger was attempting
to obtain the desired information by D. pure Socialism; would be most accurately described as Communism.
A. coercion.
B. command planning. 19. Looking at the results of the ,,EconOmiC Freedom of the World" study, between
C. moral suasion.
2000 increased
and 2010, the
fromEFWI value
56.72 of the
up to United
79.83, States
moving the United States up from 27~ place
D. offering a material reward. A.
is the subfield of economics that compares and contrasts the to 2'~ place in the ranking.
13. B. increased from 5.53 up to 6.42, moving the United States up from 4t~ place to
stracture and performance of different types of economic organization. st nlace in the ranking, down from 3'~
r
A . Comparative Economic Systems decreased from 8.5 dow n to 7.69, moving the United States
B. International Trade C.
place to 18tb place in the ranking.
C. Indusmal Organization
D . Public Choice D. d e c r e a s e d fi ' o m 9 . 1 d o w n t o 8 . 9 6 , b u t b e c a u s e m o s t o t h e r c o u n t r i e s
experienced larger declines in economic freedom over this time-period the
14. In which of the following countries do individuals enjoy the least amount of United States actually moved up from 12th place to 6t~ place in the ranking.
Economic Freedom?
A . Hang Kong.
B. New Zealand.
C. The United States.
D . Venezuela

15. In a typical modem economy, it is common for Government to have an impact on


economic outcomes by
A. defining and enforcing property fights.
B. regulating the behavior of business.
C. redistributing income.
D. More than one (perhaps all) oftha above answers is co~ect.

16. Alec Nove described as "when the state uses influence, subsidies,
grants, [and] taxes [to influence economic decisions], but does not compel."
A. Consumer Sovereignty
B. Command Planning
C. Indicative Planning
D. The Invisible Hand
Chapter #3 - Economic Systems: Capitalism versus Socialism

Organizing Principles of
Capitalist Systems
In the discussion of the Capitalist System in Chapter 3, we saw how free people
morally acquire property, how the ownership and use of property is a right, and how
people use contracts to transfer property from one rightful owner to another. In this
chapter we first delve into issues of exchange in more detail in order to undez~'mnd why
voluntary trade benefits both sides to a Wansacfion (and generally benefits society as a
whole). Then we generalize from a simple two-person exchange to exchange in a market,
where potentially millions of people are buying and selling an item. We will discover
how the market system generates equil~rium prices which bring buyers and sellers of a
good into balance with each other.
Recall the discussion of the Preliminary Circular Flow Diagram presented in
Chapter 2. This diagram illustrated the basic transfer of economic resources between
households and fmms, the two primary decision making entities in an economy.
Households derive benefits from consuming goods and services, which ave acquired from
firms. Firms produce these goods and services using inputs acquir~ from households.
(See Figure 2.1 in Chapter 2.) But, why arc these resources transferred between
households and firms? That is, what are the incentives for self-interested decision makers
to voluntarily relinquish ownership of valuable economic resources and transfer them to
others? In a market based system these transfers will take place voluntarily so long as
individuals who give up an economic resource are given something in return that they
value even more. Such transfers of resource ownership take place in markets and are
facilitated by the use of money. Money refers to an asset that is socially and legally
accepted as a medium of exchange (i.e., as a payment for goods or services).
The Basic Circular Flow Diagram illustrated in Figure 4.1 depicts how money
serves as a medium of exchange to facilitate the voluntary transfer of factors of
production fi'om households to firms and of finished goods and services from finns to
households in markets. On the right side of the diagram we have the markets for goods
and services. The dark arrows here illustrate the movement of finished goods and
services from firms to households (a transfer of reso~ depicted in the Prelimma~
Circular Flow Diagram illustrated in Figure 2.1). But now we additionally see a transfer
of money in the opposite direction (illustrated by the light arrows), from households to
firms. In a umly market based systen~ all such transfers of resource ownership (i.e.,
"trades") are voluntary. Households value the consumption goods/services which they
acquire more than the money which they give up in the form of consumer expenditures,
and likewise, firms value the money they receive as revenues more that the finished
goods/services which they give up.
Chapter #4 - Organizing Principles of Capitalts! @stems Chapter #4 - Organizing Principles of Capitalist Systems

On the left side of the diagram we have the markets for factors of production. - is an exchange of property for money. But how can the voluntary exchanges described
The interactions between households and firms in these markets are quite similar to what above benefit both buyers and sellers? Let's consider a simple example to discover some
was. described above, except the roles of buyer and seller are reversed. The dark arrows important attributes of free-market, capitalist exchange.
again illustrate a movement of economic resources, in this case factors of production Assume Beth is a lover of antique furniture who is willing to pay a significant
from households to firms. To facilitate this movement of resources we again have a amount of money to get an authentic piece. Andy has a genuine antique chest that he
transfer of money in the opposite direction (illustrated by the light arrows), from firms to inherited, and he has been using it on his farm to store tools in his barn. He would like to
households. Again, in a market based system these transfers of ownership are voluntary sell offsome of his belongings to pad his retirement savings. While driving through the
- firms value the productive resources which they acquire more than they value the countryside Beth spots the chest at Andy's garage sale. What price will the two agree
wages and rents paid to obtain the resources, while households value the income received on? Will Andy take advantage of Beth's love of antiques, or will city-slicker Beth take
for these resources more than they value the resources themselves. advantage of country Andy's desire to retire? Is there a third alternative? Can Andy and
Beth both benefit from the exchange?
Figare 4.1- Basic Circular Flow Diagram To answer these questions we need to first develop the concepts of "buyer's
reservation price" and "seller's reservation price." A buyer's reservation price for an
item refers to the maximum amount of money that she is willing to give up to acquire the
item. In general, denote this value by rb. For any particular item, each potential buyer

.,==/?-'-, has a specific value for her reservation price, reflecting the monetary value that she
places on the item.
Similarly, from the perspective of a seller, a seller's reservation price for an item
refers to the minimum amount of money that he is willing to accept in exchange for the
item. In general, denote this value by r. For any particular item, each potential seller
has a specific value for his reservation price, reflecting the monetary value he places on
the item. In the context of a firm selling an item the seller's reservation price is often
equal to the marginal costs of production (that is, the additional costs associated with
Markets for producing, bringing to market, and selling the item).
Markets for
Factors of Since different people can value items differently from one another, for any
Goods and
Product/on particular item there is no reason to think that buyer's reservation price will be equal to

I
Services
seller's reservation price. For example, suppose that as the initial owner of the chest,
Andy has a seller's reservation price of $200. This simply means that if he were offered
less than $200 for the chest, he would prefer to not sell it (i.e., if offered such a low
amount he would choose to keep the chest and continue using it for storage in his barn).
Beth really wants the chest and is willing to pay as much as (but no more than) $1,000 to
" ~ . ~ get it. That is, Beth has a buyer's reservation price of $1,000, because if the price goes
production
over $1,000 she would rather spend her money on something else.

"" "-I ==' From here, we can identify the Bargaining Range, which is simply the range of
possible transaction prices when the two people trade without coercion. Figure 4.2
illustrates Andy's reservation price as a seller and Beth's reservation price as a buyer.

Figarc 4.2- Reservation Prices and the Bargaining Range


F R E E D O M O F C O N T R A C T, V O L U N T A R Y E X C H A N G E , A N D
POSITIVE SUM OUTCOMES
B a r g ~
As we discussed in Chapter 3, very few pieces of property are acquired through
original acquisition from unowned nature. Most of the time we get goods or services o
[ ( f ' .~s
from others by purchase, which - as depicted in the Basic Circular Flow Diagram above
t
rAna.v = rs =200 i
)'Beth = Tb =1,000
79
Chapter #4 - Organizing Principles of Capitalist S),stems Chapter #4 - Organizing Principles of Capitalist Systems

WIN-WIN OUTCOMES IN POSITIVE SUM ENVIRONMENTS


In this example, the bargaining range logically consists of all prices between $200 and
$1,000. To see why this is true, first recognize that both Andy and Beth would be willing The observation that both Andy and Beth are better off from vohintary trade illustrates a
to trade at any price within this range. For example, at a price of $450 Andy is willing to general principle of interactions in a positive-sum environment. A positive-sum
sell (since he is offered more than his reservation price of $200) and Beth is willing to environment is a situation in which the summation of gains and losses over all people is
buy (since she is paying less than her reservation price). Similar observations hold for positive in value. In contrast, a zero-sum environment is a situation in which the
any price between $200 and $1,000. In contrast, at any price below $200 Andy will not summation of gains and losses over all people is exactly equal to zero.
voluntarily sell. Likewise, at any price above $1,000 Beth will not voluntarily buy. Suppose that you and your roommate decide to play a game in which you toss a
Consequently, the bargaining range consists of precisely the prices from $200 up to coin - if it comes up "heads," your roommate pays you $5; if it comes up "tails," you pay
$1,000. your roommate $5. If neither you nor your roommate derive any pleasure or displeasure
Recall that a free-market system is based upon voluntary trade - no one has the (separate from the $5 transfer) from playing this game, then it is a zero-sum environment.
authority to force anyone else to do anything. Rather, both parties have to agree in order To see this, recognize that for each possible outcome, the gains/losses for you and your
for a deal to be made. With this in mind we can further recognize why the bargaining roommate add up to $0 - iftbe coin comes up "heads," you gain $5 and your roommate
range consists of the set of prices from $200 up to $1,000. At any price in this range (and loses $5; if the coin comes up "tails," you lose $5 and your roommate gains $5. For any
only at prices within this range) both Andy and Beth are better off from trading than from such zero-sum environment, the outcome will be a win-lose outcome in which some
not trading. Again consider the price of $450. By selling the chest at this price, Andy is people are better off ("win") and others are worse off("lose"). As we can see, in a zero-
$250 better off than he would be if he kept the chest (he gets $450 and gives up sum environment the winnings of the winners come from the losses of the losers.
something that he values at only $200, so his increase in well-being is equal to the Now suppose instead that you and your roommate decide to play the card game
difference between these two values: $250=$450-$200). Similarly, by buying the chest "Exploding Kittens," which the creators of the game describe as "a highly-strategic, kitty-
for $450, Beth is $550 better off than she would be ifsbe didn't make the purchase (she powered version of Russian Roulette."l By the end of this game there is a winner and a
gets something that she values at $1,000 and gives up only $450, so her increase in well- loser, but the game is also fun to play. Suppose that if you win you derive $9 of pleasure
being is equal to the difference between these two values: $550=$1,000-$450). These from playing the game, whereas if you lose you derive $7 of pleasure from playing the
concepts, which are termed Consumer's Surplus and Producer's Surplus, provide game. You still have the $5 bet resting on the outcome, so there will still be exactly $5
measures of the benefits of trade and are defined and examined in greater detail in trading hands after the game ends. Is this still a zero-sum environment? No, it is actually
Chapter 5. a positive-sum environment. Recognize that the transfer of money from the bet is still a
The range of prices from $200 up to $1,000 is called the bargaining range since a wash - the winner's gain exactly equals the loser's loss. However, the winner gets $9 of
"bargaining process" between buyer and seller could conceptually lead to a trade taking enjoyment and the loser gets $7 from playing the game. This adds up to a $16 gain over
place at any price within this range. As will be reinforced within the discussion of the two players, a positive sum. In contrast to a zero-sum environment (which must
Chapter 5, at higher prices within this range the seller is better offand the buyer is worse always result in a win-lose outcome), in a positive sum environment we can potentially
off (while at lower prices within this range the buyer is better off and the seller is worse have a win-win outcome in which all people are better off ("win"). This is precisely the
off). But if either buyer or seller tries to negotiate too aggressively and bargain for a case for this example. The winner of the game ends up realizing benefits of $9+$5ffi$14,
transaction price outside of this range, negotiation would collapse and trade would not while the loser of the game ends up realizing benefits of $7-$5=$2 (which is also positive
take place. For example, if Andy gets carried away and demands $1,200 for the chest, in value).~
Beth would simply refuse to pay since she would be worse off from the purchase given The critical recognition is that in a positive-sum environment there is the potential
her limited budget and the other things she wants to buy. for a win-win outcome. This potential is present precisely because the environment itself
At this point we have no idea what specific price Andy and Beth will agree to, but generates value for society. That is, the interaction between people which defines the
we do know that it has to be within the bargaining range and it has to make both of them setting creates net benefits for the people involved. This is in stark contrast to a zero-sum
better off. Moreover, since there is a range of prices which makes both Andy and Beth environment, where it was noted that the winnings of the winners come from the losses of
better off, they each have an incentive (as a self-interested individual) to have trade take
place at a price within the bargaining range as opposed to having no trade take place. I See tum:lAw~*:eralodinvkiftfny.com/.
This is true for all voluntary Iransactinns that take place between any two people in the a Recognize that we don't automatically end up with win-win outcome in pnsitive-sum covironmonL If
free-market, capitalist system, including trades between shoppers and retailers, employers the monetary bet had been $8 instead of $5, this game of"Exploding Kinas" would still be pnsitlve-sttm
and employees, and borrowers and lenders. environment with collective gains of$16. However, the winner ends up with $17=$9+$8, while the loser
realizes -.$1-$7-$8 (i.e., net benefit of negative one dollar). The result of the 8ante is win-lnse
outcome.
Chapter 04 - Organizing Principles of Capitalist Systems Chapter #4- Organizing Principles of Capitalist Systems

WIN-WIN OUTCOMES IN POSITIVE SUM ENVIRONMENTS


In this example, the bargaining range logically consists of all prices between $200 and
$1,000. To see why this is true, first recognize that beth Andy and Beth would be willing The observation that both Andy and Beth are better off from voluntatT trade illustrates a
to trade at any price within this range. For example, at a price of $450 Andy is willing to general principle of interactions in a positive-sum environment. A pnsltive-sum
sell (since he is offered more than his reservation price of $200) and Beth is willing to environment is a situation in which the summation of gains and losses over all people is
buy (since she is paying less than her reservation price). Similar observations hold for positive in value. In contrast, a zero-sum environment is a situation in which the
any price between $200 and $1,000. In contrast, at any price below $200 Andy will not summation of gains and losses over all people is exactly equal to zero.
voluntarily sell. Likewise, at any price above $1,000 Beth will not voluntarily buy. Suppose that you and your roommate decide to play a game in which you toss a
Consequently, the bargaining range consists of precisely the prices from $200 up to coin - if it comes up "heads," your roommate pays you $5; if it comes up "tails," you pay
S1,000. your roommate $5. If neither you nor your roommate derive any pleasure or displeasure
Recall that a free-market system is based upon voluntary trade - no one has the (separate from the $5 transfe0 from playing this game, then it is a zero-sum environment.
authority to force anyone else to do anything. Rather, beth parties have to agree in order To see this, recognize that for each possible outcome, the gains/losses for you and your
for a deal to be made. With this in mind we can further recognize why the bargaining
roommate add up to S0 - if the coin comes up "heads," you gain $5 and your roommate
range consists of the set of prices from $200 up to $1,000. At any price in this range (and loses $5; if the coin comes up "tails," you lose $5 and your roommate gains $5. For any
only at prices within this range) both Andy and Beth are better off from trading than from such zero-sum environment, the outcome will be a win-inse outcome in which some
not trading. Again consider the price of $450. By selling the chest at this price, Andy is people arc better off("win") and others are worse off ("lose"). As we can see, in a zero-
$250 better off than he would be if he kept the chest (he gets $450 and gives up sum environment the winnings of the winners come from the losses of the losers.
something that he values at only S200, so his increase in well-being is equal to the Now suppose instead that you and your roommate decide to play the card game
difference between these two values: $250=$450-$200). Similarly, by buying the chest "Exploding Kittens," which the creators of the game describe as "a highly-strategic, kitty-
for $450, Beth is $550 better offthan she would be ifsbe didn't make the purchase (she powered version of Russian Roulette."l By the end of this game there is a winner and a
gets something that she values at $1,000 and gives up only $450, so her increase in well- loser, but the game is also fun to play. Suppose that if you win you derive $9 of pleasure
being is equal to the difference between these two values: $550ffi$1,000-$450). These
from playing the game, whereas if you lose you derive $7 of pleasure from playing the
concepts, which are termed Consumer's Surplus and Producer's Surplus, provide game. You still have the $5 bet resting on the outcome, so there will still be exactly $5
measures of the benefits of trade and are defined and examined in greater detail in trading hands after the game ends. Is this still a zero-sum environment? No, it is actually
Chapter 5.
a positive-sum environment. Recognize that the transfer of money from the bet is still a
The range of prices from $200 up to $I,000 is called the bargaining range since a wash - the winner's gain exactly equals the loser's loss. However, the winner gets $9 of
"bargaining process" between buyer and seller could conceptually lead to a trade taking enjoyment and the loser gets $7 from playing the game. This adds up to a $16 gain over
place at any price within this range. As will be reinforced within the discussion of the two players, a positive sum. In contrast to a zero-sum environment (which must
Chapter 5, at higher prices within this range the seller is better offand the buyer is worse always result in a win-lose outcome), in a positive sum environment we can potentially
off(while at lower prices within this range the buyer is better offand the seller is worse
have a win-win outcome in which all people are better off ("win"). This is precisely the
off). But if either buyer or seller tries to negotiate too aggressively and bargain for a case for this example. The winner of the game ends up realizing benefits of $9+$5=$14,
transaction price outside of this range, negotiation would collapse and trade would not
while the loser of the game ends up realizing benefits of $7-$5=$2 (which is also positive
take place. For example, ifAndy gets carried away and demands $1,200 for the chest,
in value).2
Beth would simply refuse to pay since she would be worse off from the purchase given
The critical recognition is that in a positive-sum environment there is the potential
her limited budget and the other things she wants to buy. for a win~win outcome. This potential is present precisely because the environment itself
At this point we have no idea what specific price Andy and Beth will agree to, but
generates value for society. That is, the interaction between people which defines the
we do know that it has to be within the bargaining range and it has to make beth of them setting creates net benefits for the people involved. This is in stark contrast to a zero-sum
better off. Moreover, since there is a range of prices which makes both Andy and Beth
environment, where it was noted that the winnings of the winners come from the losses of
better off, they each have an incentive (as a self-interested individual) to have trade take
place at a price with/n the bargaining range as opposed to having no trade take place. I See hltz,.'/A~'ww, ex~lodinekiffgn~¢Qm/,
This is true for all voluntary transactions that take place between any two people in the a Recognize that we don't automatically end up with a win-win outcome in a positive-sum environment. If
free-market, capitalist system, includ/ng trades between shoppers and retailers, employers the monetary bet had been $8 instead 0f$5, this game o f "F..xploding Kittens" would still be a positive-sum
and employees, and borrowers and lenders. environment with collective gains of$16. However, the winner ends up with $17=$9+$8, while the loser
realizes -$1-$7-$8 (i.e., a net benefit of negative one dollar). The result of the game is a win-lose
outcome.
Chapter #4 - Organizing Principles of Capitalist Systems
Chapter #4 - Organizing Principles of Capitalist Systems

WIN-WIN OUTCOMES IN POSITIVE SUM ENVIRONMENTS


In this example, the bargaining range logically consists of all prices between $200 and
$1,000. To see why this is true, first recognize that both Andy and Beth would be willing The observation that both Andy and Beth are better off from voluntary trade illustrates a
to trade at any price within this range, For example, at a price of $450 Andy is willing to general principle of interactions in a positive-sum environment. A pnsitive-sum
sell (since he is offered more than his reservation price of $200) and Beth is willing to environment is a situation in which the summation of gains and losses over all people is
buy (since she is paying less than her reservation price). Similar observations hold for positive in value. In contrast, a zero-sum environment is a situation in which the
any price between $200 and $1,000. In contrast, at any price below $200 Andy will not summation of gains and losses over all people is exactly equal to zero.
voluntarily sell. Likewise, at any price above $1,000 Beth will not voluntarily buy. Suppose that you and your roommate decide to play a game in which you toss a
Consequently, the bargaining range consists of precisely the prices from $200 up to coin - if it comes up "heads," your roommate pays you $5; if it comes up "tails," you pay
$1,000. your roommate $5. If neither you nor your roommate derive any pleasure or displeasure
Recall that a free-market system is based upon voluntary trade - no one has the (separate from the $5 transfer) from playing this game, then it is a zero-sum environment.
authority to force anyone else to do anything. Rather, both patties have to agree in order To see this, recognize that for each possible outcome, the gains/losses for you and your
for a deal to be made. With this in mind we can further recognize why the bargaining roommate add up to $0 - if the coin comes up "heads," you gain $5 and your roommate
range consists of the set of prices from 3200 up to $1,000. At any price in this range (and loses $5; if the coin comes up "tails," you lose $5 and your roommate gains 35. For any
only at prices within this range) both Andy and Beth are better off from trading than from such zero-sum environment, the outcome will be a win-lose outcome in which some
not trading. Again consider the price of $450. By selling the chest at this price, Andy is people are better off ("win") and others are worse off ("lose"). As we can see, in a zero-
$250 better off than he would be if he kept the chest (he gets $450 and gives up sum environment the winnings of the winners come from the losses of the losers.
something that he values at only $200, so his increase in well-being is equal to the Now suppose instead that you and your roommate decide to play the card game
difference between these two values: $250=$450--$200). Similarly, by buying the chest "Exploding Kittens," which the creators of the game describe as "a highly-sO'ategic, kitty-
for $450, Beth is 3550 better off than she would be if she didn't make the purchase (she powered version of Russian Roulette.''1 By the end of this game there is a winner and a
gets something that she values at $1,000 and gives up only $450, so her increase in well- loser, but the game is also fun to play. Suppose that if you win you derive $9 of pleasure
being is equal to the difference between these two values: $550=$1,000-$450). These from playing the game, whereas if you lose you derive $7 of pleasure from playing the
concepts, which are termed Consumer's Surplus and Producer's Surplus, provide game. You still have the $5 bet resting on the outcome, so there will still be exactly $5
measures of the benefits of trade and are def'med and examined in greater detail in wading hands after the game ends. Is this still a zero-sum environment? No, it is actually
Chapter 5. a positive-sum environment. Recognize that the transfer of money from the bet is still a
The range of prices from $200 up to $1,000 is called the bargaining range since a wash - the winner's gain exactly equals the loser's loss. However, the winner gets $9 of
"bargaining process" between buyer and seller could conceptually Mad to a trade taking enjoyment and the loser gets $7 from playing the game. This adds up to a $16 gain over
place at any price within this range. As will be reinforced within the discussion of the two players, a positive sum. In contrast to a zero-sum environment (which must
Chapter 5, at higher prices within this range the seller is better off and the buyer is worse always result in a win-lose outcome), in a positive sum environment we can potentially
off (while at lower prices within this range the buyer is better offand the seller is worse have a win-win outcome in which all people are better off ("win"). This is precisely the
off). But if either buyer or seller tries to negotiate too aggressively and bargain for a case for this example. The winner of the game ends up realizing benefits of $9+$5=$14,
transaction price outside of this range, negotiation would collapse and trade would not while the loser of the game ends up realizing benefits of $7-$5=$2 (which is also positive
take place. For example, if Andy gets carried away and demands $I,200 for the chest,
in value).2
Beth would simply refuse to pay since she would be worse off from the purchase given The critical recognition is that in a positive-sum environment there is the potential
her limited budget and the other things she wants to buy.
for a win-win outcome. This potential is present precisely because the environment itself
At this point we have no idea what specific price Andy and Beth will agree to, but generates value for society. That is, the interaction between people which defines the
we do know that it has to be within the bargaining range and it has to make both of them setting creates net benefits for the people involved. This is in stark contrast to a zero-sum
better off. Moreover, since there is a range of prices which makes both Andy and Beth environment, where it was noted that the winnings of the winners come from the losses of
better off, they each have an incentive (as a self-interested individual) to have trade take
place at a price within the bargaining range as opposed to having no Wade take place.
See http:/Atat~v.¢rolodinekittens.fom/.
This is true for all voluntary transactions that take place between any two people in the 2 Recognize that we don't automatically end up with a win-win outcome in a positive-sum environment. If
free-market, capitalist system, including wades between shoppers and retailers, employers the monetary bet had been $8 instead of $5, this game of "Exploding Kittens" would still be a positive-sum
and employees, and borrowers and lenders. environment with collective gains of $16. However, the winner ends up with $17=$9+$8, while the loser
realizes -$1=$7-$8 (i.e., a net benefit ofnegatlve one dollar). The result of the game is a win-lose
outcome.
Chapter #4 - Organizing Principles of Capitalist Systems Chapter #4 - Organizing Principles of Capitalist Systems

the losers. For a positive-sum environment, the interactions between people create value
T H E M O D E L O F S U P P LY A N D D E M A N D
which can ultimately he shared between everyone involved. Further, when the ultimate
outcome will be a win-win, rational people who have a voluntary choice over While many of us negotiate for a few purchases face-to-face like Andy and Beth,
participation in the environment will be happy to take part. most transactions don't have anywhere near as much room to haggle over price. Instead,
Retnming to the example of trade between Andy and Beth, both are able to be markets aggregate thousands upon thousands of transactions daily and generate prices for
"Winners" when they trade the chest at a price within the bargaining range. This is most goods that people trade. We now move from a relatively straightforward discussion
because the transfer of the ownership of the chest generates positive-sum gains of of two people that is easy to understand to a more abstract model of economic interaction
$1,000-$200=$800 for society, a result of the fact that the buyer places a higher value on known as the Model of Supply and Demand, which models the behavior of buyers and
the chest than the seller does. When they voluntarily trade at any price within the sellers in markets within a Capitalist system.
bargaining range, a win-win outcome is realized in that both Andy and Beth are Demand provides a summary of the behavior of buyers (or consumers) in a
individually better off. (This is similar to the game of "Exploding Kittens" with a $5 market. The Quantity demanded of a good refers to the number of anita that people are
bet.) willing and able to parehase at a particular priee. Demand is the entire relation between
But even when a buyer places a higher value on an item than a seller does (i.e., a the price of a produet and quantity demanded, holding fixed all other factors that could
positive-sum environment), coerced trade at a price outside the bargaining range would influence purchasing decisions. Similarly, supply summarizes the behavior of sellers (or
lead to a win-lose outcome. For example, suppose that the government (in an attempt to producers) in a market. The Quantity supplied of a good refers to the number of anita
increase the wealth of farmers who have inherited antiques) forces Beth to buy the chest that people are willing and able to sell at a particular price. Supply is the entire relation
from Andy for $1,500. At this price outside of the bargaining range, total gains to society between the price of a product and quantity supplied, holding fixed all other factors that
are still positive ($80(O$1,000-$200), And), still "wins" (realizing a positive gain of could influence production/sales decisions.
$1,300~$1,500-$200), but Beth "loses" (realizing a negative gain of-$500=$1,000- The model of supply and demand is a simplified depiction of reality that is used m
$1,500). Thus, trade outside of the bargaining range leads to a win-lose outcome in this describe the interactions between buyers and sellers in a competitive market, which lead
positive sum environment. (For a parallel, consider a game of "Exploding Kittens" with to a particular quantity and price at which trade will take place. It aims to highlight the
an $8 bet - as described in footnote 3 - and assume that one player knew for certain that behavioral forces at play which determine the relevant aspects for the millions of
he would lose the game.) If this win-lose outcome is going to be realized, Beth would transactions among thousands of firms and their customers daily. Once you understand
not voluntarily choose to participate in the Irade. the model you will begin to comprehend the economic system of global Capitalism. This
Finally, recognize that not all trades are positive-sum environments. What if system incorporates not only the transactions for goods and services within our country,
And), is the antiques buff, and Beth is just looking for a chest to put in her garage for her but a significant amount of all transactions both within foreign countries and between
countries, as well as financial transactions of investment markets, loan markets, currency
husband's tools. As a potential buyer she values the chest at only $200, while Andy as a
potential seller values it at $1,000. Is there any common price that could simultaneously markets, and labor markets. We will not address them all jast yet, but you will be able to
understand the gist of them all once you master Supply and Demand.
convince Andy to voluntarily sell and Beth to voluntarily buy the chest? No. For these
reservation prices the bargaining range is empty (it does not contain any prices), and
therefore no voluntary transaction can take place. When a buyer's reservation price is
less than a seller's reservation price, trade would be taking place in a negative-sum The Law of Demand
The Law of Demand states that, all other factors held constant, people will: (i)
eavlroamelt, a situation in which the summation of gains and losses over all people is
negative in value. In a negative-sum environment we can never have a win-win outcome buy less of a good when its price is higher and (ii) buy more of a good when its price is
lower. That is, with all other factors unchanged, there is an inverse relationship between
(since two positive numbers can never add up to a negative number).
the price and quantity demanded of a good. This "law" is a law in the scientific sense,
All transactions in a truly free-market Capitalist system are win-win outcomes,
like the Law of Gravity, which is universally true irrespective of the beliefs of people.
since all transactions voluntarily take place at a price within the bargaining range where
The Law of Gravity applies the same way to rich and poor, capitalist and socialist, men
both parties have something to gain. Since the transactions in Capitalism are required to
and women, and the like - so too does the Law of Demand.
be voluntary, no one can be forced to trade outside their reservation price- therefore beth Proof of the validity of this claim is easy to come by since it can be confumed
parties gain. From the Capitalist perspective we now have another reason to recommend through introspection. Think of any good that you want. If the price oftbe good went
the system of laissez faire. down would you be stimulated to buy more of it? This is the basis for firms putting
goods on sale when they are overstocked and need to reduce inventory. The lower price
motivates people to buy more than when the price was higher. Alternatively, picture a
Chapter #4- Organizing Principles of Capitalist Systems Chapter #4 - Organizing Principles of Capitalist Systems

good that you like and imagine it becoming more expensive. Obviously you would were discussed in Chapter 3.) A person can spend every waking moment piling up a
purchase less of it. This "law" is generally true because of three universal aspects of huge bank account, spending money on personal pleasures, and indulging every whim
human nature: diminishing marginal benefits from consumption, self-interest, and that occurs to them. Or they may spend some or all of their time and resources in charity
rationality. work and other benevolent activities. As we saw at the beginning of this chapter, all that
For most goods, most people derive diminishing marginal benefits from Capitalism as an economic system demands is that you engage with others through
consumption. As defined in Chapter 1, marginal benefit refers to the change in the value voluntary transactions and use no force/coercion or fraud against anyone. The moral
oftotal benefits as more of an activity is undertaken. When working through the example principles of Capitalism do not focus on what you do with your time and money, but
of Carl's decision of how much time to spend growing carrots in Chapter l, we assumed rather on whether your interactions with others are just.
that he had a diminishing marginal benefit from carrot consumption - the additional Economists normally make the assumption that while it is possible to spend must
value realized from consuming more carrots became smaller as he consumed more of your time and money and other resources doing charity work, most people, eSlX~ally
carrots. This is a general phenomenon which economists think is likely true for most when dealing with strangers, tend to pursue their own self-interest. Economists mainly
people, for most goods - the more you consume of something, the less valuable the study people interacting with each other through markets as strangers (that is, in a setting
additional units are to you. where concern for self is above concern for others). Further, economists typically
Again returning attention to Chapter I, a self-interested Individual was defined assume that people are (or would find it in their self-interest to be) rational decision
as someone who makes his own personal assessment of the benefits and costs associated makers (as defined in Chapter 1). Recall, a rational decision maker is someone with a
with different outcomes, and who subsequently uses these measures as the basis for well-defined goal, who takes actions to achieve the goal as best as possible.
decision making. Within this discussion it was noted that, by definition, a self-interested As an analytical construct, a decision maker who is both self-interested and
individual places more weight on his own benefits than he places on the benefits derived rational is referred to as Economic Man (or homo economicus). From this point
by others. Self-interest is often incon'cctly conflated with selfishness by many people. forward, we assume that all decision makers fit these characteristics of Economic Man -
While self-interest is a universal trait of mankind, it is not the only trait-people can also that is, motivated by self-interest and making rational decisions constrained only by the
be charitable, kind, and benevolent towards others. Unfortunately, they can also be rules of the economic system in which they exist (for example, in a Capitalist system, the
selfish, cruel, and malevolent. By self-interest we mean only that all people have a relevant rules would be defined by property rights and contracts with a heavy reliance on
regard for that which makes themselves better off and try to avoid that which makes and respect for individual choice and sovereignty). Within such a framework, as long as
themselves worse off. Benevolent motives and actions decline rapidly as the social individuals remain within the rules, the pursuit of their self-interest should be considered
distance between people increases - recall Adam Smith's "little finger example" legitimate.
discussed in Chapter 1. For example, people make huge sacrifices for their owe children, This assumption proves very useful in understanding large scale human behavior
make some sacrifices for relatives and friends, and make proportionally very few but has generated an enormous amount of hostility from those who do not support
sacrifices for strangers. capitalism as a system. Marxists in particular believed that Communism would create the
Selfishness can be defined as the pursuit of self-interest taken beyond proper, New Soviet Man, a person that would be motivated primarily by selfless benevolence.
acceptable bounds. Self-interest differs from selfishness in that the former can often be Socialists reject the capitalist ethical system of laissez faire, based on property rights and
legitimate while, by definition, the latter cannot be legitimately justified. Individuals contracts, because they believe that it encourages selfishness. We will develop this
clearly have a legitimate concern with getting food, clothing, shelter, education, conflict of ideas on the true nature of man in the next chapter when we deal with the
henlthcare, recreation, and a host of other desirable things for themselves and their socialist mechanism for organizing society.
families. Pursuing these ends is self-interest. But if someone attempts to steel, hoard,
defraud, or otherwise take advantage of others to "get ahead in life," this becomes
selfishness and cannot be considered acceptable. A free and decent society needs to Modeling Demand
define a limit on how far a person can go in pursuing one's owe interest while still As previously defined, demand is the entire relation between the price and
respecting space for people to "do their own thing." quantity demanded of a good, all other factors held constant. Consider the market for
Drawing the boundaries between proper and improper self-interest has consumed hotdogs in Kennesaw, GA. Many factors are probably important for determining
philosophers and economists for centuries. Within Capitalism, property rights and consumers' purchasing decisions, such as: the price of hotdogs; consumer income;
contracts make a strict separation between permissible and impermissible self-interested
consumer tastes and preferences (i.., how much do people like botdogs); the price of
actions. People are permitted to do with their owe property, including their owe time, as hotdog buns; the price of hamburgers; and the weather (e.g., people are probably more
they please without moral criticism as long as they respect the equal rights of others. inclined to buy hotdogs in June than in December). But, of all these factors, probably the
(Recall the three distinct sets of rights collectively thought of as property rights which most important influence on the quantity of botdogs purchased is the price of hotdogs
Chapter #4 - Organizing Principles of Capitalist ~/stems Chapter #4 - Organizing Principles of Capitalist Systems

(i.e., "own price"). Recognizing this, the demand for hotdogs is developed by We can see that the Law of Demand is satisfied by looking at either the numbers in Table
conceptually holding all of these "other factors" (such as income, preferences, other 4.1 or the curve in Figure 4.3. From Table 4.1, the fact that quantity demanded increases
prices) fixed at their current levels and identifying the relationship between the price of as price decreases reveals the Law of Demand. Correspondingly, the fact that the
hotdogs and the quantity of hotdogs that consumers are willing and able to purchase. demand curve in Figure 4.3 is downward sloping also reveals the Law of Demand.
Demand is this entire relationship between price and quantity.
For example, suppose that Table 4.1 provides a partial summary of the
relationship between the price of hotdogs and the quantity demanded of hotdogs in The Law of Supply
Kennesaw, GA during the first Monday in April. The Law of Supply states that, all other factors held constant, people will: (i) sell
less of a good when its price is lower and (ii) sell more of a good when its price is higher.
Table 4. ! - Relation between Price of Hotdogs and Quantity Demanded of Hotdogs That is, with all other factors held constant, there is a positive relationship between the
Quantity t price and quantity supplied of a good. Just like the Law of Demand, the Law of Supply is
Price Demanded a universally applicable scientific law that applies to all private firms.
$7 150 This reaction by business people to differences in the market price of the goods
$6 250 that they sell derives primarily from self-interest and rationality - that is, we assume that
$5 500 the people who ran businesses also belong to the species homo economicus. The Law of
$4 Supply is further motivated by the Law of Increasing Cost, which posits that marginal
850
$3 costs ofproductinn will increase as firms expand output. This increase in marginal costs
1,250
often occurs because firms face both rising resource costs due to the increased demand
$2 1,750
for the resources that the company uses in production and from diminishing productivity
of industry as overcrowding takes place.
If we plot the pairs of numbers in Table 4.1 on a graph, we can illustrate the Demand The material benefit of owning a fLrm comes from the possibility of earning a
Curve, which is a line that connects all possible combinations of prices and quantities profit, which is defined as the difference between revenues and costs of production.
demanded of a good (with all other relevant factors held constant). Profit is a residual ownership claim to the income generated by a firm. This means that
under the legal structure of Capitalism the owner has a legitimate claim to all of the
Figure 4.3 - Demand Curve for Hotdogs income that is leR over after all of the bills are paid. Consider a simple example of a
hotdog vendor who goes into business by renting a cart, purchasing hotdogs, buns, and
S condiments in bulk, and then finding a good location on the street to set up. Assume that
he sells 100 hotdogs at $5.00 each. He spent $2.00 for the ingredients to make each
hotdog and paid a rental fee of $170 to the equipment vendor. Table 4.2 provides a
simple summary of the results of his business for the day.

5 Table 4.2- Revenue, Costs, and Profit for Hotdog Vendor


total revenue $500 = $5 x 100 hotdogs
- cost ofhotdogs $200 = $2 x 100 hotdogs
3" - equipment rental $170
Demand = Profit (or Loss) $130

His profit of $130 is the difference between his revenue of $500 and costs of $370.
150 Proponents of the Capitalist system maintain that the hotdog vendor has a legitimate
500 1,250
claim to this profit that he has earned by this entrepreneurial activity.
An Entrepreneur is an individual who undertakes and oversees a business
venture. Entrepreneurial activity requires a great deal of initiative and presents the
Chapter #4 - Organizing Principles of Capitalist Systems Chapter #4 - Organizing Principles of Capitalist Systems

entrepreneur with the possibility of earning a significant return on his investment of time in Kermesaw, GA. Many factors are probably important for determining producers'
and financial resources. However, in a market based system, an entrepreneur is also selling decisions, such as: the price ofhotdogs; the price of factors of production; and the
exposed to a great deal of risk since if the business venture fails it is ultimately the specifics of the available production technology. But, of all these factors, probably the
entrepreneur who must bear the cost. Clearly a $130 daily profit is not the only possible most important influence on the quantity of botdogs that producers would want to sell is
outcome of this venture, the price of hotdogs (i.e., "own price"). Recognizing this, the supply for hotdogs is
What if our entrepreneur instead chose to setup his cart on the wrong street and developed by conceptually holding all of these "other factors" fixed and determining the
only had 75 customers? Now his total revenue is $375 ($5 multiplied by 75 units sold) relationship between the price of hotdogs and the quantity of hotdogs that producers are
and his cost of hotdogs is $150 ($2 multiplied by 75 units sold). Consequently, instead of willing and able to sell. Supply is this entire relationship between price and quantity.
"outcome (A)" as summarized in Table 4.2 above, he would have realized "outcome (B)" For example, suppose that Table 4.4 provides a partial summary of the
as summarized in Table 4.3 below. In this case he still earns a positive profi4 but it is relationship between the price of hotdogs and the quantity supplied of hotdogs in
only $$5 instead of $130. Kconesaw, GA during the first Monday in April.
What if, in addition to now selling 75 botdogs, the rental on the cart is $250 per
day? This scenario is summarized by "outcome (C)" in Table 4.3 below. With Table 4.4 - Relation between Price of Hotdogs and Quantity Supplied of Hotdogs
equipment rental costs that are now $80 higher than in "outcome (B)," his profit is $80
lower. He now earns a loss of $25 (i.e., a negative profit). Quantity
On the other hand (returning to our initial assumption of equipment rental costs of Price Supplied
$170), what if he is especially creative and develops a great hot sauce that everyone 1 ~400
loves, allowing him to sell 150 hotdogs per day? In this case his total revenue would be 90O
$750 ($5 times 150) and his costs ofhotdogs would be $300 ($2 times 150), giving him a $5 500
daily profit 0f$280 (as summarized by "outcome (D)" in Table 4.3 below). $4 200
$3 75
'TaMe 4.3- Alternative Outcomes for Hotdog Vendor $2 0

I total revenue
(A)
$500
O3)
$375
(C)
$375
fD)
$750 If we plot the pairs of numbers in Table 4.4 on a graph, we can illustrate the Supply
| - cost of hotdogs $200 $150 $150 $300 Curve, which is a line that connects all possible combinations of prices and quantifies
| - equipment rental $170 $170 $250 $170 supplied of a good (with all other relevant factors held constant).
[ = Profit (or Loss) $130 $55 -$25 $280
Figure 4.4 - Supply Curve for Hotdogs
From these various outcomes we can see that the profit of the en~epreneur is $
variable and uncertain. As the residual owner of the income, he only gets paid after
everyone else. Through a combination of hustle and good luck he might be able to make
a large profit. But, he may instead suffer a loss as in "outcome (C)" above, due to
incompetence or bad luck (perhaps the low quantity sold in "outcomes (B) or (C)" is a
result of rainy weather, as opposed to a poor choice of location). Every company,
whether it is as small as a hotdog stand or as large as Home Depot, operates on this same
principle. When rational, self-interested sellers are confronted with increasing marginal
costs of production, seller behavior emerges which satisfies the Law of Supply.

Modefing Supply
As previously defined, supply is the entire relation between the price and quantity
supplied of a good, all other factors held constant. Again consider the market for hotdogs 0
75 500 1,400
Chapter #4 - Organizing Principles of Capitalist @stems Chapter #4 - Organizing Principles of Capitalist Systems

We can see that the Law of Supply is satisfied by looking at either the numbers in Table out that the market equilibrium price arises spontaneously from the voluntary interactions
4.4 or.the curve in Figure 4.4. From Table 4.4, the fact that quantity supplied increases as of buyers and sellers.
price increases reveals the Law of Supply, Correspondingly, the fact that the supply Using Figure 4.5 below, we can see why most prices are not stable (in fact, there
curve in Figure 4.4 is upward sloping also reveals the Law of Supply. is only one unique equilibrium price). The unique market equilibrium in this market is an
The supply curve in Figure 4.4 can be interpreted as follows. If the price per equilibrium price of $5 and an equilibrium quantity of trade of 500 units. To tell the
hotdog were $5, then firms would maximize profits by collectively selling 500 units. stories which will allow us to see why this is the unique equilibrium, it is helpful to
Alternatively, if hotdogs were to sell at a higher price of $7, then firms would maximize recognize how the previously defined notions of reservation prices are illustrated by the
profit by selling 1,400 units. The supply decisions made by firms result from an demand curve and supply curve. As will be explained in further detail in Chapter 5, the
application of the cost-benefit principle discussed in Chapter 1. When the market price value of buyer's reservation price is equal to the height of the demand curve, and the
of hotdogs is higher, then benefits (i.e., revenues) will exceed costs for a greater quantity value of seller's reservation is equal to the height of the supply curve.
of units. Conversely, if the price were only $3 per hotdog, then producers would want to
sell fewer units (only 75). This is because benefits cover production costs for a smaller Figure 4.5- Demand and Supply for Hotdogs
number of units when price is lower.
5

MARKET EQUILIBRIUM 7, , , , , spply


Now that we have independently developed the concepts of Demand and Supply
5 ~ - - - v . . . . . . . . . . j
(to distinctly summarize how buyers and sellers would behave in a market), we consider
the interactions between self-interested and rational buyers and sellers in competitive i

markets. By a competitive market, we mean an environment in which no single seller


,,
and no single buyer has any significant, direct impact over market price. Rather, in a 3
competitive market, people take the market price as beyond their own control and decide
how many units to trade. This is a reasonable assumption for most (but not all) markets. i
I
B
i
After all, when was the last time you tried to negotiate with the cashier at the grocery i i
store over the price of a gallon of milk? o : I e
By bringing together our concepts of Demand and Supply, we will attempt to 75 ~ 500 1,250 1,400
identify a market equilibrium. In general, an equilibrium refers to a stable state for a
150
system, which would be expected to persist so long as conditions remain unchanged. In
particular, a market equilibrium is a stable price/quantity pair for which no individual Is a price of $7 "stable"? Start by r~cugnizing that at this price, quantity supplied
market participant could improve the outcome for himself by altering his own behavior. is 1,400 while quantity demanded is only 150. That is, at this relatively high price, sellers
As will be seen, the market equilibrium price will be a market clearing price, which gets would want to sell 1,400 units, but buyers are only willing and able to purchase 150 units.
all consumers as a group to demand a quantity of the good that is exactly equal to the What we have at a price of $7 is excess supply (or a surplus), a situation in which
quantity of the good that suppliers want to sell. If the description of consumer and quantity supplied is greater than quantity demanded. Visually, we have excess supply at
producer behavior outlined above is true, how do we get consumers (buyers) and any price for which the supply curve is "to the right" of the demand curve. This excess
producers (suppliers or sellers) to agree on a price or a quantity? After all, consumers supply at $7 is explicitly identified in Figure 4.6 below.
want the price to be low and the producers want it to be high. But, if they are beth put in Since nobody can be forced to buy or sell a good in a free market, the quantity
a legal system of contracts and property fights, they have to "bargain" to get the other Waded at $7 would be the lesser of these two quantities: 150 units. So, many of the
party to voluntarily cooperate. people who would like to sell hotdogs for $7 will not be able to do so. Numerically, there
In Figure 4.5 we combine both sides of the market - the buyers/demand side and are 1,250=-1,400-150 units that sellers would like to sell for $7 that will remain unsold;
the sclless/supply side - to ultimately determine the market equilibrium. (Figure 4.5 is for each of these units, the seller has a reservation price strictly below $7.
simply a combination of Figures 4.3 and 4.4.) What causes the market equilibrium price To see that this high price of $7 is not stable, recognize how a seller could alter
to develop?' Is it imposed on the market participants by a government agency? It turns his behavior in order to make himself better off. Suppose you are one of the betdog
vendors in this market. You have 100 hotdogs that you would be willing to sell for as
Chapter #4 - Organizing Principles of Capitalist @stems Chapter #4 - Organizing Principles of Capitalist Systems

little as $4 each (at a price of $7, your 100 hotdogs are a part of the total market quantity who would like to buy hotdogs for $3 will not be able to do so. Numerically, there are
supplied of 1,400). But, at a price of $7 only 150 hctdogs will be bought. Suppose that 1,175=1,250-75 units that consumers would like to buy for $3 that will remain
at this high price, nobody shows up to buy any of your hotdogs. Is there anything you unpurchased; for each such units, the buyer has a reservation price strictly above $3.
could do to improve the outcome for yourself? What if you offered to sell your hotdogs To see that this low price of $3 is not stable, recognize how a buyer could alter
for only $6.90? At this lower price, consumers would prefer to buy hotdogs from you her behavior in order to make herself better off. Suppose you are one of the hotdog
instead of another seller. Furthermore, you would rather sell your hotdogs for $6.90 consumers in this market. You are willing to pay up to $6 for a hotdog, but at the low
(which is above your seller's reservation price of $4) as opposed to the alternative of price of $3 you are not able to find a willing seller. Is there anything you could do to
insisting upon a price of $7 but not selling any hotdogs. The initial excess supply put improve the outcome for yourself? What if you offered to buy a hotdog for $3.25? At
downward pressure on price, revealing that the high price of $7 was not stable. Similar this higher price, a hotdog vendor would prefer to sell to you instead of a different
forces are present at any price at which there is excess supply. Thus, none of the prices customer (who is only offering the prevailing price of $3). Additionally, you would
above $5 are stable. rather pay $3.25 (which is below your buyer's reservation price of $6) and get a hotdog,
as opposed to the alternative of insisting upon a price of $3 but not getting to buy a
Figure 4.6- Exce~s Supply and Excess Demand hotdog. The initial excess demand put upward pressure on price, revealing that the low
price of $3 was not stable. Similar forces are present at any price at which there is excess
$ Excess Supply demand. Thus, none of the prices below $5 are stable.

~ ofl,250 units
at a price of $7
Lastly, consider a price of exactly $5. As illustrated in Figure 4.5, this is the one
unique price at which we have neither excess supply nor excess demand. This price of $5
"clears the market" - quantity demanded and quantity supplied are exactly equal to one
~ - Supply
~ another. Consumers are looking to buy exactly 500 units, and vendors are looking to sell
exactly 500 units. The unique market equilibrium is for 500 units to be traded at a price
i
i of $5 per unit, the point of intersection of the supply curve and the demand curve.
7 i~ e m r The uniqueness of the market equilibrium (i.e., the fact that there is only one
i
!i i equilibrium) is a consequence of the Law of Demand and Law of Supply. These laws
' respectively imply that demand curves must be downward sloping and supply curves
~
3. i
must be upward sloping. Clearly a downward sloping curve and an upward sloping curve
cannot have multiple points of intersection.

o
' ~
!
I, ¥ ,
1
i
',
i
I
(lnd Finally, recognize that the market equilibrium - in addition to being stable
(which, by definition, all equilibria must be) and unique - is a self-enforcing outcome.
By this we simply mean that if a market is ever "out of equilibrium" market forces (i.e.,
1 i I the self-interest of market participants) will push the market toward equilibrium. Prices

'i
75 [ 1,250 1,400
Q above the equilibrium price are not stable because there was downward pressure on price.
Prices below the equilibrium price are not stable because there was upward pressure on
150
uniLs at a price of $3 |
I Excess Dema~d of l,175
I price. So, at any non-equilibrium price, we are being pushed toward the market clearing
equilibrium price. Consequently, we can recognize the important principle that without
any outside interference, the self-interest of buyers and sellers will naturally guide a
Is a price of $3 "stable".'? Recognize that at this price, quantity supplied is only 75 market toward equilibrium. As this occurs, any initial shortage or surplus will naturally
while quantity demanded is 1,250. Thus, at this relatively low price, buyers would like to disappear through the same mechanism.
purchase 1,250 un/ta, but sellers would want to sell only 75 units. At this low price we
have excess demand (or a shortage), a situation in which quantity demanded is greater
than quantity supplied. Visually, we have excess demand at any price for which the The Market Equilibrium Price and the Bargaining Range
demand curve is "to the right" of the supply curve. This excess demand at $3 is explicitly We illustrated the concept of the bargaining range in Figure 4.2 to show the
identified in Figure 4.6 above. individual incentives to engage in voluntary exchange. How does the bargaining range fit
Since nobody can be forced to buy or sell a good in a free market, the quantity in with what we learned about market equilibrium price.'? For the hotdog market
traded at $3 wouid be the lesser of these two quantities: 75 units. So, many of the people illustrated in Figure 4.5 we saw that the unique market equilibrium price was $5.
Chapter #4- Organizing Principles of Capitalist Systems Chapter #4 - Organizing Principles of Capitalist Systems

Start by focusing on the "150th hotdog traded" in this market. From Figure 4.7 As the quantity of hotdogs traded is increased from 150 up to 250, 350, and 450,
below we see that the buyer of this unit (who we will identify as Charles) has a buyer's we still have both buyer and seller individually benefiting from trade, since the
reservation price of $7 and the seller of this unit (who we will identify as Daisy) has a willingness to pay by additional consumers (illustrated by the height of the demand
seller's reservation price of $3.20 (recall, buyer's reservation price is illuslrated by the curve) is greater than costs of production for additional units (illustrated by the height of
height of the demand curve and seller's reservation price is illustrated by the height of the the supply curve). This is true for every single unit up to the 500a~ hotdog, where the
supply curve). The bargaining range consists of all prices between $3.20 and $7, since a bargaining range is reduced to only the single price of $5. For the 500th unit, voluntary
trade at any price between these extremes simultaneously makes both Charles and Daisy trade can take place at only the market clearing price of $5, a price at which both the
individually better off. In comparison to the bargaining range illustrated in Figure 4.2, buyer and seller of the unit are indifferent between trading and not trading. In other
focusing on a specific unit in Figure 4.7 we effectively have the bargaining range set on words, the 500th consumer gets $5 of pleasure from consuming his hotdog, which costs
its side and arranged vertically rather than horizontally. This view reveals how the exactly $5 to produce. When this unit is traded at the equilibrium price of $5, both buyer
demand curve and supply curve illustrate reservation prices for these two market and seller "break even" on the transaction.
participants. Charles is hungry and wants a hotdog, but could also go for a slice of pizza For any unit beyond the 500th unit, buyer's reservation price is less than seller's
or a burrito. His maximum willingness to pay for a hotdog is $7. At any higher price, he reservation price. Consequently, the bargaining range is empty in that it contains no
buys a different lunch. Daisy likes operating her hotdog cart but would be happy to prices (recall the final antique example in which Beth valued the chest as a potential
switch to another line of work if it paid better. The lowest price at which she is willing to buyer at only $200 while Andy valued the chest as a potential seller for $1,000).
produce and sell this hotdog is $3.20. At any lower price, she chooses to use her Consider the 1,400th unit in Figure 4.7. For this hotdog, the potential seller (who we will
.productive resources for a different purpose. As it turns out, the market price for botdogs identify as Ethan) has a seller's reservation price of $7 and the potential buyer (who we
ts currently $5, so both of them get a benefit from and are willing to voluntarily engage in will identify as Francesca) has a buyer's reservation price of $2.40. By the time we
this transaction.3 would get up to 1,400 units traded, costs of production for potential sellers become
relatively high while benefits for potential consumers become relatively low. Since the
buyer is not prepared to voluntarily pay any price that the seller would willingly accept,
Figure 4. 7 - Equilibrium Price and the Bargaining Range the bargaining range is empty and no voluntary trade can take place. From this entire
discossion we can again see how in a free market, trade will stabilize at a price of $5 with
$ 500 hotdogs purchased and 500 hotdogs sold.
Charles' Now imagine replicating this story for every kind of good available in a modem
~_ _ _ j b a r g a i n i n g r a n g e
reservation ~ 7 " i - - - I . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Supply economy. There is a market for cars, houses, airplanes, clothes, restaurants, medical care,
price !
schools, books, and thousands of other items. Not only does the system produce the
i consumer goods listed but also produces capital goods like machinery, heavy trucks, and
i
5 factories. In addition, there are markets for all sorts of labor of different skills, from
i
Dairy's engineers and doctors to pet sitters and cleaning crews. The scale of it all boggles the
r~-ze~ation .-~ 3.20'
: mind when one considers that none of this production is planned by any government
price department, but is instead left to the individual decisions of millions of customers and
2.40" Demand thousands of firms.4 The price in each of these disparate markets is developed by the
same forces of supply and demand that determined the price of hotdogs in our example.
In each case, excess demand and excess supply eliminate themselves as the market price
rises or falls as needed until every market moves toward and reaches its equilibrium.
o
150 500

3 The technical terms for the benefits that mad<et participants gain from trade are Consumer's Smplus and
Producer's Surplus. A full description of these concepts is presented in Chapter 5. 4 See the essay "l, Pencil" by Leonard Read in the Coda of this textbook. A short video version of this
essay carl be viewed at httos://~,~a~..l~utube.comA~rach?~'=l]'03tOODISE.
Chapter #4 - Organizing Principles of Capitalist Systems

Chapter #4 - Organizing Principl~ of Capitalist Systems

As the quantity of hotdogs traded is increased from 150 up to 250, 350, and 450,
we still have both buyer and seller individually benefiting from trade, since the
Start by focusing on the "150°' hotdng u'aded" in this market. From Figure 4.7
wil ngnass to pay by additional consumers (illustrated by the height of the demand
below we see that the buyer of thls unit (who we will identify as Charles) has a buyer's
curve) is greater than costs of production for additional units (illustrated by the height of
reservation price of $7 and the seller of this unit (who we will identify as Daisy) has a
the supply curve). This is true for every single unit up to the 500th hotdog, where the
seller's reservation price of $3.20 (recall, buyer's reservation price is illustrated by the
height of the demand curve and seller's reservation price is illustrated by the height of the bargaining range is reduced to only the single price of $5. For the 500~ unit, voluntary
trade can take place at only the market clearing price of $5, a price at which both the
supply curve). The bargaining nmge consists of all prices between $3.20 and $7, since a
trade at any price between these extremes simultaneously makes both Charles and Daisy buyer and seller of the unit are indifferent between trading and not trading. In other
individually better off. In comparison to the bargaining range illustrated in Figure 4.2, words, the 500* consumer gets $5 of pleasure from consuming his hotdog, which costs
focusing on a specific unit in Figure 4.7 we effectively have the bargaining range set on exactly $5 to produce. When this unit is traded at the equilibrium price of $5, both buyer
its side and ~xranged vertically rather than horizontally. This view reveals how the and seller "break even" on the transaction.
demand curve and supply curve illustrate reservation prices for these two market For any unit beyond the 500th unit, buyer's reservation price is lass than seller's
participants, charles is hungry and wants a botdng, but could also go for a slice of pizza reservation price. Consequently, the bargaining range is empty in that it contains no
or a burrito. His maximum willingness to pay for a hotdng is $7. At any higher price, he prices (recall the final antique example in which Beth valued the chest as a potential
buys n different lunch. Daisy likes operating her hotdng cart but would be happy to buyer at only $200 while Andy valued the chest as a potential seller for $1,000).
switch to another line of work if it paid better. The lowest price at which she is willing to Consider the 1,400th unit in Figure 4.7. For this hotdog, the potential seller (who we will
produce and sell this hotdog is $3.20. At any lower price, she chooses to use her identify as Ethan) has a seller's reservation price of $7 and the potential buyer (who we
productive resources for a different purpose. As it turns out, the market price for hotdogs will identify as Francesca) has a buyer's reservation price of $2.40. By the time we
is currently $5, so both of them get a benefit from and are willing to voluntarily engage in
would get up to 1,400 units traded, costs of production for potential sellers become
this lransaction.3 relatively high while benefits for potential consumers become relatively low. Since the
buyer is not prepared to voluntarily pay any price that the seller would willingly accept,
the bargaining range is empty and no voluntary trade can take place. From this entire
Figure 4. 7-EqMlibrin~ Pric¢ and the Bargaining Range
discussion we can again see how in a flee market, trade will stabilize at a price of $5 with
$ 500 hotdogs purchased and 500 hotdogs sold.
Charles' Now imagine replicating this story for every kind of good available in a modern
/ b a r g a i n i n g r a n g e
reservation -.---> 7 ........................... Supply economy. There is a market for cars, houses, airplanes, clothes, restaurants, medical care,
price schools, books, and thousands of other items. Not only does the system produce the
consumer goods listed hut also produces capital goods like machinery, heavy trucks, and
5 l i l t . . . . . . . . . . . . . . . . II
factories. In addition, there are markets for all sorts of labor of different skills, from
I
Davy's engineers and doctors to pet sitters and cleaning crews. The scale of it all boggles the
,,
r~o-vat~--> 3.20' mind when one considers that none of this production is planned by any government
price 2.40" department, but is instead lefr to the individual decisions of millions of customers and
Demand thousands of firms.4 The price in each of these disparate markets is developed by the
same forces of supply and demand that determined the price of botdogs in our example.
In each case, excess demand and excess supply efiminate themselves as the market price
I I o rises or falls as needed until every market moves toward and reaches its equilibrium.
150 500 1,400

3The techmcal terms for the benefits tlmt market plu'ficipants gain from Wade are Cor~umer's Su~lus and
Producer's Smpins. A full description of these concepts is presented in Chapter 5.
, . ,, . ,
4 See the essaY'l,pancll byLconardRcadmtheCodanfthislextbook. Asbort video ve~ion of this
essay can be viewed at hfrt~;~/~-~r.~utubccom4~tch?r=lYO3tOoDISF,.
Chapter #4 - Organizing Principles of Capitalist @stems Chapter #4 - Organizing Principles of Capitalist Systems

demand. Visually, this is illustrated by a leftward shiR of the entire demand curve, as
CHANGES IN MARKET CONDITONS OVER TIME
illustrated by the change from Demand B to Demand A in Figure 4.8 above.
Recall that demand and supply were each defined by focusing on the relation Any factor could conceivably be a determinant of demand, but for most goods the
between price and quantity of a good, holding fixed all other factors. Over time, these most likely determinants are things such as other prices, income, consumer preferences,
other factors can and will change, What precisely are these other factors and how will size of market, and expectation of future price (for the good in question). To illustrate
changes in these other factors ultimately impact market equilibrium7 these claims, recognize that the fullowing changes would be expected to result in an
increase in demand (changing the factor in the opposite direction would result in a decrease
in demand):
Determinants of and Changes in Demand a decrease in the price ofa complement good A complement good refers to a good
that is typically consumed along with the good in question. More precisely, "good
When first considering the demand for botdogs, it was noted that consumers'
purchasing decisions are influenced by many factors beyond the price of hotdogs, such as: x" is a complement to "good y" ira decrease in the price of"good y" results in an
consumer income; consumer tastes and preferences; the price of botdog buns; the price of increase in demand for "good x." For example, a decrease in the price of hotdogs
hamburgers; and even the weather. A determinant of demand refers to any factor beyond would lead to an increase in demand for hotdog buns, revealing that hotdog buns
"own price" which has an impact on consumers' purchasing decisions for a good. When are a complement to hotdogs.
there is a change in a determinant of demand, the entire demand relation (that is, the entire an increase in the price of substitute good A substitute good refers to a good that
relation betwean price of a good and quantity purchased of the good) changes. If a change is typically consumed in place of the good in question. More precisely, "good x"
m a determinant of demand makes consumers more willing to purchase a good (in that is a substitute for "good y" if an increase in the price of "good y" results in an
quantity demanded is greater at every price), we have an increase in demand. Visually, increase in demand for "good x." For example, an increase in the price of
this is illustrated by a rightward shift of the entire demand curve, as illustratod by the hamburgers would lead to an increase in demand for hotdogs, revealing that
change from Demand A to Demand B in Figure 4.8 below. hotdogs are a substitute for hamburgers.
an increase in consumer income (for a normal ~,ood). A normal good is defined as
a good for which an increase in income leads to an increase in demand. As the
Figure 4.8 - Change in Demand name would suggest, this is normally the case for most goods (i.e., most goods are
normal goods). For example, if an increase in income induces consumers to
purchase more Coca-Cola, then Coca-Cola is a normal good.
a_.decrease in consumer income (for an inferior good). An inferior good is defined
46 .......... as a good for which a decrease in income leads to an increase in demand (or
similarly, an increase in income leads to a decrease in demand). For example, if an
:: increase in income induces consumers to switch consumption away from generic
33 ......
cola toward increased consumption of Coca-Cola, then the gancric cola is an
inferior good.
an increased preference by consume~ Fundamental tastes and preferences are
critically important for consumption decisions. If tastes/preferences change, then
demand will change. For example, if over time more people come to fred out that
' ~ ~ D c m a n d A D e m a n d B they enjoy drinking iced coffee, then this increased preference by consumers will
be reflected by an increase in demand. Conversely, if doctors were to identify an
0
additional previously unknown adverse health effect from smoking, this would
t
250 390
o decrease demand for cigarettes.
an increase in marl~ct si~,~ Insomuch as market demand is simply the "summation"
If instead a change in a determinant of demand makes consumers less willing to of individual consumer demand, demand for a good will increase as the size of the
purchase a good (in that quantity demanded is lower at every price), we have a decrease in market increases,
an expectation of hi~her future price (for the Rood in ouestion). For example, if
Something happens that makes consumers expect gasoline to cost $1 more
Chapter #4 - Organizing Principles of Capitalist 5~ystems Chapter #4- Organizing Principles of Capitalist Systems

tomorrow, demand for gasoline today will increase, To see why, recognize that If instead a change in a determinant of supply makes firms less willing to sell a
when specifying demand, it is necessary to define the market in terms of both good (in that quantity supplied is lower at every price), we have a decrease in supply. This
geographic boundaries and timeframe. For instance, when developing our botdng is illustrated by a leftward shift of the entire supply curve, such as the shift from Supply B
example, we supposed that the values in Table 4.1 provided a "partial summary of to Supply A in Figure 4.9 above.
the relationship between the price ofhotdogs and the quantity demanded ofbotdngs Any factor could conceivably be a determinant of supply, but for goods produced
in Kennesaw. GA during Ihe first Monday in April." If we consider a good outside by finns looking to earn a profit, the most prominent determinants are things that influence
of this definition, then we arc considering a good beyond the good in question. This production costs, such as factor prices, changes in technology, and realizations of uneartain
observation is really just a special case of the recognition that demand will increase events. Additionally, changes in market size and expectation of future price (for the good
when there is an increase in the price of a substitute - after all, to a large degree a in question) are also important. To illustrate these claims, recognize that the following
really good substitute for buying gasoline tomorrow is to instead buy gasoline
changes would be expected to result in an increase in supply (changing the factor in the
today.
opposite direction would result in a decrease in supply):
a decrease in the cost of any factor of production needed to produce the good
Recall, from the Basic Circular Flow Diagram, that finns in a market economy
Determinants of and Changes in Supply
acquire factors of production by paying wages and rents. If the costs of hiring any
Similarly, when first discussing the supply of hotdogs, it was noted that firms'
factor of production decreases (e.g., a decrease in the price of electricity), then
production decisions are influenced by factors beyond the price of hotdogs, such as the
production costs decrease. Consequently, for any particular unit seller's reservation
Price of factors of prodactian and the specifics of the available production technology. A
price will be lower and more units of output will pass the "cost-benefit comparison"
determinant of supply refers to any factor beyond "own price" which has an impact on
.
S eIlersI supply decisions for a good. When there is a change in a determinant of supply,
at any price.
the entire supply relation (that is, the entire relation between price of a good and quantity an improvement in technology that reduces production cost.~. Suppose a firm
sold of the good) changes. Ifa change in a determinant of supply makes firms more willing develops a new technology that allows them to produce a greater quantity of output
to sell a good (in that quantity supplied is greater at every price), we have an increase in with the same amount of inputs. As a result, the costs of producing any particular
supply. Visually, this is illustrated by a rightward shift of the entire supply curve, as unit will be lower, again leading to more units of output passing the "cost-benefit
illastntted by the change from Supply A to Supply B in Figure 4.9 below. comparison" at any price.
a favorable realization of uncertain event~. For many production processes the
relation between inputs and outputs is not entirely deterministic, but instead
Figure 4.9- Change in SRpply depends at least in part upon the realization of uncertain events (or chance). For
$ example, for any agricultural product the amount of output grown depends not only
Supply A upon the amounts of inputs (e.g., land, seeds, water, fertilizer) used but also upon
weather. When crops are planted the weather that will be realized during the
upcoming growing season could be viewed as uncertain or random. If the farmer
realizes a favorable outcome for this uncertain event (i.e., better than expectod
. . . . . . . . . . . . . . . . . . . . . .
weather) then the quantity of output produced and ultimately supplied to market
will be greater than initially expected. If instead an unfavorable outcome is realized
(e.g., a severe frost in Florida that damages citrus fruit) then the quantity of output
produced and ultimately sent to market will be less than anticipated. Thus, supply
17'--
is greater when in
an tnerease a favorable realization
market size. of uncertain
Just as market demandevents transpires.
is simply the "summation" of
individual consumer demand, market supply is simply the "summation" of
I
individual firm supply. Thus, if market size were to increase (so that there arc more
o-- I
390 585 potential sellers), then
an exoectation quantity
of lower supplied
future pricewould be ~ood
(for the greater
in at every price.
question). For example, if
0
something happens that makes sellers expect gasoline to sell for $1 less tomorrow,
supply of gasnline today will increase. This is because sellers would rather slightly
Chapter #4 - Organizing Principles of Capitalist Systems Chapter #4 - Organizing Principles of Capitalist Systems

decrease the price of gasoline today in order to sell more, as opposed to waiting Next consider a change in supply with demand fixed, as illustrated in Figure 4.11
until tomorrow and getting a full $1 less per gallon below. Demand is given by Demand B and does not change over the time under
consideration. If we initially have Supply A, then the initial market equilibrium is for 390
units to be traded at a price of $33 each. Now suppose that there is an increase in supply,
Impact of a Change in Demand or Supply on Market Equilibrium leading to Supply B (from the perspective of determining the impact on market
What happens to the market equilibrium if one of the underlying determinants of equilibrium, it does not matter what caused this increase in supply - that is, it could be a
demand or determinants of supply were to change? First consider a change in demand with decrease in the price of a factor of production, a cost reducing improvement in technology,
supply fixed, as illustrated in Figure 4.10 below. an increase in market size, or any other factor). With Supply B (and Demand B) the new
market equilibrium is for 525 units to be traded at a price of $26. This illustrates the more
Figure 4.10 - Impact of a Change in Demand on Market Equilibrium general insight that any increase in supply (with demand fixed) will result in a decrease in
equilibrium price and an increase in equilibrium quantity.

..
Figure 4.11 - Impact of a Change in Supply on Market Equilibrium

Supply A
26 .............

Demand B
~ ~ e m ~ a n d A 33 .................
I I
I
I

i Q
0
t
340 390
I I
I I
Supply is given by Supply A and does not change over the time under consideration.
If we initially have Demand A, then the initial market equilibrium is for 340 units to be
o- 1 !
traded at a price of $26 each. Now suppose that there is an increase in demand, resulting
in Demand B (fi'om the perspective of determining the impact on market equilibrium, it 0 340 390
does not matter what caused this increase in demand - that is, it could be an increase in
income for a normal good, an increase in consumer preference for the good, an increase in Figure 4.11 also illustrates how the equilibrium would change for a decrease in
market size, or any other factor). With Demand B (and Supply A) the new market supply (with demand fixed). If we initially had Supply B, the initial market equilibrium is
equilibrium is for 390 units to be traded at a price of $33. This discussion illustrates the for 525 units to be traded at a price of $26 each. If we then realize a decrease in supply to
more general insight that any increase in demand (with supply fixed) will result in an Supply A, the new equilibrium is for 390 units to be traded at a price of $33 each. This
increase in equilibrium price and an increase in equilibrium quantity. demonstrates the general outcome that any decrease in supply (with demand fixed) will
Figure 4.10 also illustrates how the equilibrium would change for a decrease in increase equilibrium price and decrease equilibrium quantity.
demand (with supply fixed). If we initially had Demand B, the initial market equilibrium Finally recognize what needs to be done - or more precisely, what does not need to
is for 390 units to be traded at a price of $33 each. If we then have a decrease in demand be done- in order to reach the new market equilibrium al~er a change in demand or supply.
to Demand A, the new equilibrium is for 340 units to be traded at a price of $26 each. This
Nothing needs to be done! Any change to either supply or demand within a market sets
illustra.tes the moregeneral result that any decrease in demand (with supply fixed) will offprice changes that bring about a new equilibrium consistent with these new conditions.
result m a decrease m both equilibrium price and equilibrium quantity.
To reach the new market equilibrium we do not need a government agency to dictate or
mandate the new price and level of trade. Rather, we can simply sit back and let market
Chapter #4 - Organizing Principles of Capitalist Systems Chapter #4 - Organizing Principles of Capitalist Systems

decrease the price of gasoline today in order to sell more, as opposed to waiting Next consider a change in supply with demand fixed, as illustrated in Figure 4.11
until tomorrow and getting a full $1 less per gallon. below Demand is given by Demand B and does not change over the time under
consideration. If we initially have Supply A, then the initial market equilibrium is for 390
units to be Waded at a price of $33 each. Now suppose that there is an increase in supply,
Impact of a Change in Demand or Supply on Market Equilibrium leading to Supply B (from the perspective of determining the impact on market
What happens to the market equilibrium if one of the underlying determinants of equilibrium, it does not matter what caused this increase in supply - that is, it could be a
demand or determinants of supply were to change? First consider a change in demand with decrease in the price eta factor of production, a cost reducing improvement in technology,
supply fixed, as inustrated in Figure 4.10 below. an increase in market size, or any other factor). With Supply B (and Demand B) the new
market equilibrium is for 525 units to be Waded at a price of $26. This illuslratcs the more
Figure 4,10- Impact of u Change in Demand on Market Equilibrium
general insight that any increase in supply (with demand fixed) will result in a decrease in
equilibrium price and an increase in equilibrium quantity.

Figure 4.11 - Impact of a Change in Supply on Market Equilibrium

s \ s.upply A
2 6 . . . . . . . . . . . . .
/ S upplyg
Demand B
~ ~ ~ m ~ n d A

0
)
I
)
I
I 3:+:-:_:::-----:-::-__
I
0 340
? 39O ~ D e m a n d B
I I
I I
Supply is given by Supply A and does not change over the time under consideration.
If we initially have Demand A, then the initial market equilibrium is for 340 units to be
o 1 !
traded at a price of $26 each. Now suppose that there is an increase in demand, resulting
in Demand B (from the perspective of determining the impact on market equilibrium, it 340 390
does not matter what caused this increase in demand - that is, it could be an increase in
raceme for a normal good, an increase in consumer preference for the good, an increase in Figure 4.11 also illustrates how the equilibrium would change for a decrease in
market size, or any other factor). With Demand B (and Supply A) the new market supply (with demand fixed). If we initially had Supply B, the initial market equilibrium is
equilibrium is for 390 units to be Waded at a price of $33. This discussion illustrates the for 525 units to be Waded at a price of $26 each. If we then realize a decrease in supply to
more general insight that any increase in demand (with supply fixed) Supply A, the new equilibrium is for 390 units to be traded at a price of $33 each. This
demonstrates the general outcome that my decrease in supply (with demand fixed) will
incraase in eqnilibriumprice
Figure and anhow
4.10 also illustrates increase in equilibrium
the equilibrium wouldquantity,
changewill
for result in an in
a decrease . , . ,
mcr~so equthbnum price and decrease equilibrium qu-mtity.
demand (with supply fixed). If we initially had Demand B, the initial market equilibrium
is for 390 units to be waded at a price of $33 each. If we then have a decrease in demand Finally recognize what needs to be done - or more vr~eisely, what does nat need to
to Demand A, the new equilibrium is for 340 units to be traded at a price of $26 each. This !no.er.toaohthenewarotequilbriume'aohanoinde
~,uun~ notes to I~ done) An,, ~, ........ g mand or supply
illustrates the more general result that any decrease in demand (with supply fixed) will # ~+,-,~= to etmer supply or demand within a market sets
offprice changes that bring about a new equilibrium consistent with these new conditions.
result in a decrease in both equilibrium price and equilibrium quantity.

Tor~:~hth~::::nn~carekoet aequ!!!,briu~n"
r ~ ~,u L~v~£ o[ ffaoe. we do notwe
Kamer, need
canasunply
government agency
sit back and to
letdictate
marketor
Chapter #4 - Organizing Principles of Capitalist Systems Chapter #4 - Organizing Principles of Capitalist Systems

forces (i.e., the self-interest of buyers and sellers) guide us to the new equilibrium outcome. Larry Page (Google), Jeff Bezos (Amazon), Sam Walton (Walmart), Dave Thomas
For example, again suppose that we initially have Supply B and Demand B as illustrated (Weedy's), and Michael Coles (Great American Cookie Company).
in Figure 4.11. In this market, the initial equilibrium is for 525 units to be traded at a price Of course, not all entrepreneurs are successful (and very few achieve the level of
of $26 each. If supply were to decrease to Supply A we now have excess demand (of success of those mentioned above) However, starting a successful business is a dream that
185=525-340 units) at a price of $26. As previously discussed, this excess demand puts many have achieved. Right here in Kermesaw we have one of our favorite success stories:
upward pressure on price. The market price naturally adjusts upward until the market Rey Regalado, who escaped from Cuba in 1990, came to the U.S., and eventually founded
reaches its new equilibrium price of $33, for which a market clearing quantity of 390 units a Cuban restaurant in Atlanta named Papi's.6 Today he is the proud owner of six locations
are traded. (one on Chastain Road). While he is not yet as rich or well known as some, we should not
count him out!
THE ENTREPRENEUR'S ROLE IN MARKET SYSTEMS
The analysis thus far of the Capitalist system has focused heavily on the behavior Examples of Entrepreneurial Failure
oftbe Economic Man in both households and firms. But, in many respects, the single most But not all stories of entrepreneurs and companies have happy endings. What
Important driver of the capitalist process is the entrepreneur (or the business owner or
happens when you run into real problems like Smith Corona (a typewriter manufacturer),
capitalist). The entrepreneur is the person who starts a company, manages it, searches for
Blackberry (an initial leading producer of early smartpbones), or Kodak (a fiLm based
markets, and absorbs the risks of the venture. Not every entrepreneur or capitalist does
camera company)? Each of these companies were at one time well known, well respected
every one of these things. For instance, an entrepreneur can buy an already existing
brands with cutting edge products, millions of dollars in revenues, high profits, and many
business or hire someone to run the venture on her behalf. If our entrepreneur is good at
satisfied customers.
these tasks and makes good decisions, enormous profits are possible, but if not, losses and
Unfortunately for Smith Corona, IBM and Apple created personal computers that
banlm~tcy lurk around the next comer. The remainder nfthe present discussion highlights
were affordable for small businesses and households. This technological leap was great
the important roles of the entrepreneur and of profit/luss in the free market, Capitalist
system. for society as a whole, but devastated the market for typewriters. As people abandoned
typewriters for computers they took their money with them, and sales revenues for Smith
Corona plummeted. The firm tried to adjust to this new competitive reality but ultimately
failed and went bankrupt.
Examples of Entrepreneurial Success
Blackberry, once one of the most successful cell-phone manufacturers in the world,
Most ongoing firms make a proilt, and some of their profits are enormous! also ran into the buzz-saw known as Apple. When the iPhone was first introduced in 2007
Consider Steve Jobs, co-foundar of Apple who started his company in his parent's garage
it took the world by storm, selling about 500,000 units in one weekend (well in excess of
in 1976 when he was 20 years old. He sold his Volkswagen bus and his business partner,
Steve Wozniak, sold his Hewlett-Paakard calculator to raise the $1,350 needed to get the 200,000 units initially anticipated).7 While Blackberry's sales continued to rise for a
time due to an exploding market for phones, by 2011 sales revenue peaked at $19.9 Billion
started. The ups and downs of Jobs' career were staggering, but the end result was a
and then fell to $1.3 Billion by 2017.s While the company has not gone out of business at
company that grew from only $3 million in sales in 1977 to sales of $182 billion and profits
the time of this writing, its demise is openly contemplated by many.
of $39.5 billion in 2014! Jobs was estimated to be worth $10.2 billion when he died of
pancreatic cancer in 2011.s In January of 2012 Kodak, a major American corporation for 131 years, filed for
chapter 11 bankruptcy protection with about $6.8 billion in debt and only $5.1 biUion in
There are many ¢mreprenenrs, like Steve Jobs, that have successfully founded large
assets. The company survives as a much diminished entity with only $2 billion in sales
companies that are now household names. In the late 19~ century and early 20~ century
entrepreneurs - such as Andrew Carnegie (U.S. Steel), Walter Chrysler (Chrysler today, compared to $19 billion in 1990. Digital cameras and technology have taken their
Corporation), John Deere (John Deere and Company), Harvey Firestone (Firestone Tire toll on this once proud company and its chemical based film business.9
and Rubber Company), Henry Ford (Ford Motor Company), John D. Rockefeller (Standard
Oil Company), and Cornelius Vanderbilt (U.S. Central Railroad) - built America's heavy s For It brief histury of Pitpi's see: I~ttp://na*av.paoiserill.com/Historv.html.
industry. Closer to our own time we have, in addition to Steve Jobs (Apple), Arthur Blank, 7 "Piper JItffray: 500,000 [Phones sold over the weekend," hnp:/hin~3v.cnet.com/newx/piper-iaffraT.500000.
Pat Farrah, and Bernie Marcus (Home Depot), Truetr Cathy (Chick-ill-A), Sergey Brin and i°hones'solcl'ovCr-the- ~ekend/
s See the bar chart following Blackberry's revenue from 2004 to 2017 at:

$ Sec. ~ ht~19:/At~l~v~st~tis~a~m/s~ati~6cs/2~624~/t,~-tVv~mte-~-rim-sinc~-2~.
,
SteveJobs. AnExa'aordmaryCareer',intheon.linemagazineEntrepreneur: See the dtseusston of Kodak s bleak future in the New York Times arhcle,
. , , At Kodak, Clinging to a
~ p r e n e u r. c o m / a r t i d ¢ / 1 9 7 , $ 3 8 Future Beyond Film," hnp://www`nvtimes.c~n~l,~/~3/2-2/business/tmk~dak-c~in~'in~-t~-a-hm~re-be~nd
Chapter #4 - Organizing Principles of Capitalist Systems Chapter #4 - Organizing Principles of Capitalist Systems

T H E R O L E O F P R O F I T A N D L O S S I N A C A P I TA L I S T S Y S T E M Conversely, what if Janice is highly competent and organized? She orders all
materials in a timely fashion, directs her workers properly, and motivates them to work
Entrepreneurs are continually guided by profits and losses. As illustrated above, if hard and efficiently. On top of everything else, she comes up with a unique design for the
you make the right product at the right price there are enormous possible rewards. Profits deck that uses much less labor than competing contractors use. Because of this she gets
and losses also discipline owners to keep a sharp eye out for inefficiencies in their the deck built for $7,000 and the homeowner is thrilled with the result. Who should
businesses, implement cost saving improvements in production methods, and modify legitimately get to keep the $3,000 left over after all bills for wages and materials are paid;
existing products (or create new products) to better meet consumers' preferences. Janice or her workers7 In this case justice requires that Janice legitimately "owns" all of
Profits lure new firms into producing goods that people desire. But, as we saw in this profit while her workers get only their contractual hourly pay.
Table 4.3 ("outcome (C)"), profit is not guaranteed. If you either produce the wrong From this simple example we have an economic theory of profit and loss and can
product or produce the right product in a costly way or charge too high of a price, you can explain their function within a capitalist system. The legal and moral theory of rightful
lose big. As you might imagine, no entrepreneur is presently investing in typewriters, film
ownership and the control that ownership implies puts the burden of successful operation
cameras, or phones with keyboards, and this is a good thing Losses push investment out
of the finn squarely on the owner. Mistakes and bad decisions cannot be shifted onto others
of losing industries producing goods that people do not want and toward businesses that
or their consequences ducked. Simultaneously, good business decisions flow through the
produce goods that people do want. Capitalism is a profit and loss system for a reason.
organization and straight into the profits of the owner who had control. This powerfully
The reason that both profit and loss exist in capitalism is due to the legal structure
concentrates the energies of the capitalist/entrepreneur on the tasks that we previously
of capitalist firms. All finns are organized in such a way as to make the owner a residual
identified: finding new markets, innovating new products and methods of production,
claimant. This means that the owner may not pay himself until all other contractual
maintaining tight discipline and motivation in the workplace, and a myriad of other things
claimants are satisfied. The owner must first pay workers, suppliers, landlords, and
that must be done to make a successful organization. Competent owners get rewarded with
lenders, before paying himself. If, afier all bills are paid, there is money left over a profit
profits and incompetent ones get punished with losses.
is declared and the owner gets to keep all of it. If, however, there is a loss, the owner most
absorb all of it as well. He may not tell the workers and suppliers that he is taking his
money out first and the workers and suppliers have to "cough-up" enough money to cover
the losses. This residual claimant status is not a punishment for owners; rather it is the Bankruptcy and Subsidy within Capitalism
logical corollary to the fact that the owner has the righl of control,l0 In the following What happens to businesses that fail? Bankruptcy broadly describes a legal
example the logic of this legal connection between ownership, control, and the residual process for an entity (person or business) that cannot honor the repayment of debts owed
status of profits (and losses) will be made clear. to others. For a finn, it is the final stage where failed businesses go to die, be dismembered,
Consider Janice, the owner of a small consU'uction company with 3 employees. She and have their parts parceled out to new rightful owners. Bankruptcy is triggered when a
contracts vath a homeowner to install a wood deck for a pnce of $10,000 with an estimated finn owes more money to creditors than it has in assets, and therefore has a negative net
cost of $8,000 and estimated profit of $2,000. Assume Janiee is not very competent and worth. Both current and future expected losses convince a bankruptcy court judge that a
forgets to order the lumber in time when her workers get to the job site Time is lost making company is a failure. Since the firm is losing money and getting deeper into debt on a
an emergency trip to the lumber yard. She also reads the plans backwards and the deck is continual basis, there is no way that all contractual obligations taken on by the owner can
angled incorrectly under her directions. Naturally, the homeowner demands that the deck be satisfied. Once a bankruptcy petition is filed and settled through the courts, a judge
be dismantled and instal ed correctly. This drives up the costs of the deck to $11,000 when will direct that all assets of the finn be seized and sold. Whatever funds are received from
it Finally gets completed. Can Janice legitimately take $2,000 out oftbe $10,000 check the sale are distributed to the creditors based on legal priority - back wages and taxes first,
from the homeowner for herself and then tell her three workers that they need to come up secured creditors next, and finally unsecured creditors." If unything is left over after this
with the other $3,000 to cover all of the mistakes? Clearly not. It is her company and she process, the initial owner gets the residual. In the vast majority of cases the money runs
has the right of controL All mistakes are her problem since none of the workers has the out before all creditors are paid and therefore the owner gets nothing. The company is then
right to overrule any of her decisions. To now impose the losses caused by her mistakes
on them would clearly violate any of justice. The business owner legitimately
" O " . ll.orm$ S ecured ered' tots have a 'diR, ct egal claim to a particular piece of property. For example, a home Ioan or
th sl°ssandtheworkerslegtttmatelyowntheiragreeduponhourlypaydespitethe car loan has specific identifiable propen)' that can be sold. All of the proceeds of the sale of the house or
lussWnS car go to pay the secured creditor. An unsecured creditur has no particular identified piece of property, but
only a general fight to be repaid by the business owner. A credit card company would fall into this
category. After you buy a meal with your credit card there is no identifiable property for the credit card
lo Resall the discussion of the three distinct dimensions of property rl hts in Cha company to seize if you do not make your payments. Similarly, a student loan is unsecured credit, since
g pter 3. the lender cannot "take back your education/degree" ifyou fail to repay the debt. All other factors equal,
mtarast rates set m free markets must be higher for unsecured debt then for secured debt.
Chapter #4 - Organizing Principles of Capitalist Systems Chapter #4 - Organizing Principles of Capitalist Systems

disbanded and the inventory, machinery, and buildings end up in the hands of other Consider the workers in Janice's construction company. What if the losses were
entrepreneurs who use these assets in other businesses. big enough to force Janice to declare bankruptcy and shutdown? The workers would be
While this process is a painful one to go through, it could actually be viewed as one laid-off and become unemployed. In that example the numbers are small and we can
of the greatest attributes of the capitalist system. One of the most difficult things for both quickly and easily absorb the workers into new eonstsuction companies. But what about
individuals and institutions to do in any society is to admit failure, cut short the resulting the Smith Corona and Kodak bankruptcies? What would happen if Blackberry goes under?
losses, and move on to other activities. Bankruptcy can be thought of as a "recycling" In these cases thousands of workers were or would be affected. What is the moral and
program for business assets by accomplishing three main tasks: practical thing to do in these cases?
I. it stimulates entrepreneurs to find profitable things to do with their assets so It is clear that government can prevent bankruptcy through subsidies to failing
that they do not end up in Bankruptcy court to begin with, firms. Both Smith Corona and Kodak could have kept their thousands of workers on the
2, it removes failed antrepreneurs frnm tbe contrnl of valuable assets, and payroll if taxpayers were willing to pay billions to keep the finns afloat. But, this requires
3. it puts the assets of failed fu'ms into the hands of successful entrepreneurs who taxpayers to surrender their wealth and income involuntarily to accomplish this goal. It
can find a beneficial use for the assets of the failed company. also reduces incentives for firms to keep costs low and to devote resources to the production
of goods that are most valued by consumers. This conflict in moral principles that we first
discussed in Chapter 3 has both a capitalist answer and a socialist answer. We take up the
Subsidy for Firms capitalist answer next and defer the socialist response to Chapter 6, where that system is
For government owned firms in a socialist system (and, to a large degree, discussed in greater detail.
govamment subsidized firms in a mixed economy) the threat of bankruptcy is weak or non
exnstent. A subsidy is a payment by a government to an individual or firm to reduce the
pttrehase price of a good or costs of production. For example, many governments subsidize
individuals by providing access to housing, student loans, or hcalthcare at below market Creative Destruction in the Capitalist System
prices. Governments also regularly subsidize government enterprises such as the Postal In pure capitalism the moral principles underlying the system clearly point away
Service or MARTA. While these types of payments can cause some degree of contrnversy, from subsidizing fu'ms, since doing so requires involuntary transfers of income and wealth.
none generates more concern than the subsidy of privately-owned, for-profit firms in a In "Capitalism, Socialism, and Democracy," Joseph Schumpeter makes an additional,
capitalist system. practical argument for bankruptcy which he coins "Creative Destruction.''t2 He wrote:
Subsidy of a privately-owned firm violates the basic morals and principles of the
capitalist system. As we saw in both this chapter and Chapter 3, ownership is not only "The opening up of new markets, foreign or domestic, and the
about the rights of the capitalist to own, control, and profit from his property, but also the organizational development from the craf~ shop to such concerns as U.S.
responsibility to use it wisely and also bear the consequences of loss and failure. Neither Steel illustrate the same process of industrial mutation -- ifl may use that
Janice (the construction company owner in our example) nor Michael Dell (the founder biological term -- that incessantly revolutionizes the economic structure
and major owner of Dell Computer) has the moral or legal right under capitalism to push from within, incessantly destroying the old one, incessantly creating a new
off their losses onto others while keeping any profits for themselves. The owner must be one. This process of Creative Destruction is the essential fact about
the residual claimant. He or she gets to keep the profits if there are any, but also absorb capitalism." (p. 83)
the losses when they occur. If the losses are large enough, bankruptcy ensues, and
ownership an.d control are stripped away legally and turned over to others legitimately. He made the practical point that no new innovation can take place without
Subsndies, however, are mvnluntary transfers of income and wealth from one group simultaneously destroying some already existing firm or industry. Consider the example
of people (usually taxpayers) to another. When the Uan.ffers are to low income students or of the desk-top computer revolution kicked off by the inventions of IBM and Apple. While
poor senior citizens you may be able to make a moral argument for doing so. But if the most people naturally focus on the wonderful new gadgets of the computer age, we must
U'ansfers are to wealthy capitalists who are simply trying to increase profits or avoid also recognize that they came at a huge price for the folks who owned or worked for Smith
bankruptcy, the argument is significantly more difficult to make on moral grounds. Corona, When computers were adopted en masse by consumers, both the consumers and
Capitalism as a system does not try to justify these transfers and instead condemns them. the computer makers benefited enormously. Clearly, however, this invention necessarily
Pmpenents of government subsidies within the mixed capitalist system often justify spelled the death of the typewriter industz'y, But given the present capabilities of
.transfers to firms based on the impact that a bankruptcy would have on workers and others
m society.
nz See Scharapeter, Joseph A, Capitalism. Socialism. and Democrat.. 3d ed. 1942. New York: Harper end
Bmthe~ 1950,
Chapter #4 - Organizing Principle~ of Capitalist Systems
Chapter #4 - Organizing Principles of Capitalist Systems

computers, nobody would begin to argue that it would make sense to have typewriter firms path of entrepreneurs the economy stagnates and the very people they are trying to help are
continue producing their vintage products. harmed in the long-run. If they do not do enough to shelter people from the short-term
So, how can we get the typewriter firms to stop producing these now obsolete hardships of capitalism, people may turn to other systems, thereby destroying the capitalist
products? Capitalism has an obvious answer. When consumers move their purchases to system itself.
computers, revenue and profits decline, and losses ensue, in the typewriter industry. If the
losses continue too long, and the firms do not transition to some different productive
activity, they go bankrupt. The bankruptcy system dismembers the typewriter firms and CONCLUSION
sells offtheir inventory, factories, offices, and machinery to others. Some of these capital
goods will find new uses by other entrepreneurs, but some of it will have to be scrapped. In this chapter we developed and analyzed the model of Supply and Demand to
Of course, innocent workers will he laid-off nod their lives disrupted. Some may have to illustrate how the free interaction between self-interested buyers and sellers results in an
sell their homes and move to areas where firms are hiring. While most will find new equilibrium. The equilibrium price and quantity makes every market participant better off
employment (perhaps in a different sector after rcttalning) some will have to take a pay cut since the resulting transactions are voluntary and take place between two people who gain
or retire earlier than desired. Small towns or entire regions may be devastated, some never from the exchange. The market only produces goods that consumers value at more than
tO r~cov~r.13 the costs of production. Finns strive to produce goods that people value - and avoid
This process has happened many times throughout history in capitalist societies. producing goods that people do not value - precisely because it is in their self-interest to
Ford's invention of the assembly line supercharged the auto industry, but destroyed the do so. After all, it is very difficult to make a profit on goods that people won't buy! The
horse and buggy industry. Tens of thousands of blacksmiths, harness makers, horse firms discover what people value by observing their purchasing decisions and the prices
breeders, buggy whip makers, and others were ruined. The invention of the mechanical
they are willing to pay. This process, repeated in countless markets, leads to an efficient
cotton picker by IntematiunaI Harvester destroyed the livelihood of millions of
economy that satisfies most people's wants at the lowest possible cost.
sharecroppers and migrant farm workers in the south after WW-IIJ4 The invention of the
What we have essentially described is a laissez faiee environment in which
automated telephone switch caused the layoffs of switchboard operators, the invention of
interactions between economic decision makers are not influenced by government
the automated teller machine (ATM) displaced bank tellers, and the invention of the
automated elevator led to layoffs of elevator operators. regulations, restrictions, mandates, taxes, or subsidies. In such a setting, government plays
a limited economic role of defining and enforcing property rights and contracts, and then
In each case cited above, a new invention or process leads to gains for one group
leaves people alone to do as they please)s
but causes losses for another group. Schumpeter celebrated this "churn" in the marketplace
and claimed that it was one of capitalism's greatest accomplishments. He believed that This broad description of the benefits of the market process are of course idealized.
non-capitalist societies would stagnate since they had no inherent mechanisms to
encourage the emergence of new firms, to remove outdated firms, and to continually
r?Pati:,Ty2sT,execntioismofthismodelboththefneoofcapim
reallocate workers (and other productive resources) to their most productive uses. He
believed that since capitalism and its entrepreneurs were so dynamic, workers laid off in
one industry would find employment in new industries. However, he also recognized that
the disruption caused by this constant "churn" would lead many in the capitalist system to
turn against it as people voted for government to protect them. How governments handle
this problem is crucial for the success of society. If they put too many roadblocks in the

o For example, in the Istc lS00s and early Ig00s, Scranton, PA was a wealthy, booming metropolis heavily
dependent upon the extraction ofanthracite coal. According to the 1900 census it was the 381 most
populous city in the U.S., having more people than Atlanta and roughly the same population as Los
Angeles. The population of Scranton, PA peaked in 1930 at 143,433. When oil and natural gas replaced
coal as widely used heating fuel post WW-tt, the fortunes and population of Scranton declined. By 2010
its population was only 76,089, making it the 420~ most populous city in the couna'y. These days, many
people outside of the northeast only Imow of the city as the home of the fictional company"Dander
Mifflin" from the sitcom "The Office."
]( It is estimated that each I-H cotton picker replaced 80 workers leading to n decline of21% of the rural
b~ck ttP°wpo//latl°n ~.theSeuth betwcen 1940 and 1950 as these work= moved to fectory job~ in the North
"~""~'t'~,uvmemstorvtorm.ore/formineintheSOs/machines I.~-ht,,,I for more in formation -'-" is The French words laiss~faire can be translated as "let (the people) do (as they choose)."
Chapter #4 - Organizing Principles of Capitalist Systems Chapter #4 - Organizing Principles of Capitalist Systems

7. Consider an item for which Amy has a reservation price as a seller of $25 and
CHAPTER #4 MULTIPLE CHOICE QUESTIONS
Benny has a reservation price as a buyer of $45. Which of the following prices is
Which of the following could NOT result in a "Change in Supply" for "MP3 inside their bargaining range?
Players"? A. $20.
A. An improvement in the technology used to produce MP3 Players. B . $35.
B, A decrease in the number ofsallers of MP3 Players. C . $70.
C. An increase in the market price of MP3 Players. D . More than one (perhaps all) of the above answers is correct.
D . A decrease in the price of plastic (an input used in the production of MP3
Players). 8. "Good X" is a substitute for "Good Y." Consequently, if the price of"Good Y"
were to increase, then for "Good X" equilibrium price would ~ and
refers to an asset that is socially and legally accepted as a medium equilibrium quantity would __
of exchange. A. increase; increase.
A . Money B. increase; decrease.
B . Profit C. decrease; increase.
C . The bargaining range D. decrease; decrease.
D . Demand
9. refers to someone who undertakes and oversees a business
Demand venture.
A. refers to the entire relationship between the price of a good and the number of A. An Invisible Hand
units that people are willing and able to purchase, all other factors fixed. B. An Entrepreneur
B. refers to the amount of a good that consumers buy at the equilibrium price. C. A Central Planner
C. provides a summary of the behavior of both buyers and sellers in a market. D. A Social Surplus
D. More than one (perhaps all) of the above answers is correct.
10. Between July 2017 and July 2018 there was a decrease in both price and quantity
Which markets are represented in the Basic Circular Flow Diagram? traded of corn. This change in market equilibrium outcome would result from
A. Markets for "Imports and Exports" and markets for "Factors of Production." A. an increase in Demand.
B. Markets for "Goods and Services" and markets for "Factors of Prodoctian." B. a decrease in Demand.
C . Markets for "Goods and Services" and markets for "Financial Assets." C. an increase in Supply.
D . Markets for "Financial Assets" and markets for "Im arts and Ex arts"
P P D. a decrease in Supply.

A situation in which the sum nfgains and losses over all people is positive in value 11. Which of the following demonstrates the "Law of Demand"?.
is defined as a
A. After Clarissa got a raise at work, she bought more donuts at a price of $8.00
A. win-win outcome.
per dozen than she did before her raise.
B. win-lose outcome.
B. After the price of flour increased by 8%, Sabrina chose to sell fewer donuts.
C. negative-sum environment.
C. Melissa would choose to sell more donuts at $7.50 per dozen than at $6.25 per
D. positive-sum environment.
dozen.
D. Joan would choose to buy fewer donuts at $10.00 per dozen than at $8.50 per
In a free market, the equilibrium quantity nf Wade and equilibrium price of a good
are determined by dozen.
A. the interaction of both self-interested buyers and self-interested sellers in the
12. An increase in income will result in a decrease in demand for
marketplace.
B. only the buyers in the market. A. a normal good
C. only the sellers in the market. B. an inferior good
D. neither buyers nor sellers, but rather by a government bureaucrat. C, a substitUte good
D. a complementary good
Chapter #4 - Organizing Principles of Capitalist Systems Chapter #4 - Organizing Principles of Capitalist Systems

13. Consider an outcome in which Joe gains $30, Kevin gains $20, and Nick loses $40. 19. Jamal owns a popular food truck which he operates near campus. Last week he
Based upon this alone information, it appears as if this is a earned revenues of $3,500 and incurred costs of $2,500. Based upon these
A. win-win outcome in s positive-sum environment. numbers, it follows that his profit was
B. win-win outcome in a negative-sum environment. A. -$1,000 (i.e., negative $1,000)
C. win-lose outcome in a zero-sum environment. B. $1,000
D. win-inse outcome in a positive-sum environment. C. $3,000
D. $6,000
14. "Voluntary Trade" generally
A. makes both parties to the trade worse off. 20. According to the theory of capitalism, in a "free market economy" profits
B. makes both parties to the trade better off. A. refer to the "gain" that a buyer gets from purchasing a good/service.
C. makes buyers better off, but sellers worse off. B. serve as a "signaling device," directing resources to their most valued uses.
D. makes sellers better off, but buyers worse off. C. are only earned by finns who exploit workers.
D. More than one (perhaps all) of the above answers is correct.
15. A "seller's reservation price"
A. refers to the maximum dollar amount a buyer is willing to pay for an item. For questions 21 and 22, refer to the graph below. This graph illustrates the supply
B. refers to the minimum dollar amount a seller is willing to accept in exchange and demand ~or shirts in 2018.
for an item.
C. is visually illustrated by the height of the supply curve. 313 ce

D. More than one (perhaps all) of the above answers is correct. Supply 2018

16. Economic Man (aka, homo economicus) is


A. neither rational nor seff-interasted.
B. both rational and self-interested.
C. rational, but not self-interested.
D. self-interested, but not rational.

17. The Basic Circular Flow Diagram builds upon the Preliminary Circular Flow ......
Diagram by
A. deleting the illustration of the role played by fu'ms in the economy.
B. adding an illustration of the movement of money between households and
1525-4- i ~ ~ ~ ~"" Demand 20t8
finns, which facilitates the voluntary transfer of economic resources.
C. adding an illustration of how equilibrium price and quantity arc each
determined in a market.
01 i0
I i 925 1,750 2,580
D . adding an illustration of the role of government in collecting taxes from firms 21. In equilibrium shirts will be traded, each at a price of
and households. A. 925; $15.25.-'-~-~
B. 925; $35.50.
18.
On January 29, 2018, the NBA's L.A. Clippers and De~-oit Pistons agreed to a trade C. 1,750; $25.00.
involving six players (including superstar Blake Griffin) and two drat~ picks. Since
D. 2,580; $35.50.
this voluntary trade took place, we can infer that
A. the L.A. Clippers thought the trade was in the best interest of their team.
22. In this market there would be at a price of $20.00.
B. the Detroit Pistons thought the trade was not in the best interest of their team.
A. excess supply
C. neither team thought the trade was in their own best interest, but league
B. excess demand
commissioner Adam Silver thought it was in the best interest of the NBA.
C. neither excess demand nor excess supply.
D. None oftbe above answers are correct.
D. both excess demand and excess supply.
Chapter #4- Organizing Principles of Capitalist Systems

Surplus, Efficiency, and


Deadweight Loss
In Chapter 4, we saw how the interaction between buyers and sellers in a free,
unfettered market resulted in a unique equilibrium outcome. This equilibrium is
characterized first and foremost by an equilibrium quantity and an equilibrium price.
These values represent the number of units of the good traded and the price at which
trade takes place. We now examine this equilibrium more closely to determine the
impact of this outcome on the well-being of different people in society.
Consider the market for used economics textbooks, supposing that Supply and
Demand are as illustrated in Figure 5.1. Applying the insights from the discussion of
market equilibrium from Chapter 4, we can readily see that in this market 720 textbooks
will be traded, each at a price of $58. Within this chapter, we will see how to eonstruct
measures of the benefits of trade, allowing us to answer questions such as:
How much does a buyer in this market gain from purchasing a textbook?
How much does a seller in this market gain from selling a textbook?
In total, how much do buyers collectively and sellers collectively gain from
the trade which takes place in this market?
In total, how much does society as a whole gain from the trade which takes
place in this market?

B U Y E R ' S R E S E R VAT I O N P R I C E A N D
S E L L E R ' S R E S E R VAT I O N P R I C E

To answer the questions posed above, we will rely heavily on the previously
defined euncepts of "buyer's reservation price" and "seller's reservation price." Recall
that a buyer's reservation price for an item refers to the maximum amount of money
that he is willing to give up to acquire the item. This value, denoted by rb, reflects the
monetary value that a buyer places on the item.
Suppose your reservation price as a potential buyer of a used textbook is r6 = 50.
If you were given a choice between having either $64 or the book, you would pick the
$64 (at~er all, since r~ = 50 you value the book at $50, whereas you value $64 at $64).
Similarly, if you were given a choice between having either $38 or the book, you would
pick the book (again, you value the book at $50, while you value $38 at $38). If you go
to the bookstore and the book is selling for $64, you would not buy it, whereas if the
Chapter #5 - Surplus, Efficiency, and Deadweight Loss Chapter #5 - Surplus, Efficiency, and Deadweight Loss

book is selling for $38 you would buy it. More generally, if textbooks are selling for on a buyer's reservation price rb, recall that this value reveals the individual's maximum
$p, then you (as a rational, self-interested consumer) would buy the book if and only if
willingness to pay to acquire the item under consideration. The actual value of a
rb > p. This condition is quite intuitive: in a free market yon will choose to buy an item consumer's reservation price potentially depends upon many factors, such as product
if and only if the value you place on the item is greater than the price you have to pay for characteristics, consumer income, and prices of substitutes or complements. But, it does
the item. not depend upon the price at which the item is being sold. Do not incorrectly confuse a
Also recall that a seller's reservation price for an item refers to the minimum buyer's reservation price with "an offer to pay" or a "starting point for bargaining."
amount of money that she is willing to accept in exchange for the item. This value, Instead, properly recognize that this value is truly (by definition) the maximum
denoted r,, again reflects the monetary value that a seller pieces on the item. willingness to pay to acquire the item. Suppose rb = 50. If the buyer has the option to
Now suppose that it is the end of the semester and your reservation price as a buy the item for p = 50.00, then he should do so. If instead price were p = 50.01, then
potential seller of a used textbook is r~ = 32. If you are given a choice between getting he should not make the purchase because now the price is above what the item is worth to
$26 versus keeping the used textbook, you would keep the textbook (after all, since him.
r, = 32 you value the book at $32, whereas you value $26 at $26). Keeping the textbook You can think of a buyer's reservation price as being a cut-offvalue that he would
Is your better choice, since you would not want to give up something that you value in want to state to someone that he is sending to the marketplace on his behalf, without any
excess of $26 in exchange for something that you value at $26. If instead you were given knowledge of what the selling price of the item actually is. For example, at the start of
a choice between getting $38 versus keeping the used textbook, you would part with the the semester you need a textbook for your economics class, but you have to work so you
book (again, you value the book at $32, which is now less than the amount of money you cannot go to the bookstore today. Your roommate is going to the bookstore and offers to
are receiving in exchange for it). In general, if a buyer offers to pay $ p for an item, then buy your economics textbook (so long as you pay for it later). Without knowledge of
what the actual selling price is, you want to state a cut-off price instructing your
you (as a rational, self-interested seller) will accept the money in exchange for the item if
roommate to buy the economics book if and only if selling price is below a certain
and only if p > r,. This condition is quite intuitive: in a free market you will choose to
amount. The best you can do is to state your true buyer's reservation price as this cut-off:
sell an item if and only if the price yon will receive for the item is greater than the value if your tnJe maximum willingness to pay is rb = 50, then state $50 as your cut-off.
you place on the item.
To see if $50 is indeed the true value of your reservation price, think about how
It is worth noting a similarity between the two general conditions just derived. A
you would respond if your roommate came home and said, "I didn't buy the book for you
buyer will purchase an item if and only if rb > p, while a seller will sell an item if and
because the price was $50.01." If your true reservation price is r~ = 50, then you might
only if p > rs. Recognize, when trade takes place in a market, each patty is giving
have some disappointment in not getting your book, but you should not regret your
something up in exchange for something else (recall the "Basic Circular Flow Diagram" roommate's decision to not make the purchase for $50. If instead you are actually upset
presented in Chapter 4). The buyer is giving up $ p in exchange for an item that he with your roommate's decision to not make the purchase for $50, then what this reveals is
values at $rb, while the seller is giving up an item that she values at $r, in exchange for that your true reservation price is in fact some amount greater than $50.
$ p . Thus, each condition states that an individual will want to trade if the item received As noted in Chapter 4, the value of buyer's reservation price is equal to the height
is more highly valued than the item given up. of the demand curve, and the value of seller's reservation is equal to the height of the
supply curve. To see this, again consider the demand and supply curves illustrated in
For both buyers and sellers, the reservation price represents a cut-off price above
Figure 5.1. Focusing on the demand curve, recognize that at a price of $75 quantity
and below which behavior in the marketplace differs. Recall the notion of consumer
demanded is 460 units. Recall that by the Law of Demand (discussed in Chapter 4),
sovereignty discussed in Chapter 3 which essentially noted that in a free market the
quantity demanded is lower at higher prices. This implies that at a price of $75.01,
individual consumer ultimately has the choice to either buy or not buy a good. All that is
being argued here is that the consumer can use this notion of reservation price as the basis quantity demanded is less than 460. Concentrating on the behavior of the individual who
would buy the 460~ unit, we see that at a price of $75.01 he does not purchase the item,
for making this choice. When a buyer goes out into the marketplace and exercises his
whereas at a price of $75 he does purchase the item. As a consequence, this reveals that
sovereignty he will choose to purchase those items (and only those items) for which the
market price is below his reservation price. Similarly, a seller will choose to sell those his reservation price is exactly equal to $75. But recognize that $75 is exactly equal to
items (and only those items) for which the market price is above her reservation price. the height of the demand curve at the 460~ unit. This argument could be repeated
To use these notions of reservation prices to derive measures of benefits from anywhere along the demand curve to see that the height of the demand curve at any
trade it is necessary to have a proper understanding of what they truly measure. Focusing arbitrarily chosen quantity is exactly equal to and directly reveals the value of the
reservation price of the consumer of the unit under consideration (e.g., the consumer of
Chapter #5 - Surplus, Efficiency, and Deadweight Loss Chapter #5- Surplus, Efficiency, and Deadweight Loss

the 720~ unit has a reservation price of $58; the consumer of the 1,055~ unit has a Consider a good traded at a price of p, for which the buyer has a reservation
reservation price of $44). price of r~ and the seller has a reservation price of r,. When the buyer gives up $ p for

Figure 5.1 - Demand umi Supplj, in the market for used textbooks an item that he values at rb, his Consumer's Surplus from this trade is CS =rb -p.
When the seller gives up an item that she values at r, in exchange for S p, her
Producer's Surplus from this trade is PS = p - rj.
Supply
Given the information conveyed by the demand curve and supply curve, it is
straightforward to graphically illustrate and conceptually determine the magnitudes of
these gains. Figure 5.2 replicates the demand curve and supply curve from Figure 5.1
with the aim of illustrating the Consumer's Surplus and Producer's Surplus that would be
75- generated from trading the 460th textbook at a price of p = 58. Recall, the buyer of this
I unit has a reservation price of r~ = 75, while the seller of this unit has a reservation price
58-
f
44- of r, = 44. Numerically, it immediately follows that the buyer of this item would realize
a gain of CS = 75 - 58 = 17 from making his purchase, while the seller of the item would
mand realize a gain of PS = 58-44 = 14 from making her sale. These values provide the
t
, [
t
answers to the first and second questions posed at the start of this chapter.

i I quantity
Figure 5.2 - Surplus from trading the 460t* textbook at a price of $58
460 720 945 1,055
$

Similar logic can be applied along the supply curve to see why the height of the
Supply
supply curve at any arbitrarily chosen quantity is exactly equal to and directly reveals the
value of the reservation price of the seller of the unit under consideration. Thus, the
seller of the 460s unit has a reservation price of $44, the seller of the 720~ unit has a
reservation price of $58, and the seller of the 9456~ unit has a reservation price of $75.

p =58 ........ =p----><._


BENEFTITS FROM TRADING ONE SINGLE UNIT OF A GOOD

Recall the first and second of the four questions posed at the start of this chapter:
"How much does a buyer in this market gain from purchasing a textbook?" and "How
much does a seller in th/s market gain from selling a textbook?." At the most basic level, L~[' ps = 58_ 44 = 14 ~'" Demand
market participants (i.e., buyers and sellers) make trades, giving up one thing of value in V
0 quantity
exchange for something else of value. The net gain or net surplus from such a trade is
I
naturally measured by the value of the item that is acqui~d minus the value for the item
that is relinquished. Consumer's Surplus is a measure of the net gain that a buyer 0 :
460
realizes from making a purchase, equal to the difference between his reservation price for
the item and the price he actually pays for the item. Producer's Surplus is a measure of From Figure 5.2, we can easily see how these gains can be illustrated graphically.
the net gain that a seller realizes from making a sale, equal to the difference between the The value of Consumer's Surplus is essentially equal to the vertical distance between the
price she actually receives for the item and her reservation price for the item. demand curve and transaction price at this unit. Similarly, the value of Producer's
Chapter #5 - Surplus, Efficiency, and Deadweight Loss
Chapter #5 -Surplus, Efficiency, and Deadweight Loss

Surplus is essentially equal to the vortical distance between the transaction price and the the net benefit of this transfer is r~ - r,, which is exactly equal to the expression for
supply curve at this unit.) Social Surplus derived above. So, for our running example, we could directly calculate
Next, recognize how these notions of Consumer's Surplus and Producer's Surplus the value of Social Surplus (from re = 75 and r, = 44 ) as SS = 75 - 44 = 31.
can be used to construct a measure of the benefits to society from this trade. Define
Social Surplus as a measure of the net gains to society from a trade, equal to the Second, the price at which trade takes place completely drops out of the
summation of the individual gains (or losses) from the trade over all members of society. expression for Social Surplus. As long as no third party is confiscating a portion of the
That is, in general, the Social Surplus from a trade will be equal to the Consumer's transaction price (i.e., so long as the amount of money paid by the buyer is exactly equal
Surplus, plus the Producer's Surplus, plus any other net gains or net losses realized by to the amount of money received by the seller), then this transfer of money has no impact
people other than the buyer or seller of the good. whatsoever on Social Surplus. To see why, recognize that this transfer generates a gain
In many cases, the only people significantly impacted by a trade are the buyer and for the person receiving the money and a loss for the person relinquishing the money -
the seller. Assuming that this is the case, it follows that the benefits to society from the seller receives Sp, while the buyer gives up Sp. But, the combined effect of this
having this trade take place are equal to the sum of Consumer's Surplus and Producer's transfer of money is the difference between the gain to the seller and the loss to the
Surplus. As a result, Social Surplus is equal to Consumer's Surplus plus Producer's buyer: p - p = 0. Regardless of the price at which the transaction takes place, the
Surplus.2 Again consider the trade of a textbook that a buyer values at re = 75 and a transaction price completely drops out of the expression for Social Surplus.
seller values at r, = 44, at a price of p = 58. As noted above, CS = 75 - 58 = 17 and To emphasize this point, consider a trade that takes place at a price of $ p, and
PS=58-44=14. Thus, SS=17+14=31. suppose that the transaction price had instead been $1 higher. How would the welfare of
More generally, recognize that Social Surplus is: the buyer, the seller, and society differ as a result of this higher transaction price? The
seller would be $1 better off (i.e., PS = p-r, would be $1 larger), while the buyer
$ S = C S + P S = ( r, - p ) + ( p - r, ) = r, - p + p - r. = r, - r, .
The social gains from trading an item are equal to the difference between the buyer's would be $1 worse off (i.e., CS = re - p would be $1 smaller). As price is increased,
reservation price for the item and the seller's reservation price for the item. This general any gain for the seller is a direct loss for the buyer (and similarly, if price were decreased,
recognition, that SS -- rb - rs, leads to several important and intuitive insights. any gain for the buyer is a direct loss for the seller). As a consequence, Social Surplus
First, the gains to society from a trade ate equal to the difference between the (which is here defined as the sum of Consumer's Surplus and Producer's Surplus) does
buyer's value for the item and the seller's value for the item. At the most basic level, a not change as price is varied. However, while the value of Social Surplus does not
trade involves ownership of a good. service, or resource being transferred from one depend upon transaction price, it is clear that transaction price is of critical importance
person to another) This transfer generates a gain for the person getting the item and a for determining how these social gains are split between buyer and seller. With re = 75
loss for the person relinquishing the item. More precisely, the buyer acquires something
and r, = 44, if price had been p = 59 instead of p = 58, then we would still have
that he values at re, while the seller gives up something that she values at r,. As a result,
SS=75-44=31. But now CS=75-59=16 (instead of CS=75-58=17) and
PS = 59 -44 = 15 (instead of PS = 58 -44 = 14).
i More precisely, think of Cortsumer's Surplus as being equal to the area of a rectangle with a base of 1 Third, considering all units that could conceptually be traded, there are some units
for which trade would generate a positive Social Surplus and other units for which trade
and a height of re - p, and think ofPrnducer's Smplus as being equal to the area of a rectangle with base
would generate a negative Social Surplus. More precisely, since SS = re - r,, trading a
of I and height of p - ra. In each case the base of l represents the "one unit of the good" that we are
unit generates a positive Social Surplus if re > r, but generates a negative Social Surplus
focosing co. Since the asea °f a re~tangin is "base tirnea height,- the asea of the former rectangle is
rb - p, while the area of the latter ~'tangle is p - rs. if re < r,. Again focusing on the fundamental aspect of trade (as a transfer of ownership
2 The assumption tha nobody beyond the buyer and the seller is signifieandy tmpacled by the trade is not from one person to another), these conditions are quite intuitive. A trade generates a
alwa~ satisfied. For example, consider a good which generatea a substantial amount of polindon, thereby positive gain for society if and only if the person getting the item has a higher value for
tmposmg a oust on someone other than the buyer or seller. In the pre~nce of asch an external effect (in
this example, negative externality), the concept of Sociui Surplus as defined here is still valid (and the item than the person giving up the item. If re > r, (i.e., the potential buyer values the
actually quite importsnt), but Social Surplus is not simply equal to the sum of Consumer's Surplus and
Producer's Sts, plus. For the prnscot discussion, focus on situations in which Social Surplus is equal to the ittem the
more thanofthe
hands thepotential seller),isthen
buyer (which taking the
essentially item
what away
trade from the seller
accomplishes) and placing
generates a
sum of Consumer) s Smplus and Producer , s Surplus. An analysts
. of markets in which such external effects
ase prese:rtt positive Social Surplus. If instead re < r, (i.e., the potential buyer values the item less
3 Recall theisdiscussion
discussed in
ofChepter
the right10.
to transfer ownership of property in Chapter 3.
than the potential seller), then taking the item away from the seller and placing it in the
Chapter #5 - Surplus, Efficiency, and Deadweight Loss Chapter #5 - Surplus, Efficiency, and Deadweight Loss

hands of the buyer (which. gain, is what trade accomplishes) generates a negative Social Finally, Total Social Surplus is generally illustrated by the area below the demand
Surplus. Again, as an example, trading an item for which rs = 75 and r, = 44 generates curve but above the supply curve, up to the realized level of trade. Focusing on Figure
positive Social Surplus. If we instead focus on an item for which rb = 50 and r, = 70 5.3, at the equilibrium outcome this corresponds to "areas (a)+(b)+(c)+(d)+(e)+(f)." This
area can be thought of as the vertical distance between demand and supply, added up over
(i.e., an item for which buyer's reservation price is less than seller's reservation price),
all units traded.
trading this item would generate negative Social Surplus.
Fourth, Social Surplus can be graphically illustrated by the vertical distance
between the demand curve and the supply curve at the unit being traded. This is again
direct consequence of the fact that Social Surplus is equal to the sum of Consumer's Figure 5.3 - Total Consumers' Surplus, Total Producers" Surplus, and Total Social
Surplus and Producer's Surplus. Focusing on the 460th unit illustrated in Figure 5.2, the Surplus
$
height of the demand curve is r~ = 75, while the height of the supply curve is r, = 44.
Thus, we yet again have that Social Surplus is equal to SS = 75 - 44 = 31.

B E N E F T I T S F R O M T R A D I N G M U LT I P L E U N I T S O F A G O O D
Recall the third and fourth questions posed at the start of this chapter: "In total, 7 5 . . . . . . . . .
how much do buyers collectively and sellers collectively gain from the trade which takes
place in this market?" and "In total, how much does society as a whole gain from the
trade which takes place in this market?" The concepts developed thus far can easily be -
4 4 " ~
extended to the entire market, in order to answer these questions. 5 8 ~ u p p l y
' ~ D c m a n d
Let Total Consumers' Surplus refer to measure of the total gains from trade
re.altzed by all consumers, defined as each individual's Consumer's Surplus, added over
all units purchased. Similarly, let Total Producers' Surplus refer to a measure of the 0 [ quantity
total gains from trade realized by all sellers, defined as each individual's Producer's
Surplus, added over all units sold. Recognize that Total Consumers' Surplus is equal to
0 460 720 945
the difference between buyer's reservation price and actual price paid, added over all
units purchased, while Total Producers' Surplus is equal to the difference between actual
These measures provide the answers to the third and fourth questions posed at the
price received and seller's reservation price, added over all units sold. Finally, let Total
start of this chapter. At the equilibrium outcome, for example, buyers collectively gain
Social Surplus refer to a measure of the total gains fi'om trade realized by society,
an amount equal to "areas (a)+(b)+(e)," sellers collectively gain an amount equal to
defined as Social Surplus, added over all units traded.
"areas (c)+(d)+(f)," and therefore society gains an amount equal to "me, us
Each of these three market level concepts can be illustrated graphically by again
playing offof the demand curve and supply curve. Focus on Figure 5.3, which depicts (a)+(b)+(c)+(d)+(e)+(f).'~ Recognize how equilibrium price essentially splits Total
the same market as in Figures 5.1 and 5.2. Suppose that the market realizes the Social Surplus into a portion that goes to buyers (Total Consumers' Surplus) and a
equilibrium outcome, with 720 units ~'aded, each at price of $58. Total Consumers' portion that goes to sellers (Total Producers' Surplus).
Surplus is generally illustrated by the area below the demand curve but above rice u to
the realized quantity of trade. At the equiHbrinm outcome illustrated in Fi~u~ 5 3, Pis
corresponds to "areas (a)+(b)+(e)." This is essentially the vertical distance between MAXIMUM POSSIBLE BENEFTITS FROM TRADING A GOOD
demand and transaction price, added up over all units purchased.
Similarly, Total Producers' Surplus is generally illustrated by the area below price We can think of market equilibrium as providing description or prediction of the
but above the supply curve, up to the realized quantity of trade. For the market in Figure outcome that arises in free market when buyers and sellers interact with each other. For
5.3, at the equilibrium outcome this is equal to "areas (c)+(d)+(f)." Again, recognize that
this is basically the vertical distance between transaction price and the supply curve,
added up over all units sold. (W hen measuring the impact of a Wade on society, we define society as all of the people impacted by a
transaction. As already noted, for the majority of cases, that is only the buyers and sellers themselves.
Thus, Social Surplus, the benefit to society, is simply the sum of gains to buyers and gains to sellers.
Chapter #S - Surplus, Efficienc); and Deadweight Loss
Chapter #5 - Surplus, F~eieacy. and Deadweight Loss

the market illustrated in Figure 5.3, we would expect 720 units to be traded, each at a Presumably, more frequent mammograms would increase the likelihood of early
price of $58. Further, we just noted that this would result in buyers collectively gaining detection of breast cancer, thereby providing a substantial benefit to the individual getting
"are.as (a)+(b)+(e)," sellers collectively gaining "areas (c)+(d)+(0," and society the test. But, more mammograms arc cosily, in that to provide more mammograms
collectively gaining *'areas (a)+(b)+(c)+(d)~e)+(f)." Recalling the distinction from society must divert productive resources away from other medical procedures (or some
Chapter l, recognize that these are positive (as opposed to normative) observations. other good or service). As an illustration, suppose the cost of providing a mammogram
The equilibrium outcome is what we expect to arise. But, is it a good or desirable to a 40 year old woman is funded by reducing screening for cervical cancer. It may turn
outcome? To begin to even address this normative issue, we need to impose some value out to be that the number of women saved by early mammograms is more than offset by
judgments. The accepted approach is to suppose that society aims to maximize Total the increased number of deaths due to less screening for cervical cancer - but perhaps it
Social Smphis.5 Under this assumption, we will attempt to identify the efficient level of is not. An economist would address this question by applying the principles of costs and
trade - that is, the level of trade which maximizes Total Social Surplus. After benefits that have been discussed throughout this text.
identifying this ideal level of trade, we will try to see how the equilibrium level of trade If we simply said, "More frequent mammograms provide benefits to women by
and efficient level of trade compare to each other. reducing breast cancer death rates; therefore, all women should get mammograms on a
Before undertaking this exercise, it is important to pause and recognize that the regular basis," we would be falling victim to the open-ended fallacy. Total Social
socially best level of trade (i.e., production/consumption) for any good is finite. This is a Smphis is not maximized by engaging in all activities for which benefits are positive.
result of the fact that productive resources are scarce, thereby implying that tredanffs Rather, to maximize Total Social Surplus we must appropriately compare and balance the
exist in regards to levels of production of different goods. Thus, when thinking about the additional benefits for society against the additional costs for society of the activity under
level of lxade that would maximize Total Social Surplus, we do not want to fall prey to consideration (exactly as suggested by the Cost-Benefit Principle in Chapter 1). To
the open-ended fallacy. The opon..ended fallacy is a logical error whereby someone thoughtfully assess the economic implications of the proposed DHHS guidelines, we
mcorreeily concludes that simply because there are benefits (to some people) from higher would need to compare the benefits of more frequent mammograms to the associated
levels of an activity, that more of the activity is always better. costs (again, many of the costs stem from diverting productive resources away from other
It is especially important to be cognizant of this common analytical mistake when valued uses). If we are currently starting at a point where some mammograms are
considering pubfic policy (for which trying to maximize Total Social Surplus seems like provided for which benefits are less than costs, then Total Social Surplus could possibly
a particularly reasonable objective). But, as will be apparent from the discussion below, be increased by providing fewer mummograms.
any attempt to manipulate the realized level of Total Social Surplus can only be done by We now return attention to the previous framework (and the market presented in
altering the level of trade in a market, implying that it becomes necessary to ultimately Figure 5.3) to see how to conceptually proceed with an identification of the socially best
choose a level of trade (i.e., identify some level as the ideal or best level of trade).
level of trade. When determining the benefits from trading any single unit of good it was
For example, consider the choice of frequency of a precautionary medical
noted that trading a unit generates a positive Social Surplus if rb > r, while tyading a
procedure. In November 2009, the U.S. Preventative Services Task Force of the
Deparlment of Health and Human Services (hereafter DHHS) issued revised guidelines unit instead generates a negative Social Surplus if rb < r,. So, to maximize Total Social
regarding the regularity with which women should get mammograms to detect breast Surplus, we need to do two things: (i) make sum we trade all units for which rb > r, and
cancer. The existing guidelines advised all women over the age of 40 to undergo a
mammogram annually. The revised guideline suggested that women over the age of .50 (ii) make sure we do not trade any units for which rb < r, 7 Inspection of Figure 5.3
should get a mammogxam every other year, while women below age 50 need not get reveals the implicatiuns of following these two pieces of advice. First, we need to make
mammograms at all.6 Why would a division of the DHHS suggest that women get sum we trade every unit up to the 720~ unit, since for each such unit rb > r, (recall,
mammograms less frequently? Is this possibly good medical or good economic advice?
resecvatiun values are revealed by the heights of the demand and supply curves). Second,
we need to make sure that we do not U'ade any unit beyond the 720a= unit, since for each
s Stamng
, st an outcome for which Total Socla Surplus is not maximized, it would always be po~ible to such unit r, < r,. Thus, the efficient (or Total Social Surplus maximizing) level of trade
realize different outcome (pedmps includln~ tnmsfer ~ts ~'-- ~- is 720 units,s Trading exactly this quantity makes Total Social Surplus as large as
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; ~ . ,s~octly
. u v m ~better
e s e g nof/)
l c n tuothey
l s o c iwere~ the
ctv to a n o tinitial"
h e r ' l a"t
possible, in Figure 5.3 generating collective gains for the members of society equal to
outcome. Because of this, Total Social Suqflus maximi~t/on is an accepted pflmary goal for s~.iet-/.
, , see "A Breast Cancer Preview"
5 F or further du~slon, "areas (a)+(b)+(c)+(d)+(e)+(f)."
(~IP://°nlin~
Health Cam~t~i.co.m/arlicle/SBIO00142405.~748704~043045745437212536887~O
I~tlomng Behind New Mmnmography Recommendations" h '~) and "Critics See
7 A ' . . . ,
(]ffllJ'/At~,~¢ff~rn~t~.cont/tmliticM200~/l I/[7/cHties-health-carc-rationin~-ne~breast.can~cr.~¢reenino
rct'oramendatio~" , R~vgn~e
S~- ,t~up~
tmutha!
what
nobedy
we Dave
be.yeed
do~e
thet~
buyer
an appticatio~
or seller ts significantly
of the general
impacted
~ for by
graphically
the trade.applying the
Cost-Benefit Principle, as discussed in Chapter I.
Chapter #5 - Surplus, E~cieney, and Deadweight Loss Chapter #5 - Surplus, E.~ciency, and Deadweight Loss

Any other level of I~'ade, either less than or greater than 720 units, would result in was discussed in Chapter 3. The individual motives of self-interested buyers and self-
a lower realized value of Total Social Surplus. Define Deadweight Loss as the interested sellers induce the market participants to Wade exactly those units (and only
difference between maximum possible Total Social Surplus and realized Total Social those units) for which social gains from Wade are positive. Thus, when individuals act in
Surplus. By construction, Deadweight Loss is zero at the efficient level of trade. their own self-interest, they collectively behave in a way so as to make Total Social
Further, Deadweight Loss is positive at any other level of trade. Deadweight Loss Surplus as large as possible. As a result, Total Social Surplus is maximized at the
provides a measure of the loss to society from realizing a level of trade other than the equilibrium outcome. Further, so long as this is true, it follows that any government
efficient level. Such a loss is present if society makes either one of two different types of policy which alters the level of wade will create a positive Deadweight Loss.
mistakes, either: (i) they do not produce all units which generate a positive gain for The observation that the equilibrium outcome is efficient is quite intuitive. A
society or (ii) they do produce some units which generate a negative gain for society. voluntary trade between a buyer and seller can benefit both parties if and only if the wade
In the market illustrated in Figure 5.3, first suppose that unly 460 units were itself generates a positive surplus. In the present context, for this to be true, it must be
traded. By trading 460 units, this society realizes gains equal to "areas (a)+Co)+(c)+(d)," that the buyer places a greater value on the item than the seller. Buyers and sellers in
which corresponds to the area below the demand curve but above the supply curve, added markets are self-interested. In a free, unfettered market, market forces (i.e., the rational
up over these 460 units. Since the maximum possible Total Social Surphis is equal to pursuit of self-interest) induce buyers and sellers to wade all units for which there is a
"areas (a)+(b)+(c)+(d)+(e)+(f)," it follows that Deadweight Loss (i.e., the difference positive gain to be had. When nobody beyond buyer or seller is impacted by the Wade,
between maximum possible Total Social Surplus and realized Total Social Surplus) is: this prompts buyers and sellers to trade all units (and only those units) for which Social
DWL¢oo = (a+b+c+d+e+ f)-(a+b+c+d)= e+ f . Surplus is positive, thereby maximizing Total Social Surplus. This is because such trades
The Deadweight Loss (of "areas (e)~f)") results from society trading too few units. ultimately result in the item ending up in the hands of the person who values if most
More precisely, while they do realize the positive gains from u'ading each of the first 460 highly, which is exactly what efficiency requires.
units, they do not realize the potential positive gains from trading the units between the
461~ and 720~ units. That is, society is failing to maximize Total Social Surplus, since it
is making the mistake of not trading all units for which rb > r,.
Now suppose 945 units were traded. In this case, society realizes all of the
potential positive gains from trading each of the fu'st 720 units. But, trading each of the
final 225 units (between the 721a and 945~ unit) decreases Total Social Surplus (since
SS = rb - r, is negative for each such unit). In total, wade of these final 225 units
decreases Total Social Surplus by "area (g)." Thus, with 945 units traded, realized Social
Surplus is "areas (a)+(b)+(c)+(d)+(e)+(f)-(g),,, so that Deadweight Loss is:

DWL~s =(a+b+c+d+e+ f)-(a+b+c+d+e+ f_g)=g


Recognize that even though the consumers of these final 225 units benefit from having
these items, producing and consuming these units decreases Total Social Smplus. This is
because the cost of these units is in excess of the benefits of these units (reflecting the
fact that in order to produce these items, society has to in essence give up some other
good of even greater value). Thus, society is failing to maximize Total Social Surphis,
since it is making the mistake of trading some units for which rb < r,.
Finally, recognize that the equilibrium level of trade and efficient level of trade
coincide with each other- the free market equilibrium level of wade is the efficient level
of wade? This observation iIInswates Adam Smith's notion of the Invisible Hand, which

9M ore prettily, the free marke~ level of trade is efficient, so long as certain conditions are reeL As noted,
t~ ~u~%~n~ ~u~d ~ that nobody beyond buyer or seller is significantly impacted by
m which the flee market
~" ' ac
outcome
Pr"~enco
~ Inefficient
o[soco externm
and ~m'a,2terlzed
effects can
by lead
positive
to "nmrket
Deadweight
fntlure-
Loss).
(i.e..
Such
a aituntion provision of public goods (i.e., goods that are "non-excludable" and "non-rival in consumption." such as
market failure can tlso arise as result ofpriclng by firms with substantial monopoly power or market national defense). A full treatment of these topics is beyond the scope of the present discussion, but is
discussed more fully in Chapter 10.
Chapter #~ - Surplus. E~clency, and Deadweight Loss Chapter #5 - Surplus, Efficiency, and Deadweight Loss

4. "Deadweight Loss" refers to


C H A P T E R # 5 M U LT I P L E C H O I C E Q U E S T I O N S
A. the burden that consumers incur from having to pay for goods, instead of
I. Ty owns a copy of the book "Sapiens" autographed by the author Yuval Noah getting them for free.
Harari. His reservation price as a seller of this item is $45. Ed's reservation price B. the negative impact of industrial production on our environmental resources.
as a buyer of this item is $5. If thls unit was traded (i.e., transferred from Ty to Ed) C. the difference between "maximum possible Total Social Surplus" and
A. Social Surplus would be decreased by $40. "realized Total Social Surplus."
B. Social Surplus would be increased by $25. D. the profits that firms make in a free market economy.
C. Social Surplus would be increased by $40.
D. Social Surplus would be increased by $50. 5. refers to the logical error whereby someone incorrectly
concludes that simply because there are benefits (to some people) from higher
For questions 2 and 3, refer to the graph below. This graph illustrates the supply and levels of an activity, that more of the activity is always better.
demand for huts in 201& A. The Invisible Hand
B. The Economic Calculation Problem
~rice
C . The Open-Ended Fallacy
D . Deadweight Loss

6. Dave bought 10 comic books from Eric. This trade gave Eric a Producer's Surplus
of $20 and generated a Social Surplus of $36. It follows that Dave realized a
from this trade.
A. negative Consumer's Surplus
B. Consumer's Surplusof$16
18.10
1 -. 9 5 ~ u p p l y 2 0 1 8 C. Consumer's Surplus of $56
D. None of the above answers are correct.
5.00

0
~ I
Demand 2018
quantity
7. If the efficient level of trade is 6,400 units, Deadweight Loss would be positive if

A. 0.
units were traded.
I
3,350 6,625 9,275 B. 3,250.
In equilibrium C. 9,125.
D. More than one (perhaps all) of the above answers is correct.
A. both Total Producers' Surplus and Total Consumers' Surplus are zero.
B . Total Consumers' Surplus is equal to "areas a+b+e" and Total Producers
8. The market equilibrium price
Sin]flus is equal to "areas c+d+f."
C . To t a l C o n s u mrs 'Surplus Is
" equal to ,,area a and Total Producers Surplus is A, prevents the efficient quantity of trade from arising.
equal to "areas b+c+d." B. determines the split of total gains from trade between buyers and sellers at the
D . Total Consumers' Surplus is equal to "areas a+b+c" and Total Producers' market outcome.
Surplus is equal to "area d." C. determines if Deadweight Loss is positive or negative at the market outcome.
D. None of the above answers are correct.
If3,350 units were traded, Deadweight Loss would be
A. negative. 9, In most markets Total Social Surplus is equal to
,t
B. equal to "areag." A , Total Consumers Surplus" plus "Total Producers' Surplus."
C. equal to"areas e+f." B. "Total Consumers' Surplus' minus "Total Producers' Surplus."
D. equal to "areas g+h." C. "Total Benefit to Buyers" minus "Total Amount Paid by Buyers."
D . Equ' hbnum
' ' 1
Price muinphed by' Equd . .bnum
. Quantity.
Chapter #5 - Surplus, Efficiency, and Deadweight Loss

Organizing Principles of
Socialist Systems
In Chapter 4 we examined the economic principles that underlay a competitive free-
market system, commonly called Capitalism. In this chapter we examine the principles
that underlay a centrally planned command system, commonly called Socialism (or
Communism). After you have read these chapters you should have a good understanding
of the two polar opposite systems that societies choose from when constructing their
economies, as well as the compromises that have been tried in the Socialist world.
In this chapter we focus mainly on the fully centrally planned command system
since it makes no concessions to Capitalism or its foundations of private property and
individual control of resources. The main emphasis is on understanding the system at a
purely theoretical level with some attention paid to the practical realities of historically
existing Socialist societies. Even though there have been other societies governed by
Socialist principles, we primarily examine the methods and achievements of the former
Soviet Union. This focus on the Soviet Union is justified by the fact that it was the first
socialist society and was instrumental in either the formation or mentoring of most of the
other experiments in Socialism that have come about.

T H E E S TA B L I S H M E N T O F S O C I A L I S M I N T H E S O V I E T U N I O N

The Russian Revolution, which began the transformation of Russia from a semi-
feudal societyI into a socialist one, occurred in 1917 during the political chaos and
disintegration surrounOing the disastrous impact of ftghting WW-I. The Bolshevik faction
among the socialists, while nowhere near a majority of those opposing the Czar (or king of
Russia), were well organized and took advantage of the weakness and disorganization of
other groups to gain control of the Russian government. After gaining control of the
political system the Bolsheviks went to work changing the economic system.2
The fu'st economic system implemented by the new communist government is
known as War Communism, which was imposed during the Russian Civil War and lasted
from 1918 to 1921. This economic system included nationalization of all industry, forced
or obligatory labor duty, requisition of agricultural commodities, banning of private
enterprise, and other forms of direct government control over society and its productive

I8
2 ee page 44 mChapter 3 for further detail. The Russian serfs were formally freed in 1861
~tr~a .~. l~opL New York. y Daniel Pipes (1990),
Chapter #6 - Organizing Principles of Socialist Systems
Chapter #6 - Organizing Principles of Socialist Systems

ECONOMIC PLANNING IN THEORY AND PRACTICE


resources. This period is generally glossed over in most discussions of the Soviet planned
economic system since it was imposed during an all-out civil war when most ordinary
Now that the state owned all businesses it had to figure out what to do with them
economic processes had broken down. The main purpose of War Communism was to
and how to manage them. Starting in 1928 Stalin implemented the first of many successive
support the Red Army in its battle with those forces resisting the communist takeover.
While it may be considered a success due to the military victory of the Bolsheviks, the economic plans known as 5-Year plans. These 5-Year plans became the basis for all
economic directives from the central government to the government owned operating units
imposition of War Communism collapsed the economy.
The second economic system implemented by the Bolsheviks was the New (collective farms, steel mills, chemical plants, factories, etc.) that in Capitalism would be
Economic Policy (NEP) which ran fi'om its inception in 1921 to its dissolution in 1928. called businesses. In order to understand how a large country is managed in Socialism we
Vledimir Lenin, the leader of the Soviet Union at the time, recognized that War need to examine these economic plans in more detail.
Communism, while congruent with socialist principles of state ownership and
management, was "too-much too-soon" for Russia to absorb. His NEP was a partial
repudiation of strict Socialist principles and a reintroduction of some elements of C e n t r a l P l a n n i n g a n d t h e 5 - Ye a r P l a n
Capitalism into the system to help revive the economy. The new system was similar to the In a centrally planned economy a political authority at the "center" (Central
mixed economy discussed in Chapter 3. Private individuals were permitted to own Committee or Politburo for the Soviet Union) would make the highest level decisions
property and operate small businesses and light industry. However, large scale industries about what should be done with the economic resources that society collectively owns (as
(the Commanding Heights), banks, and the foreign trade sector were still controlled by the well as all other important government decisions). For instance, a decision must be made
government. Farmers were permitted to own their own land and make their own decisions
regarding how much of society's resources should be put into the military for defense, into
on how to operate their farms. Forced grain requisitions without compensation, common health care, into consumer goods, into education, and so forth. Once the political system
during the Civil War, were abolished and replaced by a tax.
has determined the relative amounts of resources to allocate to various uses, orders are
This new policy was very successful as the private entrepreneurs and farmers
given to a Council of Ministers which oversees the Ministries that will actually implement
responded to the new incentives to produce. Production, which had fallen drastically
the decisions of the Politburo. In the U.S. the institutions called ministries are called
during the civil war, rebounded quickly with peasant output rising 40%. This new policy
not only increased output but also created a class of"NEP-men", the name given to the government departments, such as the Department of Defense, the Department of
entrepreneurs and businessmen that the NEP created. These small capitalists thrived in the Education, and the Department of Transportation. These are referred to as regular
shortage conditions prevalent in Russia at this time and quickly gained higher incomes than government ministries and exist in almost all modern states whether they are capitalist or
ordinary workers. This new class of business people and the system that caused them to socialist.
come into being generated a great deal of dismay among the leaders of the Communist In addition to these "normal" government ministries that exist in all societies, the
Party. The inconsistency of having a capitalist class - even one that was restricted to small planned socialist economy has two additional ministries or agencies: Planning Agencies
scale business, light industry, and farming - was in direct conflict with Socialist principles. (GOSPLAN in the Soviet Union) and Industrial Ministries. While a Defense Ministry or
The NEP had to go, and Lenin's successor, Joseph Stalin, abolished it in 1928 to impose Department exists in every country, the planning agencies and industrial ministries only
full scale central planning and reintroduce complete state control of the production of goods exist in planned socialism. The planning agency draws up 1 year, 5 year, and long-range
and services.3 plans for the growth of the economy and also sets goals for and coordinates the activities
When Stalin abofished the NEP in 1928 he introduced the first "5-Year Plan," of the industrial ministries. The industrial ministries actually execute the plans of
which was the beginning of full central planning of the economy. We will devote the GOSPLAN and run the state owned f'L,'ms directly with their own employees. Examples
majority of the rest of this chapter to understanding both the theory of central command of Industrial ministries would be the Steel Ministry, the Oil Ministry, the Automobile
planning and the historical accomplishments achieved using this system in the Soviet Ministry, the Chemical Ministry, and the Machine Tool Ministry. Each of these ministries
Union. This system was in place from the disbanding of the NEP in 1928 to the disbanding would be organized with a vertical relationship between the central government and the
of the U.S.S.R. in 1991. government owned production units under its command. A minister represents the
politburo, and the government owned factories farther down the chain of command report
to that minister. Each ministry is responsible for producing the amount of output of each
~ R~9~7~" W. Service, A ti~story of Twemietk.Cemury Russia l'~ard Onivers -. D .........
good (e.g., steel, gasoline, ears, and houses) that the government wanted produced. Once
Chapter #6- Organ/zing Principles of Socialist Systems Chapler #6 - Organizing Principles of Socinlist Systems

we get into the details of bow such a system operates, its complexity is mind boggling[ into more concrete directives to various industrial ministries that will actually produce the
However, we will attack this problem one step at a time. goods and services implicit in the politburo's plan For example, GOSPLAN must decide
A classic example to communicate this idea of a vertical system is to think of the bow many ships (some for the Navy, some for civilian transport), how many miles of
chain of command in the military. The President and the Congress agree that it is a good railroad tracks, how many vehicles (some as jeeps and trucks for the military, some as cars
idea to invade some country for reasons ofnatiuna] defense Once the political decision to for consumers, and some as trucks for businesses), and how many steel bridges wiU b¢
go to war is made, orders are given to the Defense Department to actually plan and built. Once these choices have been made, experts then determine how many tons of steel
implement the war. The Defense Depenmant forwards the orders to the Pentagon, the are necessary to fulfill the Politburo's plan.
¢quiva]unt of the industrial ministry mentioned above. Within the Pentagon the generals
Finally, we are now at the point of considering choices by the ministry of steel,
and admirals of the Army, Navy, Air Force, and Marines divide up the task of prosecuting
which controls all of the steel mills In the country. They have just received their orders
the war. The Navy figures out how many ships it will take to move the troops and their
from GOSPLAN that 100 million tons of steel are necessary this year in order for the plan
tanks and trucks to the war zone. The army decides how many armored units, how many
to be fulfilled. The ministry of steel, checking with enterprise managers (government
a/rbome units, and how many infantry units will participate in the battles and where the
officials that actually run a production unit such as a steel mill, mine, or factory),
troops will come from. The Air Force must determine how many hoop carrying planes
determines which steel mills will produce how much steel. This now leads the enterprise
versus how many bombers versus how many fighter planes will be needed to help the Army
in their tasks. The Marines arc tasked with an amphibious assault to establish a beachhead managers and the ministry leaders to calculate how many inputs (e.g., how many tons of
coal, iron ore, limestone, manganese, chrome, and other ingredients) are needed from other
for all of the follow-nn troops. As you can imagine, there must be many sub-"ministrins"
within the military "ministry" with specialized knowledge of the various tasks to industrial ministries that produce those ingredients. Don't forget, the steel ministry will
accomplish. Finally, picture the orders coming down from the Pentagon, through the itaelf need steel for the production ofita steel mill. In addition, manpower requirements
. . .
,, . . .
would be calculated, and the amount of new machinery needed to replace, update, or
varinns "unmstnes" and agencles untd they get to an actual operatrag umt," whzch in the expand the steel mill would be determined.
Army is a regiment or battalion. This is the level at which troops and their officers actually
fight the enemy. Everyone above them is directing and planning. Notice that none of the Once all of this is accomplished the steel ministry would send its requests up to
decisions by the military are made based upon profit or observable prices, nor do the GOSPLAN which would use that information to inform the coal ministry, minerals
soldiers have any say in what their commanders decide. This is not an accidental byproduct ministry (for the limestone and other minerals), and the machine tool ministry of its needs.
of the systam, but rather is designed into the system. These other ministries are likewise sending their requests for resources and manpower up
Now let's shift from the Defense Ministry- which exists in all countries, including to GOSPLAN so that they can produce the required inputs for the steel industry. For
capitalist ones - and consider how an industrial ministry (which only exists in a socialist instance, the coal industry needs steel for the rail lines leading to the mines, for beams and
system) such as the minislzy of steel will operate. The steel ministry must first get its roof supports to prevent cave-ins, and for the machinery to dig the coal. As you can see,
"marching orders" about how much steel to produce. Where will they get that information? this is going to get very complicated very quickly since the needed inputs of one industry
As discussed above, political decision makers in the Politburo make broad decisions about are the outputs of some other industry, which become the inputs to yet another industry,
the relative dis~bution of resources. For example, they might decide that of all available and they all need resources. Remember though, all of the requests for resources must not
resourees the military will get 20%, education I o exceed 100% of the available resource base.
and transportation 5%In reality there are far more 0~, consurner goods 500/0, healthcare 15%,
things that a society needs, but the list How is all of this accomplished without going over the total amount of resources
available? The Soviet planning process used what is called Material Balances4 to answer
wo.uld be too long for our example. The next thing to notice is that the total percentage of
society's resources allooatod to various needs cannot exeeod 100% ,,-, ........ this question. The goal of the Material Balances method is to establish a balance between
to borrow fro ~ ,,.
m f o r e l g n e, c s . L. e t s k e e p t h i~,¢u~,~
n - s s iwcm -ar~
I . wlum
.... g the sources of available resources and the uses of those resources in a multistage process.
e~ l-' ann asannle a Closed system with no
borrowing. Lnstly' the decisi°ns of the steel ministry, just like in the military, will not be In the first stage GOSPLAN sends "control figures," which are the priorities of the
based on prices, profits, or any input from the population. Governmental leaders control Politburo converted into numerical requirements of preducts desired. These priorities can
the entire process. be disseminated as physical output targets or as percentage changes from previous output
Oac¢ these relative shares of resources are decided by the Politburo this information targets. In the next stage, the enterprises (such as the individual mine or steel mill) make
is transmitted to GOSPLAN, which is a Russian acronym for the central state planning

agency. TheplaanersatGOSPLANwilltranslatethegeneraldirectivesfromthePolithuro 4 For a fuller explanation of Material Balances see Central Planning by Paul G. Hart, Harwood Academic
Publishers, 1991.
Chapter #6- Organizing Principles of Socialist Systems Chapter #6 - Organizing Principles of Socialist Systems

a detailed listing of resources necessm, y to fulfill their output targets. Then in the third
Assumptions of the problem
stage planners at GOSPLAN construct a material balance that "forces" equality between
Suppose the Politburo decides that the country should produce 200,000 delivery
the total amount of resources available and the total uses for the resources in production.
trucks, 500,000 cars for civilian use, and 30,000 condos of 800 square feet (among many
This balance is generated by shiRing resources among and between the different ministries,
other products). GOSPLAN (with the help oftbousnnds of technical experts working for
thereby generating an equilibrium analogous to (but different from) that generated by
"supply and demand" in the capitalist system. the planning bureau) has calculated that it takes 2 tons of steel to make a truck, 1 ton to
This material balances approach can be represented by the following identity (a produce a car, and ½ ton to make a condo (for reinforcing bars). This means that
relationship that must be true by defmitinn):5 GOSPLAN will need 915,000 tons of steel to fulfill the desires of the Polithuro.
GOSPLAN informs the steel ministry of its need for 915,000 tons of steel. The steel
Source of Resourcns = Uses for Resources ministry determines how many workers it needs, which steel mills will produce which
or specific steel products, and any resource needs from other ministries. The steel ministry
Supply = Demand. calculates that:
We further define: it can produce 600 tons of steel per worker, so it needs 1,525
steelworkers to produce 915,000 tons of steel;
Source of Resources = (Current Production) + (Inventories) + (Imports)
it needs 2 tons of coal per ton of steel to smelt the steel, so it needs
and 1,830,000 tons of coal to produce 915,000 tons of steel;
Uses of Resources -- (Government Services) !t needs 3 tons of iron ore per ton of steel, so it needs 2,745,000 tons of
+(Consumer Goods) + (Inter'industry Demand) tron ore to produce 915,000 tons of steel; and
+(Investment Goods) + (Exports). it needs 1 ton of limestone per ton of steel to absorb impurities in the
So, necessarily: smelting process, so it needs 915,000 tons of limestone to produce
915,000 tons of steel.
'`current Production" "Government Services" plus "Consumer The Steel Ministry informs GOSPLAN of these needs for workers, coal, iron ore,
plus "Inventories" and limestone to produce the targeted 915,000 tons of steel. GOSPLAN informs the coal
~ Goods" plus "Interinduslzy Demand"
plus "Imports" plus ,,InvestmnntGoods,,plus "Exports" mlmstry and the minerals ministry of the steel ministry's needs, and the minerals ministry
. , , . , .
_fi~ffr.contacts tts own. sub-rmmstnes zn the n-on ore and lzmestone bureaus to get them
In a market based Capitalist system this equilibrium is not reached by government p,ouucmg me appropriate amounts.
planners shiRing resources to where they ate needed, but by price signals generated in In turn, the coal ministry calculates that since coal miners can dig 200 tons of coal
markets by producer supply and consumer demand which then create equilibrium prices per year it will need 9,150 miners. The iron ore sub-ministry within the minerals ministry
and quantities. As we discussed in Chapters 3 and 4, each business makes its own decision calculates that since its miners produce 1,500 tons each it needs 1,830 miners, and the
regarding whether to expand or contract - that is, to ask for additional or fewer resources limestone sub-ministry calculates that since its miners produce 750 tons each it needs 1,220
based on profitability, which in tuna is determined by consumers' desires embodied in nunera. When this data flows up the chain of command, GOSPLAN calculates that all
demand. In stark Contrast to the decentralized market process, in a centrally planned production units will need a total of:
system this equilibrating must be done actively by the planners themselves.
1,525 + 9,150 + 1,830 + 1,220 = 13,725
The following simplified example illustrates the principle of the material balances workers to make the steel needed to meet the Politburo's target.
approach to planning a society's economy. In our example we will only be trying to The problem, however, is that we have only 13,176 workers available. With only
"balance" the steel indusCy' sproductton of steel forjust three differem preduets. The real 96% of the necessary workforce, we could probably only roduce abo o
world, with its multiplicity of predocts, will be exponentially more difficult. level of steel outnut. ....... ~o¢
"rh;~,mLu .~ ,_ ........ P ut 96 '/o of the target
-r- -~,~ onty ~/~,q.O0 tons of steel. That is, with the available
,
workforce the most steel we could produce is 36,600 tons short of the initial target.
s T h e 'Idenuty specified .
can be wntlen,m ordma~
, Enghsh as. 'you can t use mote tesources ti~ you have
availabley This' is obvmesly
. true because any answer' that "violates
' this' condition is impessiblc So, what must be done? GOSPLAN informs the Politburo of the shortage of labor,
can be very useful because they limit your search for an answer to and the members of the Pohtburo need to decide the tradeoffs m the number of trucks, cars,
' Identities
p°mttheoHzingabouturnla nn~6 ,~;.~.-~,~:
mmgs mat .....are imposs bwhatmactualIylx)SSlbe
e. It ~.;a-- _ ~On There'mno
L utopian and condos it wants produced. Recall, it takes 2 tons of steel to make a truck, l ton to
;.,.v..u~ check . 01 nk ng.
produce a car, and ½ ton to make a condo. They decide that laxtcking is most important
Chapter #6- Organizing Principles of Socialist Systems Chapter #6 - Organizing Principles of Socialist Systems

and leave target production at 200,000 trucks. Target production levels for cars are lowered planning of GOSPLAN and the directives it gives to the steel ministry and the resource
from 500,000 to 466,400 and fur condos are lowered from 30,000 to 24,000. This former ministries.
reduction of 33,600 cars decreases steel usage by 33,600 tons (since each car requires 1 ton In addition, steel, wood, aluminum, or plastic (and a host of other manufactured
of steel), and this latter reduction of 6,000 condos decreases steel usage by 3,000 tons (since products) can be used in different combinations to make boats, x-ray machines, chairs,
each condo requires ~.4 ton of steel). The new target levels of 200,000 trucks, 466,400 cars, tables, airplanes, gas pumps, computers and thousands of other goods. As you can see, this
and 24,000 condos are a onsistent plans which satisfies the requirement of the Material problem is so vast (after all, there are hundreds of thousands of items produced in a modem
Balancing method: economy) that in practice the Soviet Union only planned a subset of all goods by setting
Total Source of Resources = Total Use of Resources targets for what the leadership considered most important. After WW-II centralized
(supply of 13,176 workers) = (demand for 13,176 workers). planning increased considerably. While only 1,600 items covering 14 groups were
centrally planned in 1951, by 1960 targets were set for 12,750 items.~ But even this was
far less than the total number of items being produced, leaving a considerable amount of
Further Problems with Planning the Economy leeway for planning at subordinate levels in the ministries themselves and in sub-regions
This simple example, while daunting to understand, is not nearly complex enough oftbe economy. So, even the former Soviet Union did not in practice implement "full-
to do justice to the difficulty of planning an entire economy. The steel ministry, which scale" central planning!
controls the steel mills, needs more than just workers and resources. It also needs
machinery like blast furnaces, cranes, and rolling mills to carry out necessary tasks. Each
one of these machines is made of steel and produced by other workers, and we need to
Is a Consistent Plan Enough?
account for this need in our calculations as well. In addition, all of the resource suppliers
A consistent plan is a minimum requirement for determining resource usage in an
such as coal, iron ore, and limestone (among many others) also need machinery (or capital)
economic system, but it is not necessarily ideal. An optimal plan is both consistent and
in addition to miners. This machinery is also made of steel and needs to be accounted for
efficient, in that it produces the greatest value from the available resources at the lowest
in our calculations.
possible cost. Did the politburo choose the right mix of trucks, cars, and condos? Could
In addition to accounting for these between-ministry uses for steel (known as inter-
industry demand in our material balancing equation above), the planners also have to make society have been made better offby a different combination?
decisions about what kinds of materials should be used in production in the first place. We This question can be more easily understood if we compare the centrally planned
mechanism of generating a consistent plan, where the total source of resources is equal to
assumed that ½ ton of steel would be used in producing a condo. What if the building was
made of wood 2x4's instead of steel studs? What if we decided to build 20 story high-rise the total use of resourees, with the market mechanism of supply and demand. Assume the
condos instead of 2 story low-rise ones, altering the amount of steel needed per housing USSR was a capitalist society. It would still like to produce trucks, cars, and condos, and
unit? What if instead of steel beams and girders for the high-rise condo we used concrete would still be constrained by nature to keep total demand equal to total supply. As we
reinforced with a few steel rods? What is the "right" amount of steel in a condo? How discussed in Chapter 4, the market mechanism does the same thing, but by a different
about the cat? Should the engine block be steel or a Uminum? How about the wheels? method)
How much plastic should be used in the bumper assembly and how much chromed steel? Continuing with the assumption that the USSR was a capitalist society, how would
How we answer these questions changes the amount of steel that is needed, and then the relevant number of trucks, cars, and condos be determined? The answer would be
changes the amount of coal, trnn ore, hmestone, machines, and workers needed. "where supply is equal to demand." Recall, supply measures the costs of producing the
We forgot to mention earlier that the machines used in digging coal, iron ore, and goods, and demand measures benefits that consumers derive from the good. Consumers
limestone mn on diesel fuel. So we need oil drilling equipment, refineries, and pipelines get value from delivery trucks by making online purchases and paying for shipping, lflots
or tanker trucks or milcars. Each one of these separate industries needs steel to produce of people want to avoid the hassle of physicully going to the store, then shippers such as
their equipment and workers to man their machines, so this further complicates the UPS and FedEx make a larger profit and buy more trucks. If people would mther shop in

7 S¢ page 100 of Stalinist Planning for Economic Growth. 1933-1952, by Eugene Zaleski, 1980,
6hi real life this prob em cannot be done verbally, but must be COnverted to a mathematical system, known University of North Carolina Press.
as Input.Output Analysis, to handle the large amount of data. For s deeper treatment of this method see: $ Th~ essay," l, Pent I" (which
,, appears m the Coda of this textbook) illustrates the passive way in which
The Economics of Input-Output Analysis by Thijs Tea Raa, Cambridge University Press, 2005. economic activity is efficiently coordinated in a system of free markets
Chapter #6- Organizing Principles of Socialist Systems Chapter #6 - Organizing Principles of Socialist Systems

person, then shippers make less profit and buy fewer trucks. The same process takes place The steel ministry is required to contact GOSPLAN, tell them what they need, and then
in the car market and the condo market. It may turn out that for Russians, the "proper" GOSPLAN will then in turn contact the appropriate supply ministries if they agree to the
number of trucks, ears, and condos are 150,000, 560,000, and 36,800 respectively.9 change. Ideally, all communication goes up and down the chain of command (vertically)
Moreover, maybe the ideal size of condos (accounting for decreased consumption of other from GOSPLAN to the ministries, but not between the ministries (horizontally). This is
goods) is 1,400 square feet, not 800 square feet.
designed to maximize the control of the central authorities, but is done at the expense of
Why did the Politburo get the numbers so "wrong"?'° This is due to the fact that slow, bureaucratic decision making.'2 As we will see later, this problem contributed to the
no one but the consumer knows how much they desire more living space, whether they
slowdown in economic growth that the USSR suffered from starting in the late 1960s.
would rather go to the mall than order online, and how urgently they want a new ear (rather
Another problem eansed by the planning system is that production units (firms) did
than keeping their old one for another year). These are all subjective desires that no
not produce to sell to a willing buyer, but produced to meet the targets of the planning
technical expert can know. Markets, however, find this information by aggregating
bureau, GOSPLAN. As long a unit was produced, it counted toward the total and quality
purchasing decisions of millions of people who have to spend their own hard-earned didn't matter Soviet firms routinely produced shoddy goods that did not meet the buyers'
money. The resulting sales and profits oftbe different finns generate the pattern of output needs since the "buyers" received their allocation from a monopoly supplier For inatanee,
that matches people's desires. In many cases the market system produces the optimal or the leading cause of house fires in the former Soviet Union was television sets that would
efficient mix of goods and services.It overheat and explode.13 As long as GOSPLAN was satisfied the ultimate consumer was
out of luck.
All of these problems led to inefficiencies on a mass scale. According to Yegor
Impact of Planning on Productivity Gaidar, former Prime Minister of Russia in 1992:
Consider the problem of the "vertical" nature of organization and control in a
centrally planned economy. Earlier in this chapter we used the U.S. military to explain a "Examples of how inefficient the Soviet economy was are well known. The
"chain.of-command,, where lower levels take directions and orders from higher levels Soviet Union mined eight times as much iron ore as did the United States.
within the organization. To further our understanding of vertical relationships within That ore yielded only three times as much pig iron, and the pig iron only
organizations (as opposed to horizontal relationships between organizations) let's consider twice as much steel Finally, from that steel it was able to produce machines
worth roughly the same as those produced in the United States
an example. Ifa Captain in the Army needs some men to help set up a tent can he order
Navy sailors to help since he out-ranks them? If you have any experience with the military, The use of raw materials and energy in the production of each final
product was, respectively, 1.6 and 2.1 times greater than in the United
you know the answer is an emphatic "No!" Only naval officers can order navy sailors, and
States. The average construction time for an industrial plant in the U.S.S.R.
only army officers can order army soldiers. There is no horizontal interaction between
was more than ten years, in the United States less than two years. In
army and navy. If the army captain needs help from the navy he needs to request that his
manufacturing per unit, the U.S.S.R. in 1980 used 1.8 times more steel than
superiors contact the superiors in the navy who will then order a naval officer to order the the United States, 2.3 times more cement, 7.6 times more [mineral]
sailors (if the navy decides to cooperate; the army can't order them to do so). Analogously, fertilizer, and 1.5 times more timber. The U.S.S.R. produced 16 times as
if the steel ministry needs to adjust
" tt productaon for any reason it cannot directly contact many grain harvesters, but harvested less grain and became dependent on
.
the coal tmmstry or the minerals ministry since they are in a different "branch" ofindnstry. grain imports."t4

9 These output levels are consistent with the 878,400 torts of stecl assumed to be available. However, in a Since the system did not rely on private ownership with its profit and loss system,
capaalist system the amount ofavmlable steel IS alSO bas~ on profits (of the steel industD,). If demand for the economy did not have the proper incentives to produce efficiently. Everyone in the
steel is high, profits will be high. "
and produce more outpuL This would make steel producers hire more workers (at higher wages)
1 2 T hIs
. . Is true of all buraaucractes
. . m all countncs,
. nnt just bureaucracies in the Soviet Union. The inability
le. Wrong as
different defined by
objective the concept
in mind ,4 ,I,~of Total Social Suhis
r p see
( Cha pier 5). Socialist leaders of the FBI, the CIA, and other security agencies to commun cato with each other due to
.__..._ ant ~cTl~IOre, m ght not conc-~- ,g-* .L may have
. any problem w th their a organization s y1red
part c 'ted with the failure
. to connect
,, strictterrorist
the dots in the lead up to the 9-11 vertical
~wcrs. ~ u~, mere LS set of
anack, See the report of the "National Commission on Terrorist Attacks Upon the United States" at:
L2'2/°wlueonen
e°tl°' °l°fetobeecen thoodiobe
tefl toprovide theefficieet a ....... nsrnast
t
Inparhcular a
t h o r n a r e s i g n i fi c a n t e x t ~ o ~ : ~ . . . . . . m o u r n o r l t g o o d I l e l t h e r t h e m a r k e t - . . . . . . . '
httu.'l/t,
u See: ovinfo librar~SOviets
"Meanwhile, unt.edw,View
g l l h.eport/911Report Ch l 3.ht;,.
a Hit-Parade of Shoddy Goods," by D. Remnick, Washington Post,
Cha-.-- ,n ~,~..=s, or me gooa Is a public °ood 'r,.~. _.... , o ,,~-~orapentlve, h'n ~n~~f ~~¢nwlffh'-sov/ets-vi~t..a.hit.
t,,~, Jw, ~ ~,,~ ~lumnnns ave discussed more fully in 12/4/ 989, htt ~,y va~, ~

, g , Brooking Institution, 2007. page 75.


Chapter #6- Organizing Principles of Socialist Systems Chapter #6 - Organizing Principles of Socialist Systems

system worked to achieve the plan, whether the plan made any sense or not. Distant Starting with the NEP in 1921 we see a strong upswing in growth which levels off
bureaucrats working for GOSPLAN in Moscow had only a general, statistical by the mid-1920s. Again, we see another burst of growth in the early 1930s after the
understanding of what was going on in the factories and farms of the Soviet Union. imposition of Stalin's conunand planning system, known as Forced Industrialization.
Without an owner risking his own money and dealing with a buyer who has alternatives, During this same time period the U.S. and the West were suffering from the Great
the system failed to achieve efficiency or growth.
Depression After WW-II we see a surge of economic growth. This period of growth was
This problem was clear to Soviet Leaders as well. Mikhail Gorbachev, former
so strong that it led Nikita Khrushchev, the leader of the Soviet Union at this time, to make
President of the Soviet Union and General Secretary oftbe Communist Party, attempted to his famous boast in 1956 that the USSR "would bury" the United States. As you can see,
reform the Soviet system with his program called Perestroika. In his book, "Perestroika:
GDP Per Capita grew from $1,913 in 1946 to $7,112 in 1989 (but tumbled to $6,425 in
New Thinking for Our Country and the World," he said:
1991 when the USSR was dissolved).

"An absurd situation was developing. The Soviet Union, the world's
Figure 6,1 -Real GDP Per Capita in the Soviet Union, 1917 to 1991
biggest producer of steel, raw materials, fuel, and energy has shortfalls in
them due to wasteful or inefficient use. One of the biggest producers of
grain for food, it nevertheless has to buy millions of tons of grain a year for
fodder. We have the largest number of doctors and hospital beds per
7,0oo
.thousand of population and, at the same time, there are glaring shortcomings
m our health services. Our rockets can find Halley's Comet and fly to 6,000
Venus with amazing accuracy, but side by side with these scientific and
technological triumphs is an obvious lack of efficiency in using scientific 5,0o0
achievements for economic needs, and many Soviet household appliances
4,000
are of poor quality.,,15
3,0o0

2,000
ECONOMIC PERFORMANCE OF THE SOVIET ECONOMY
1,00o
Other than the period of War Communism, which was an eConomic disaster, the
Soviet Union's planned economy had some notable successes with strong economic 0
growth. As will be discussed in Chapter 7, Real Gross Domestic Product (GDP) Per Capita
provides a rough measure of individual eConomic well-being, since it is derived from a
measure of total eConomic output of society. Figure 6.1 illustrates the value of Per Capita
G D P f Soweto r Umon t h eover. ~ts
. . enlaro
. existence fi'om 1917 to 1991)~ While impressive, this growth looks different when compared to capitalist oriented
Western Europe during the same time period, as illustrated in Figure 6.2. Focusing on the
post WW-II period, we see that Western Europe experienced a more substantial increase
Z5 ~,p , , . . in Per Capita GDP than the Soviet Union. Based on the values noted above, by 1989 Per
ere.stroika, byMikaflGorbechev, m. Perastt°ika:
,, How New is Gorbanbev's New thiaking?,,. Edited
by Eraast W. Lefever and Robert D. Vandcr Lugrg Ethics and Pub c Policy Canter, 1988, page 5. Capita GDP in the Soviet Union was 3.7 times as large as it had been in 1946. However,
Figure 6.1 wM created with data from Madthson Project Database, version 2013," Bolt, J. and J'. L. van in Western Europe this measure increased in value from $3,925 in 1946 to $16,751 in 1989
Zandan (2014), avaihthlc at bttt~..//~v~ru~.nl/c.~,dcd~[storiealdcvelopment/maddison/relem.es/raaddisoJ~=
(without a subsequent falloff) - that is, the value for Western Europe in 1989 was 4.3 times
~..Tac monetary unit ofraeastu'e is" 990 G-K lnterna,~-., r,..I,rs...... twn,anarc as large as its value in 1946. Comparing across these two regions, in 1946 the average
~o'~.v.a.
~ r o t ~ aIlLo!rsrs);toranexplanstionotG.KlntcmatlonalDot__
a l - d o l l a r. h t m l D a t a . . . . . . . . . " , - ~ . . . . . . ==~.
,,~,,:
n t ......
://',t~9.bu$ ea~-cas . Western European was approximately $2,000 richer than the average Russian, but by
~'~pa,
/ I p ~ 'el ,s ' ~
. .U. .~.$yea~
f o r were
t h ~ Imputed
~" by-the
- ~ authors.
A t v t u V a I l a O l C I ~,~ o r ,7~.,.
l ' 9 lo4 construct
t h r o u - the
k~
h e w a s a p p r o x i m a t e l y $ 9 , 6 0 0 r i c h e r. 1989
Chapter ~6- Organizing Principles of Socialist Systems Chapter #6 - Organizing Principles of Socialist Systems

FIgHre 6.2 - Real GDP Per Capita in the Soviet Union & Western Europe, 1917 to 1991
C H A P T E R # 6 M U LT I P L E C H O I C E Q U E S T I O N S

18,000 1. The first economic system implemented by the new communist government
~Western following the Russian Revolution was
16,000
A. Perfect Communism, which lasted from 1866 to 1874
14,000 B. Pacifist Communism, which lasted from 1879 to 1929
C . War Communism, which lasted from 1918 to 1921.
12,000 D . Social Communism, which lasted from 1946 to 1989.
I 0,000
2. was leader of the Soviet Union when the Bolsheviks implemented the
8,000 New Economic Policy (NEP).
~ E u r o p e A. Karl Marx
B. Vladimir Lenin
6
4,000 , 0 0 0 ~ U S S R C. Joseph Stalin
D. Nikita Khrushchev
2,000

0 3. When discussing the material balances approach, which of the following was not
identified as a "use of resources"?
~ ~ ~, ~ ~, ~, ~ - ~ ~ A. Government services.
B. Interindustry demand.
C . Consumer goods.
Another way of addressing the growth issue is to look at annual growth rates in the
D . Imports.
Sovmt Umun over several different mtesvals from 1950 to 1987. Growth was a mbust
7.2% from 1950 to 1960, was 4.2% from 1960 to 1970, and then fell dramatically
4. An "optimal plan" is
thereafter. Growth was a modest 3.2% from 1970 to 1975 and an anemic 1.0% from 1975
A. both consistent and efficient.
to 1980. Growth reached its nadir from 1980 to 1985 when it equaled the abysmal rate of
B. consistent, but not efficient
0.6%. With Gorbachev's reforms in the mid-1980s there was some modest growth that
C. efficient, but not consistent.
reached 2% by 1987.I~ In addition to these dismal GDP statistics, 1979 "began a series of D. neither consistent nor efficient.
seven poor harvests, leading to the imposition of food rationing in several of the more hard-
pressed regions of the country.,,ts All-in-all, the planned Soviet economy was stagnating 5. Looking at the scope of central planning in the Soviet Union post W'W-II, between
and not closing the gap with richer, We.stem European capitalist economies. 1951 and 1960 the number of items for which output targets were set
The ultimate collapse of the Soviet Union and its economy was primarily due to the A. increased from 10 items to 525 items.
inefficiency of its economic system. Government ownership of the means of production B. increased from 1,600 items to 12,750 items.
and command planning to direct the economic resources of a vast country proved to be C. decreased fi'om 25,482 items to 16,351 items.
impossible. D. decreased tom 4,592 items to zero items (since central planning was abandoned
in the country in 1960).

6. The leading cause of house fires in the former Soviet Union was
7 Data am from Tab e l, page 146 in "Soviet Economic Growth Sinc© 1928: The Alternative Statistics of A. "Molotov cocktails" being thrown through windows by anti-communist
G.I. Khecin," by Mark Harclson, Europe-Asia Studies, Vol. 45, No. 1,1993, pages 141-167. revolutionaries.
Kh~Mn' s estimates
' are on the ow side ofofficia! Soviet Stattshcs, they mirror the same pattern of long-run B. gas lamps (which people used for light since most homes lacked electricity)
decline m growth rates. " . . . . . While
tipping over.
bg Marshall I. Goldman, G~. Turn~rounti CEOj Harvard Business Review, May 1988.
C, television sets that would overheat and explode.
D. gas leaks from stoves with poorly manufactured pipes,
Chapter #6- Organizing Principles of Socialist @stems

In the former Soviet Union, GOSPLAN


A. was the primary military agency, which provided for national defense of the
¢ o u n U ' y.
B. was the primary planning agency, which drew up plans for the economy, setting
goals for output levels and overseeing coordination of economic activity. Gross Domestic Product
C. were the various industrial minis~es, which executed economic plans, by
running state owned enterprises thereby making day-to-day decisions regarding
the use ofeeonomic resources.
and Economic Growth
D . were the workers who were members ofboth the official Communist Party and
the labor union "Solidarity" (only about 17% of the workforce belonged to both
"It is indeed true that the stock market can forecast the business cycle. The
groups).
stock market has called nine of the last five recessions."
The economy of the former Soviet Union grew at an average annual rate of 7.2% - Paul Samuelson
between 1950 and 1960. In contrast, between 1980 and 1985 it grew at an average
Within this chapter we discuss how to measure a society's economic output. We
annual rote of.
A. 0.6% start by defining the concept of Gross Domestic Product (or GDP). We then discuss
adjustments to the measure of GDP which must be made to correct for comroon
B . 2.1%
C. 7.1% shortcomings. These adjustments help us obtain a measure which gives more meaningfid
D . 12.4% insights on the well-being of individuals in a society. Next, we examine how the value of
GDP changes over time, both in the short-run and long-run. The short-rim ups and
Commenting on the inefficiency of the Soviet economy, Yegor Gnidar (Prime downs of GDP illustrate the different phases of the business cycle. In the long-run the
Minister of Russia in 1992) noted: value of GDP typically increases, revealing economic growth. As part of our discussion
A. ~Th average eonstruetmn' tlroe for an industrial plant in the U.S.S.R. was more we observe actual realized changes in the value of GDP for the U.S. in the short-run and
than ten years, in the United States less than two years." for the U.S. and other countries in the long-run. Factors which cause long-term economic
B . "In manufacturing per unit, the U.S.S.R. in 1980 used 1.8 times more steel than growth are identified and discussed.
the United States, 2.3 times more cement, 7.6 times more (mineral) fertilizer,
and 1.5 times more timber."
C . "The U.S.S.R. produced 16 times as many grain harvesters (as the United
MEASURING THE SIZE OF THE ECONOMY
States), but harvested less grain and became dependent on grain imports."
D . More than one (perhaps all) of the above answers is correct. The best way to measure of the size of an economy is Gross Domestic Product,
defined as the total market value of all final goods and services produced within a society
Real GDP Per Capita (measured in 1990 G-K International Dollars) in the Soviet over a certain period of time. From its name you can infer that it is a mcasuro of
Union increased fi'om $1,913 in 1946 to $7,112 in 1989. In comparison, between production. Economists get a total measure of the value of all goods and services by
these same years the corresponding figure for Western Europe assuming that each individual good and service is best valued at its market price. This is
A. decreased from $13,748 to $11,942. a reasonable assumption since, as discussed in Chapter 4, the market price is a result of
B . !ncreased fi'om $1,793 to $8,556. the interaction of consumer demand with producer costs. If people are willing to pay a
C. increased from $3,925 to $16,751. certain amount for something, when they have alternatives, then the good must be worth
D . increased fi'om $5,429 to $6,984.
that amount to them.
Multiplying the market price of a good by the quantity produced gives us the
value of the total amount produced. If we add up the value of every single good using
this procedure, we have the entire value of all goods produced - that is, GDP. This
method can be summarized in the following equation:

aoe = (e~ × QD + (e~ x Q=) + (p~ x Q3) + '-- + (P~ x QN)


Chapter #7 - Gross Domestic Product and Economic Growth
Chapter #7 - Gt~oss Domestic Product and Economic Growth

the value of each of these four components for the U.S. in 2017, in trillions of dollars,z
where the subscripts from 1 up to N represent all the different goods produced in the The negative value of-$0.572 for net exports reveals that in 2017 U.S. imported roughly
$572 billion more than it exported.
s°cietY'Let's work through an example to illustrate. Picture yourself marooned with a
few other people on an island like in the 'IV show Lost. After one year you look back on Table 7.1 - Components of GDP in the U.S., 2017
all of the things that have been made on the island for consumption by the members of
your society. If you wanted to know how much your group produced you would
calculate your GDP by adding up the value ofaU the goods. To keep the problem simple
let's assume that you and your friends "produced" through your own effort 1,000 fish
$19.391 °Pi c , io NxI
$13.396 $3.213 $3.354 -$0.572
caught, 500 yams grown, 200 coconuts gathared, and 20 gallons of milk from a wild goat
These different components of GDP can be illustrated graphically by slightly
that you captured.
expanding the Basic Circular Flow Diagram discussed in Chapter 4, adding roles for
To keep the example going, assume that just before you were marooned you
government and international trade) Doing so gives us the Expanded Circular Flow
happened to be walling through a grocery store and you noticed that the average fish sold diagram illustrated in Figure 7.1.
for $10, yams for $2 each, Coconuts for $5 each, and goat milk for $6 per gallon. Let's
now put this data into our formula:
Figure 7.1- The Expanded Circular Flow Diagram

GDP = ($10 x 1,000) + ($2 x 500) + ($5 x 200) + ($6 x 20)


GDP = $12,120
socto,~ os /'.~'~1
You and your friends produced goods valued at $12,120, so your little island
economy produced a GDP of $12,120. You should immediately notice that not only is p r o d u c t i o ~ f X ~ gooa, ona

your production $12,120, but your income is as well since the goods you produced are Income Consumer "~'~ services
used to increase your consumption and well-being. Not bad for your first year, but you

/(;ii ..;;;;7;\k
are obviously not very rich. Now let's do the same thing for an entire country. Let's add
up every car built, house constructed, restaurant meal served, gallon of gas refined, pair
of pants sewn, and on-and-on until we have added up every good or service produced.
Now go collect all of the prices that these goods were sold at and enter all the data in the
formula. The formula would be the same, just a lot longer. For the U.S. we would have
come up with $19.4 trillion in 2017} Just like in the individual example we can show
that the nation's income is also $19.4 trillion as well, since we essentially have the ability Production
oo.=°.°,
Markets for ] production ond services I'

Forell~
Services Markets
to consume this level of goods and services.
More fully, we can decompose GDP into four components: consumption by
households (denoted C), investment expenditures by businesses (denoted I), government
consumption (denoted G), and net exports (denoted NX). Consumption by households
s T
includes purchases of things such as food, clothing, medical care, vacations, and cars.
Investment expenditures by businesses include the purchases of items such as machinery, sooooo,
productionhired I o,
office equipment, buildings, and delivery tricks. Government consumption consists of
purchases such as planes and guns for the military, teachers time for providing education,
tmcks to deliver the mail, and concrete for roads. Finally, net exports is simply the services

difference between the total value of exports and imports. Exports are goods produced goods end~~ ~ fi n i s h e d

domestically and sold abroad. Imports am goods produced abroad and purchased
domestically. So, collectively these four components account for all of the goods and 1 These figures arc also from the BEA report Iwilable at:.
services produced within our society. That is: GDP = C + I + G + NX. Table 7.1 states
3 T h " s Expanded ,
Circular Flow Dmgl~m
, will
, provide an.fllustranon of C, G, and NX, but will not directly
hJnJs:lAcww, heo,~ovlne~t~releascs/notional/edt~/2OlS/lxlf/~dplql8, ad~,,pJf.
ross Demesne Produc. F rst Quarter 2018 (advance esnmate), Bureau of Economic Analysis, April illustrate £ This is doe to the fact that while this diagram is much more complicated than
27, 2018, https.//wu~).bea.eov/newsreleases/notional/Qdl~f2Ol8/pdf/ed~la]8 adv.p~ Flow Diagram discussed in Chapter 4, it is still a vast simplification of aa actual economy,the Basic Circular

148
149
Chapter #7- Gross Domestic Product and Economic Growth Chapter #7 - Gross Domestic Product and Economic Growth

In this Expanded Circular Flow Diagram we still illustrate the central interactions accurate count of GDP we have to go through all transactions and remove the
betw~n households and firms in the markets for factors of production and markets for intermediate goods from the calculation and then add up only the final goods, the ones
goods and services. Notice that consumption by households (i.e., C), is represented by that end up in the hands of the ultimate consumer.
the darker arrow flowing to households from the markets for goods and services. Other major problems in getting an accurate figure for GDP are related to the sale
The role of government is illustrated in the center of the diagram. Government of used goods, non-market production, and the "underground economy." Usedgoods
collects taxes from both households and firms (illustrated by the lighter arrows flowing
that were produced in a previous period were already counted toward GDP when they
from households and firms to government). Additionally, government hires some factors
were produced. For example, we would need to remove re-sales of items such as cars,
of production and produces some finished goods and services. The finished goods and
houses, and art that were produced in previous time periods (but not the markup of
services (represented by the darker arrow flowing from government to the markets for
dealers of these goods, since this represents current services provided by the dealer).
goods and services) correspond to government consumption (i.e., G).
Non-market production is the creation of goods and services that are not sold
Finally, intematiunal trade is represented by the flow of finished goods and
through a market, making them very difficult to measure. For instance, consider a
services between the markets for goods and services and foreign markets. Goods flowing
out of this economy to other countries represent exports, while goods flowing into this homeowner mowing his own lawn or cleaning his own house. If you hired a provider of
these services we could count the value easily since there would be a market transaction,
economy from other countries represent imports. Thus, net exports (i.e., NX) can be
thought of as the difference between the two arrows on the fight-hand side of the figure. but if you do them yourself there is no verifiable evidence that the work was done. As a
To further emphasize a previous point, notice that this diagram illustrates how the result, since such non-market production is very difficult to quantify, we choose not to
total production of goods and services is equal to the income of the members of society. include it in the calculation of GDP. For developed countries such non-market activities
The arrows illustrating the production flowing to the markets for goods and services make up a smaller percentage of total economic activity than is the case in less developed
essentially generates income flowing to households. Therefore, the dollar amount of countries. Consequently, GDP figures for less developed countries are very likely biased
GDP is equivalent to the dollar amount of income for individuals in this society. downward to a greater degree than corresponding figures for developed countries.
Lastly, we have the problem of the underground economy, or black-market, where
goods and services are bought and sold without reporting the sale to authorities.
Sometimes this is done because trade in certain goods and services is illegal, and in other
Problems with Properly Measuring GDP
cases the sales are themselves legal but the seller wishes to avoid paying taxes on the
Calculating GDP is pretty simple in concept, but in practice there are many
complicating factors to consider. First of all, in the examples above we have only transaction and therefore does not report the value of goods or services produced. In the
explained the Expenditure Method for computing GDP. Under this approach we add up former case think of drugs or prostitution, and in the latter case think of a server in a
restaurant who does not report all of her tips or a home repair person who works for cash.
th2 value of the goods and services produced and sold. An alternative method that gets
None of the people mentioned in either of these groups are reporting the value of the
to the same result is the Income Method. This method uses the fact that all goods or services that they are producing.
production is simultaneously income to the person who produced the good or service. If
we add up everyone's income we should get to the same dollar amount that we get when
we add up the dollar value of production. For simplicity we will be using only the
Expenditure Method for calculating GDP, but it is a crucial economic principle that a T h e I s s u e o f I n fl a t i o n f o r t h e A c c u r a t e M e a s u r e o f G D P
society's total output and income are just different names for the same economic reality. The previous problems with the calculation of an accurate GDP measure are
We will refer to the GDP of different nations for comparison purposes, normally dealt with by the professional economists who work for the U.S. government's
we are also describing the nation's income level, and in doing so statistical deparlments, and users of the data generally have to accept the results. One
One problem with getting a proper GDP measurement is making sure that we potential concern when examining any economic data based upon market prices (such as
don't double count goods and thereby inflate the value of our production. For instance, if GDP) is that the person interpreting the data must be aware of distortions introduced by
you add to the GDP a $45 pair of jeans that were just sewn and then sold by Levi-Strans inflation. To correctly interpret such data in a meaningful way, one should ultimately
and Company, but also added in separately the $20 worth of cotton grown by farmer examine figures which are adjusted for changes in prices. Let's explain this by way of an
Brown to make the jeans, you will have counted up $65 worth of production. The illustration: Suppose Mr. Williams, a carpenter, has worked for Mr. Martinez, owner of
problem with this calculation is that the jeans manufacturer has already included the $20 Martinez Construction Company for the past 10 years. Table 7.2 below reports some
worth of cotton in the $45 price he charges for jeans. In this example cotton is an illustrative data on Mr. Williams' income and on prices
Intermediate good, or a good that is not sold to the final consumer but is rather sold to
As you can see, Mr. Williams has had a doubling of his income but according to
another finn that will use the good as a resource in its own production process. To get an
the Price Index prices have tripled. As will be discussed in fiwther detail in Chapter 8, a
Price Index is a mathematical representation of the price level or the average price for
Chapter #7- Gross Domestic Product and Economic Growth
Chapter #7- Gross Domestic Product and Economic Growth

Price Indexbase year = Real Datacurrent year


goods and services sold in a count-ry in a particular year, with the price level in the base Nominal Datacurrent year X Price Indexcurrent year
year forced to be equal to 100. The base year is the year in which a massive survey of
consumers' purchasing decisions is made. Once we have a list of what the average Using the data from Table 7.2 above we would get:
person buys we can take the list and go shopping every year to see how the prices have
changed.4 We can also calculate the index for past years as well. The price index for all 1 0 0 2 0 0 8 p r i c e tndex = $20,00020ts salary in 2008 prices
$60,O0020rasalary X 0
30 2OlSpr[ceindex
other years is then adjusted relative to the price level in the base year. Once the index
numbers have been calculated for various years we can see how much prices have risen, What this calculation shows is that Mr. Williams' salary of $60,000 in 2018 would only
and in this case over the I0 year period from 2008 to 2018 the average of all prices has purchase as many goods and services as a $20,000 salary would have purchased in 2008
tripled.5 paying 2008 prices. Since Mr. Williams was paid $30,000 in 2008 we can see that Mr.
Williams had a decline in real salary from $30,000 to $20,000 even though he had an
Table 7.2 - Price Index and Mr. IJqlltams' Salary Over Time increase in nominal salary from $30,000 to $60,000. In order to maintain a constant

t Sala~
[ Price Index
2008
$30p000
100
2018
$60,000
purchasing power, his salary in 2018 would have to be exactly three times as large as his
salary in 2008 - that is, his nominal salary in 2018 would have to be $90,000. So, an
economist would agree with Mr. Williams that he had not received a raise, because the
300 nominal data of the actual pay is misleading without "removing" the inflation Always
look in the legend of any data you are relying on to see if it has been adjusted for
Mr. Williams complains to Mr. Martinez that his "income" has fallen and he
inflation. If it has, it will be reported as real in the data label. For example, we would
needs a significant raise, and Mr. Martinez pulls out his checkbook and shows Mr.
see inflation adjusted income data reported as Real Income or the inflation adjusted oil
Williams that he now pays him twice what he used to and refuses to pay any more Who
is correct here, Mr. Williams who claims his income has fallen or Mr. Martinez who says price reported as the Real Oil Price.
it has risen? Economists label the cause of this problem as the conflict between nominal If the data for a specific individual can be so misleading, just imagine how
and real data. Nominal data is data measured in money terms from the year in which the misleading the reported data for the GDP of entire countries can be! Nominal GDP is
transaction takes place. Real data is nominal data adjusted for inflation and therefore the value of GDP computed in current period prices. In contrast, Real GDP is the value
measures the real ability to pumhnse goods and services. Just by looking at the data of GDP computed using prices from an arbitrary base year. The following data6 in Table
provided you can see that Mr. Williams' Real Income (nominal income data adjusted for 7.3 for the U.S. will illustrate:
inflation) has fallen over the past 10 years. How do you know this? Consider yourself in
Mr. Williams' situation where your nominal pay has doubled but the prices you pay for a Table 7.3 - U.S. Nominal GDP and Real GDP
new car, a restaurant meal, a pair ofjeans, a gallon of gas, etc., have Ixipled. Even though
you have twice as much money in your paycheck, prices have tripled so that you cannot Year Nominal GDP Price Index7 Real GDP
buy as much in 2018 with your $60,000 salary as you could buy in 2008 with your 1977 $2,086.0 billion 27.8 $7,503.6 billion
$30,000 salary. In real terms your income has gone down since you only care about the 1987 $4,870.2 billion 52.1 $9,347.8 billion
ability to consume actual goods and services, not the number of dollar bills in your hands. 1997 $8,608.5 billion 73.6 $11,696.3 billion
How do we prove to Mr. Martinez that he needs to give a raise to Mr. Williams 2007 $14,477.6 billion 95.1
just to get him back to his consumption standard of 2008? Let's adjust all nominal dollar $15,223.6 billion
2017 $19,390.6 billion 112.4
amounts to the base year (the year that the market basket survey was done) of 2008 $17,251.4 billion
dollars using the following formula: Nominal GDP was more than nine times larger in 2017 than in 1977. Did our
economy really grow that dramatically over these four decades? If we look at the price
4 The method described here is a. s]mphfied .version of the Consumer Pnce Index, or CPI that is published
indexes for those two years we see that prices rose by approximately 304.3% between
monthly by the Bureau of Labor Statistics. For more details go to: ~!o:/Avww.bls.eov/cDi/. Another
method used for calculating the inflation rate is the GDP Deflator which is created by the Bureau of
Economic Analysis ~. The CPI uses a fixed market basket method while the GDP Deflator
allows the market basket to change from year to year.
The numbers in Table 7.2 have been chosen to make the COmputatlorts simple, In reality, pfice~ in the 6 Nominal GDP and Price Index data are available from the Federal Reserve Bank of Saint Louis at
U.S. only increased by about 17,4% between the start of 2008 and the start of 2018, A much more
complete discuss. on of changes m
. pncas
. , . m the U.S, Js
over ttme . presented in Chapter 9.
hnlas is
GDP ://frcd'sd°uisfed, or~/serieslGDP.t
from authors' calculations, basedand ht~s.'//fred.xtlmdsfed.ore/serWs/CPAL
upon these corresponding figures, TTO I USA 661 S; Real
7 The Base Year for the Price Index was 2010 when the index value was set equal to 100.
Chapter #7 - Gross Domestic Product and Economic Growth
Chapter #7- Gross Domestic Product and Economic Growth

GDP
1977 and 2017.8 It is meaningless to make a direct comparison between the nominal data GDP Per Capita = Population
for the two years since the 2017 GDP calculation was based on adding up the value of
production using much higher prices than were used when the GDP was calculated back
Table 7.4 reports the value of GDP, population, and GDP Per Capita in Indonesia
in 1977. Using the methods developed above for figuring out Mr. Williams' real income
and Norway, along with twenty-two other countries plus both the European Union and
we can make adjustments to the nominal GDP data reported and convert it to real GDP
World (as a whole). GDP Per Capita gives us a more accurate picture of the average
data. For example, the $2,086.0 billion Nominal GDP in 1977 can be converted into Real
relative living standards of people in each country. GDP Per Capita shows how much
GDP (measured in 2010 dollars) using the formula described above:
income is available per person if it were equally spread across the entire population.
9 na~ ~ lO0~010pricemdrx
"+v~v'v1977 GDP X = $7,~03"61977 GDP In 2010 prlces.
27.81977 prlc# Index Table 7.4- Per Capita GDP Across Select Countries
The other values of Real GDP reported in Table 7.3 arc calculated in a similar fashion.
Examining the values of real GDP we see that economic output did increase GDPPPP in Billions of Population in GDPPpp Per Capita
dranmtically between 1977 and 2017, hut not as much as the nominal data would Country
2017 U.S. Dollars Millions 2017 U.S. Dollars
mistakenly portray. Looking at Real GDP, we see that real output was "only" 2.3 times
larger in 2017 than in 1977. While this is still a substantial increase, it is much smaller Qatar $342 (52"d) 2.31 $124,900 (2"d)
than the increase suggested by looking at Nominal GDP (for which the value in 2017 is Singapore $514 (40m) $90,500 (7m)
9.3 times larger than the corresponding value in 1977). If you want to know the truth Norway $376 (48m) 5.32 $70,600 (12m)
when using data that can be "conupted" by changes in prices, use real data and not Hong Kong $453 (4Yd) 7.19 $61,000 (18m)
nominal data. United States $19~360 (2nd) 326.63 $59,500 (20~)
Germany $4,150 (5m) 80.59 $50,200 (27~)
Japan $5,405 (4m) 126.45 $42,700 (41~
GDP versus GDP Per Capita European Union $19,970 516.20 $39,200
We have seen how misleading economic statistics can be when we don't make a Italy $2,307 (12th) $38,000 (481a)
correction for inflation. There is one more correction that we should make to the data if Portugal $311 (55m) 10.84 $30,300 (64*)
we want to use GDP as a proxy meusar¢ for individual well-being. Consider the Russia $4,000 (6m) 142.26 $27,900 (70~)
following data for two countries in 2017: Indonesia had a GDP of $3.243 trillion while Chile $452 (44m) 17.79 $24,600 (79m)
Norway's GDP was $376 billion, making Indonesia's economy more than 8.5 times Mexico
larger than Norway's.9 Since we have already noted that the production of goods and $2,406 (11m) 124.57 $19,500 (89m)
World $127~000 7,405.11
services measured by GDP is also a nation's income, we see that the total income of $17,300
Indonesia is more than 8.5 times that of Norway. Does this mean that the people of China $23,120 (1~) 1,379.30 $16,600 (105~)
Indonesia have an average living standard that is this much greater than the people of South Africa $757 (30m) 54.84 $13,400 (ll4th)
Norway? Indonesia $3.243 (7m) 260.58 $12,400 (123~)
To have a useful measure of well-being or living standard, we would want to look Jamaica $26 (140th) 2.99 $9,200 (141st)
at output (or income) per person. Think of GDP as measuring the size of a society's total Morocco $300 (57th)
economic pie. If we divide this value by population, we obtain a measure of the size of India
$8,600 (146m)
$9,447 (3~) 1,281.94 $7,200
the average slice per person. GDP Per Capita is computed as the value of GDP divided Angola (155m)
$192 (66m) 29.31
by population: Honduras $6,800 (159m)
$46 (111m) 9.04
Sudan $187
$5,500 (1681h)
(68m) 37.35 $4,600
' The percentage change in prices between these two years is calculated from the price index values (YI Kenya (172~)
$163 (74th) 47.62
and Y2) as: [(Y2-YI)/YI] x I00 ~ rot 2 4--27
9 T h e d a t a a r e . . . . 8)/'27.8J x 100- 304.3%. Nepal $79
$3,500 (185~)
(94m)
Congop Dem. Rep. of $68 (194~)
.~f ~. k / D
~ eao tf rao mi st h er CeI A
p oWo
r tr led dF a cat sB o p
o kp: ph t - ~r sp: /u/ ~rv.cc~i o.. ~ o. v. / ./ i .b r. a. .A u ( 10Y'd)
make meamngful ¢onounc , compunanns . across x diff~nt countries,
. -~mg rower, rarity),
~
to account ~ differences in prlces.
for
a statlstical, method used to (2~)
Tiffs is accomplished by convert/ng aH data from national curt ' "
em~ney buys in the home counwv com.~a .......encms into O.S. Dollars by com~u'in~ what a Within Table 7,4, countries are ordered according to GDP Per Capita (the
are from this same source. -~ e ....waa~ the aoflar buys m the U.S, The values in Table7.4" - rankings indicated within the second and fourth columns are the c
out of the 227 countries for which the CIA reports data). As weountry s overall
can see, ranking
even though
Chapter #7 - Gross Domestic Product andEconomic Growth Chapter #7 - Gross Domestic Product and Economic Growth

China now has the largest economy in the world (as measured by GDP), its Per Capita refers to improvements over time in quality of life and living standards. In practice,
GDP of $16,600 ranks 105:h (Out of 227 countries). To put this in perspective. China's economic development is probably more important than economic growth (i.e., economic
value of Per Capita GDP is: 59,5% of Russia's value; 42.3% of the European Union's development - which essentially gauges improvements in well-being - is what we should
value; 27,9% of the United States' value; and 18.3% of Singapore's value. From these actually care about). But, by its definition, economic development is very qualitative in
observations we can see how misleading a statistic like GDP can be if we do not know nature. It could be assessed by looking at - among other things - factors such as: life
how to properly interpret it. If you are interested in getting insights on average living expectancy at birth; infant mortality rates; literacy rates; access to clean drinking water;,
standards in a country, it is much better to look at GDP Per Capita instead of GDP. access to vaccinations; electricity access; telephone or internet access; and average
Moreover, if you want to study living standards from different years you need to make leisure time per year (i.e., the converse of hours worked per year). From this list, we see
the further adjustment and calculate the Real GDP Per Capita to make sure that you are that coming up with a single measure of economic development would be impossible.
also accounting for changes in prices. For this reason - along with the fact that income can in fact buy many of the things that
The value of GDP Per Capita is determined by the available productive resources most people would include in their list of economic development - we focus on economic
(i.e., human capital, industrial capital, and natural resources), level of technology and growth as a proxy measure of economic development. That is, we use increases in Per
infrastructure (e.g., intemet access, highways, and airports), and economic institutions
Capita GDP as a proxy measure for increases in well-being.
(e.g., contract laws, business regulations, tax codes, and levels of corruption) in place
The easiest way to measure this growth is to compare the GDP of a country over
within a country. From the values in Table 7.4, we see that there are tremendous
several years, making sure that we adjust the nominal data for inflation to get Real GDP
differences in living standards across the globe. Some countries - such as Qatar - enjoy
so that we are making fair comparisons. We also need to adjust for the size of the
an abnormally high value of GDP Per Capita because of an abundance of natural population since we live in a growing country. To compare the GDP of our country from
resources. For the World as a whole GDP Per Capita is $17,300. In some sense there is
100 years ago to today would be completely inappropriate if we did not make these
an almost continuous distribution of the value of GDP Per Capita between countries such
as Norway (12th in the World with a Per Capita GDP of $70,600) and Nepal (194th in the adjustments considering how much inflation and population growth has taken place.
World with a Per Capita GDP of $2,700), in that for any dollar amount between these
extremes we could likely find some country with a GDP Per Capita within a few hundred
dollars oftbe chosen value. Short-Run Changes in GDP: The Business Cycle
While it is not the case that we are living in a world of "haves" and "have-nots" Before we look at the long-run historical data we need to develop an
(but rather there are many countries "in-between") it is often insightful to distinguish understanding of the Business Cycle, which shows how GDP behaves over time.
between Industrially Advanced Countries and Less Developed Countries. The Unfortunately, GDP does not increase smoothly every year but instead has periods of
Industrially Advanced Countries are the high income countries with primarily market growth and then periods of decline. The growth phase in the economy, known as a
based economies, large stocks of technologically advanced industrial capital, and a highly business cycle expansion (or expansion for short), is marked by increasing GDP over
educated and skilled workfome. Examples include the United States, along with Norway, time. During these expansions, also known colloquially us booms if they are strong ones,
Australia, Germany and Japan. In contrast the Less Developed Countries are lower the economy typically realizes: low or falling unemployment; decreasing bankruptcies;
raceme countries which are held back by some combination of poor economic rising sales, profits, and wages; and the creation of many new businesses. Generally
institutions, undeveloped industrial capital, and/or an uneducated and unskilled people are quite optimistic about the future since they experience the economic growth
workforce. Examples include India, Ghana, Bangladesh, and the Democratic Republic all around them.I° All booms come to an end at some point and the economy fails into a
the Congo. of recession, or business cycle contraction, which is a period marked by falling GDP over
time. Colloquially a recession is known as a bust leading to the phrase, The Boom-Bust
Cycle, another name for the Business Cycle. When the GDP is falling during a recession
or contraction we see: a rise in unemployment; a decrease in sales, profits, and wages;
ECONOMIC GROWTH AND DEVELOPMENT and the bartknJptey of many more firms and individuals. As you might expect, people
Now that we have the basic idea of how to measure an economy using the concept lose optimism and faith in the future. Figure 7.2 shows a stylized figure to illustrate the
of GDP, in this section we examine what has happened to the size of both the U.S. phases of the Business Cycle.
economy and other economies over time. Economic Growth refers to sustained
increases over time in the value of Real GDP. Economic Growth is very quantitative in
nature and can be measured by the GDP Growth Rate, the annual percentage change in 10N
the value of Real GDP. A closely related notion is Economic Development, which ot all areas of a country experience an experts on in the same way. In e large country like the U.S. it is
possible for the counh'y as a whole to be experiencing e boom while a particular region is declining
economically.
Chapter #7- Gross Domestic Product and Economic Growth Chapter #7 - Gross Domestic Product and Economic Growth

As you can see in the figure, the economy rises during an expansion until it the third quarter of 2009 you can see some upward movement in the economy as it slowly
reaches a business cycle peak (or peak) which is the highest level of GDP achieved recovers. From peak to trough the economy saw a decline in economic output from
during any particular cycle. Then the economy falls into recession where the GDP falls approximately $15,000 Billion to $14,400 Billion, for a decline of roughly $600 Billion.
towards a business cycle trough (or trough) which is the lowest level that the GDP falls At the same time that output fell the unemployment rate rose from 4.4% in May 2007 to a
to during a recession. Once the economy "bottoms out" it starts to recover and enters peak of 10.0% in October 2009, a more than doubling of the rate)2
into another expansion. We measure a complete cycle from the peak of one boom to the
While the actual recession shown in Figure 7.3 closely resembles the stylized
peak of the next boom, including the intervening recession. This cycle has repeated itself
version from Figure 7.2, the actual business cycle is neither regular in timing nor in
many times in the past, and there is no reason to think that it won't continue in the future.
severity (like in Figure 7.2). Consequently, it is hard - perhaps impossible - to
Another point that the business cycle graph in Figure 7.2 illustrates is the tong-
confidently predict when an economy will enter into (and ultimately get out of) an
term trend, which is the average growth of the economy over many business cycles.
economic downturn. This fact is at the essence of the quote by Paul Samuelson which
Wh/le the business cycle shows the short-term path of the economy's growth, the long-
term trend shows how the economy has behaved over a significant period of time. Just opened this chapter: "It is indeed true that the stock market can forecast the business
cycle. The stock market has called nine of the last five recessions."
because the economy may be growing at a rate of 5% in this particular boom year does
not mean we should start to think that is the norm. The long-term growth rate of real
GDP in the U.S. has been appmxhnately 3.2% since WW-IL As you can see in Figure Figure 7.3 - Real GDP in the U.S. During the "Great Recession," billions of dollars
7.2, real GDP at the trough of a recession is often higher than peak GDP in earlier booms.
15,400

Figure 7.2- The Business L'~ele 15,200

$ GDP Growth 15,000


one long-term trend 14,800
business-------~ ~ ,
14,600
c y c l e f ~ ~ R e a l G D P 14,400

14,200

14,000

13,800
r,. r*. r-. 0o oo oo ch o 0 ¢; (:~ ~ ~ ~ ,.~
8 ~ 8 8 . . . . .

: .:
o, ~
.. i ! time Table 7.5 lists the I l post-WW-II [ecessions and expansions,u As you can see,
both the severity and duration of recessions vary dramatically from as little as 6 or 8
months to as long as 18 months, with an average of ll.I months. The decline in
economic output has been as little as 0.6% to as high as 4.1% and with peak
,77 " unemployment rates ranging from roughly 6% to over 10%. Luckily, the expansions
have been significantly longer lasting than the recessions with the range from as short as
Figure 7.3 shows the experience of the U.S. during the most recent recess/on 12 months to as long as 120 months (10 years), with an average duration of 60.5 months.
(which has been dubbed the" " , 9, not in a stylized form, but using actual
Great Recession
data.H As you can see, the economy stops rising (peaks) in the third quarter of 2007, This partly reveals why we experience an upward trend as illustrated in Figure 7.2. It is
wobbles until May of 2008, and then drops precipitously to a trough in early 2009. By
.
I I A precise defimtion oftbe Unemployment rate, along with a more detailed discussion of ~alized values
II 771 in the U.S,, is presented in Chapter 9,
e numerical va ues used to construct this graph are from the Bureau of F.conom/e Analysis. t3 These figures ,.,.'ere obtained from the National Bureau of Econonfic Research, "U.S. Business Cycle

EXl~asioes and Contractions" (htn):/A ~ ~, nber ort, l¢~rle,~cax le~t~i~ hfraO.


Chapter #7 - Gross Domestic Product and Economic Growth Chapter #7- Gross Domestic Product and Economic Growth

important to recognize that experiencing expansions which last longer than recessions is a lasted from 1929 to 1939. Thankfully there has not been another depression, an
relatively recent phenomenon. As noted, for the I I business cycles that the U.S. has economic downturn of far greater depth and scope than a normal recession, since the
realized since WW-II the average length of recessinns was l 1.1 months and the average 1930's. In Figure 7.4 we see the business cycles for the U.S. economy from 1854
length of expansions was 60.5 months (i.e., since WW-II the typical expansion has lasted thrungh 2016.16
over five times longer than the typical recession). In contrast, for the 16 business cycles
that occurred between 1854 and 1919 the average length of recessions was 21.6 months
Figure Z4 - Real GDP Per Capita in the United States, 1&54 to 2016
and the average length of expausiuns was 26.6 (i.e., during this earlier time period, the
typical expansion was only 23% longer than the typical recession).

Table 7.5- Post WF/-II Recessions in the U.S. 50,000

DllrQ nolI
~n of Subst lent
Peak 40,0GO
erc£nt Unemployment
ion Expa ionths cline in Rate Due to
: Peak Month
. November 1941 ~l GDP Recession 30,000
7.9*/o
"--5 6.1%
7.5% 20,000
December, 1969 t2*~, 7.1°/o
---5 6.1%
--i 10,000
9.0%
7.8%
10.8% 0
7.8%
6.3%
_ 10.0%

This record of growth has been quite remarkable and is visible across the
Long-Run Changes in GDP: Economic Growth capitalist world. What caused this level of growth and when and where did it start?
Seen from up close with only a few quarters of data, downtums such as the "Great While there is some disagreement over exactly when this "revolution" began, it is
Recession" look like colossal setbacks. These recessions, which Karl Marx called "crises generally believed to have started between 1760 and 1840 in England and then rapidly
of capitalism," were alleged by many to be the undoing of the capitalist system. Marx spread to America and the continent of Europe.t7 This revolution is evident in the
believed that workers would ultimately revolt against the system due to the transition from band production to machine production, the conversion of fuel from wood
to coal, the increase in the use of steam power, and the development of iron production
unemployment generated during these downUlrns 14 Even supporters of Capitalism, like
John Maynard Keynas, beheved that something needed to be done to solve the problem and a nascent chemical industry.
of the business cycle.IS In Chapter 8 we identify and discuss the relatiunship between the Eoonomie growth can be illustrated in an intuitive way by recalling the concept of
money supply and changes in aggregate economic output. For now we continue our the Production Possibilities Frontier (PPF) from Chapter 2. Recall, this curve illustrates
exploration of the lung-term trend of the business cycle. When seen from the perspective all the different combinations of any two goods which can be produced with fixed
of the lung-run, the "crises" or recessions almost seem to fade into the background and amounts of inputs and currently available technology. This curve essentially presents a
the record of Capitalism and its growth looks much better. However, even from this vast society with a menu of possible combinations of the two goods that can be produced at a
perspective of time we can clearly see the devastation of the Great Depression which
,6 The data used to eottstn.tct Figure 7.4 are from the Maddison Project Database, version 2018. Bolt. Juna
,4 M~'r~ Karl, The Communist Manifesto. available at Robert Inklaar, Herman de Jong and Jan Lulten van Z.anden (2018), "Rebasing "Maddison': new income
eomparisous and the shape of long-run economic development," available at
z5
~ aKeynes.J
r x / n ' o r k s /ynar
1 8 4 ~(1936)
8/£om m uGeneral
The n s t m oThm [ ....
e s t"o / c' h 0 4 h m .[L~.
Macmillan (reprinted 2007). ~ry o, tzmployment, Interest and Money London. b1n~:/A~-~t~`ru~`n~/~d~/hi~t~rlc~dev~pm~n~maddis~n/re~ases/hmddis
Dollar amounts are measured in 2011 U,S, Dollars. n- 7r~f ~-data s-2018
~ See: Ashton, Thomas S. (19481 The Industrial Revolution (I 760-1830). Oxford University Press, or
Hob~bawm. Erie, (1975) The Age of Capitah 1848-t 87J,
Chapter #7 - Gross Domestic Product and Economic Growth Chapter #7 - Gross Domestic Product and Economic Growth

specific point in time. However, over time as the amounts of available resources change example, the Brazilian economy grew at a rate of 8.47% per year in the 1970s but only at
or the production technology advances, the shape and placement of the PPF can change. 1.88% in the 1990s. Similarly, after growing at an annual rate of 4.1 I% in the 1970s and
As an example, consider a society that produces cars and wheat. This change in 4.37% in the 1980s, Japan experienced a "lost decade" during the first ten years of the
the placement of the PPF over time is illustrated in Figure 7.5. Note that in 2018 there
21st Century growing at a rate of only 0.53% per year. Myanmar experienced the highest
are combinations of cars and wheat that are possible to produce that were not feasible in
average growth rate of any country in the world during the first decade of the current
1998 (such as point B). This outward shift of the PPF is economic growth. To see this
century (12.40%) after growing at only 1.94% per year in the 1980s.
more precisely, suppose that in 1998 the society had produced point A (30,000 cars and
12,000 bushels of wheat). If it then produces point B (40,000 cars and 15,000 bushels of China's growth over this entire period has been nothing short of remarkable. The
worst decade for the Chinese economy was the 1970s, when an average growth rate of
wheat) in 2018 it is producing more of both goods,
7.42% per year was realized. To put this in perspective, only three other countries on the
Flgu~ 7.5- Economic Growth Illustrated as a Shift of the PPF list had a growth rate above this level in any single decade (Brazil in the 1970s, South
Korea in the 1970s and 1980s, and Myanmar in the 2000s).
Wheat

F PPF 2018
Table 7.6- GDP Growth Rates Around the World

15,000 ................ B Country/Region 1970-20161 1970-79 1980-89 1990-99 2000-09 [ 2010-16


China 9.19 7.42 9.74 10.00
12,000 ............. I 10.35 8.10
South Korea 7.12 t
PPF 1998 Myunmar
India
6.39
5.62
%5 8.78
1.94
7.13
6.12
4.68
12.40
[

I
3.48
7.41
2193 5.69 5.77 6.90 7.34
Brazil

o i\"
3.76 8.47 2.99 1.88 I
3.37 [ 1.37
Mexico 3.48 6.43 2.29 3.62 1.84 ] 3.11
Sub-Saharan Africa 3.4 I 4.36
0 1.44 1.97 5.51
30,000 40,000 World 3.90
3.14 4.16 3.03 ~
2.68 2.83 2.96
United States 2.81 3.54 3.14 3.23 1.82 ~
T H E I M P L I C AT I O N O F G R O W T H O N T O P O F G R O W T H Japan 2.48 2.14
4.11 4.37 1.63 ~
0.53 [ 1.46
2.27
As previously noted, lung-term economic growth can he measured by the annual
Central African Re .
percentage increase in the value of GDP, known as the GDP Growth Rate. In recent
decades, most countries around the world have experienced moderate, positive growth.
Table 7.6 provides a partial summary of average annual GDP Growth Rates for several It is important to recognize that what might appear to be small differences in
growth rates can have a big impact over time. This is because of the impact of growth on
countries and regions around the world from 1970 through 2016.ts
top of growth (also known as compounded growth). Consider a country that grows at a
Countries/regiuns are ordered in Table 7.6 based upon the average value of GDP
constant rate of 4% per year. How many years will it take for GDP to double (i.e.,
Growth Rate over the entire 47 year period from 1970 through 2016, as reported in the
first column of numbers. Of all 106 countries in the world for which data was available increase by 100%)? You may be tempted to think that it will take ~ = 25 years. But,
in every year during this time period, China had the highest average Growth Rate this incorrect answer does not account for the growth on top of growth. If the country
(9.19%) and the Central African Republic had the lowest average Growth Rate (0 99%) started with GDP of $100 billion, during the first year it grows by $4 billion to $104
Note that the World as a whole grew at an average rate of 3.14% during these years. The billion. But now in the second year when it grows by 4% it not only gets a 4% increase
remaining columns provide information on the average GDP Growth Rate by decade. on the initial GDP of $100 billion, it also gets a 4% increase on the extra $4 billion
. For each country/region, growth rates vary fi'om decade to decade, reinforem the gained in the first year. In total, during the second year GDP increases by $4.16 billion,
prevmus observation that economies exnerieno, ~,~,t. ...... "g going from $104 billion up to $108.16. This is a little bit higher than GDP of $108
. - . . . . ,a g~a.m nines and bad times. For billion, the level that would have been realized if the country grew by only 4% of the
a These values arc from the "World Bank": blto.'//data, wor/dbank.ort,/tndicafor/NY, initial base. Over time this difference snowballs. After 10 periods the country has a GDP
of $148.02 billion (instead of only $140 billion), after 15 periods GDP is $180.09 billion
Chapter #7 - Gross Domestic Product and Economic Growth Chapter #7 - Gross Domestic Product and Economic Growth

(instead of $160 billion), and GDP has more than doubled to $202.58 after only 18 building new manufacturing facilities (of the same type and technology that already
periods (not 25 periods). These differences become more substantial over longer time exists). Extensive growth makes a country as a whole wealthier but does not necessarily
horizons. increase the income or living standard of its people. It is even possible to have extensive
As an approximation, if something grows at a constant rate of X% per period it growth and a declining standard of living at the same time.
will double after roughly 7yx periods, a result known as the Rule of 72. So, a country Consider the following example to illustrate extensive growth. Imagine that you
growing at a constant rate of 4% per year will find that its GDP is twice as large after are part of the westward expansion of the U.S. during colonial times. The colonies
about 7~4 =18 years)9 To see the dramatic differences which can result from seemingly together have a Real GDP of $1 billion and a population of I million. Real GDP Per
minor variations in growth rates, consider one country that grows at a constant rate of Capita is $1 billion/l million people = $1,000 per person.21 This $1 billion economy was
5.4% per year and another country that grows at a constant rate of 3.6% per year. (These created by growing corn on 100 million acres (with each farm family having 100 acres to
values are roughly equal to the rates of 5.62% and 3.76% respectively experienced by work with) using 200,000 horses and plows. Now suppose that the population doubles to
India and Brazil over the 47 year period from 1970 through 2016, as reported in Table 7.6 2 million, and these people have moved further west onto new land, having purchased
above.) Using the Rule of 72, a country that grows at a constant rate of 5.4% will have productive capital such as plows, horses, and other farming equipment. An additional
its GDP double every 13.33 years. In contrast, a country that grows at 3.6% per year will 100 million acres is brought into cultivation (.providing the new farmers with 100 acres
have its GDP double every 20 years. Recognize what this implies over the course of 40 each) using the existing technology and human resources, bringing total real GDP up to
years. The country that grows at 5.4% per year will have experienced three doublings of $2 billion. The economy is now twice as large as before, but what about the individuals
GDP, so that the value is eight times its starting value (the first doubling makes GDP who make up the country? Are they any richer than before? The calculation of Real
twice as large, the second doubling makes GDP four times as large, and the third GDP Per Capita, is now $2 billion/2 million people = $1,000 per person. Even though
doubling makes GDP eight times as large). In contrast, the country that grows at the only the economy has doubled, the income per person is the same as what we started with.
slightly lower rate of 3.6% will experience only two doublings over these 40 years, so This example of extensive growth was deliberately constructed to give a result
that the value of GDP is four times its initial value. So, if both countries start with Real where there is no increase in Real GDP Per Capita and therefore no Increase in the
GDP Per Capita of $5,000, after 40 years the country that grew at 5.4% has Real GDP standard of living. It is possible to increase people's income under extensive growth if
Per Capita of $40,000 while the country that grew at 3.6% has Real GDP Per Capita of you can expand resources faster than population growth. What if the farmers moving
$20,000.20 Now that we appreciate the importance of economic growth, we will identify west find so much land that each of them can now have 150 acres instead of 100? Then
and discuss the factors which allow a society to achieve such gains. each farmer will be able to have a higher standard of living than existed before since they
have more resources per worker. This same increase in production and income can be
generated by adding capital to the production process instead of land. Instead of having
western lands to expand into, let's assume that instead we doubled the number of horses
DETERMINENTS OF LONG-RUN ECONOMIC GROWTH
available for farmers from 200,000 to 400,000 (keeping the amount of land constant).
Economists have long debated the causes of the tremendous increase in output of Now a farmer has the ability to switch out a tired horse for a rested horse, so he can now
GDP since the beginning of the industrial revolution and the resulting increase in income plow more of his 100 acres than he could before. By increasing the Capital/Labor
for the average person. However a consensus has emerged to explain these phenomena. Ratio, the amount of capital available for each worker, the farmer is able to increase his
total production fi'om the same amount of land.
Unfortunately, neither of these two sources of growth is sustainable long-tenn.
Extensive Growth versus Intensive Growth As Americans moved west the frontier was eventually swallowed up leaving no more
All economic growth can be subdivided into extensive growth and intensive unsettled land for new farmers. The second possibility of increasing capital is also not
growth. Extensive growth is growth due to bringing new land into cultivation or sustainable. Just imagine adding a third horse to our 100 acre farm, and then a fourth and
a fifth. As we add more capital (horses in this instance) we start to get smaller increases
Rule of 72 is an approximation. More precisely, expressin the co in output from any additional unit of capital. Eventually the addition of some horse will
decimal denoted by r (e.~. Xe,4-4~ : ...... g nsUon growth rate of A% as a not increase production at all. With no new land available to either cultivate or absorb
o, ,~ rffi.u.~), a vartanle that grows at a constant rate of r per period will
double in t = la(~l~l÷r) periods (where in(.) denotes the natural logarithm).
20 This final s~tement assumea a constant population, so that merenses m GDP directly convert to similar
mcrcasas in Per Capita ODP. Additionally, this entire discussion aSSUmes that the growth rate of X~a per
period is ds~rib ng "real .... ~ - 2, Between 1720 and 1775 Read GDP per Capita in the American colonies rose from $1,375 to $1,883. We
,,~ ut ~as °PPused to "nomlnal growth" due to chenges in pricas).
have constructed an artificial example and all data are illustrative only.
Chapter #7- Gross Domestic Prodnct and Economic Growth Chapter #7 - Gross Domestic Product and Economic Growth

the extra horses used to plow, and a growing population that needs to eat, we have the farmers in 1870 are each fanning a 50 acre parcel of land for a total of 1,000 acres. Their
stage set for a declining Real GDP Per Capita (that is, a falling standard of living).22 output is 960 bushels per acre making total output of 960,000 bushels for all of the
Another source of extensive growth, one that has increased the living standards of farmers together. Each farmer works 2,000 hours per year (40 hours per week x 50
people around the world, has been the rapid movement of people from rural areas to weeks per year) generating a total of 40,000 labor hours for the community. This gives
urban areas. When workers in rural areas, who maintain themselves by subsistence them a Labor Productivity of 24 bushels per worker-hour (960,000 bushels/40,000
agriculture using little or no capital, move to urban environments they usually realize a hours). When we fast forward to 2018 we see that output has risen to 4,800 bushels per
large increase in their productivity as they are absorbed into manufacturing or other types
acre, producing a total of 4,800,000 bushels from the same 1,000 acres of land. Only one
of employment which use more capital and are therefore more efficient.23 Under these
farmer owns the entire 1,000 acres today since most of the farmers have moved to the
conditions the economy grows faster than the population and the average income of
city. This one farmer, with a total workforce of 5 workers, produces the entire output of
workers (or GDP Per Capita) can rise. This source of increasing incomes is, just like
the farm generating worker productivity of 480 bushels per worker-hour,z5 Notice that
westward expansion during the colonial period, not sustainable. When the percentage of
20 times more corn gets produced per worker! Economists normally make one more
workers in agriculture has declined to low levels there is no longer an ability to gain large
adjustment and convert rite output of corn in bushels to output in dollars, so that the
increases m productivity by moving to the city, since most people already live there. If
productivity of workers in different industries can be added together to calculate GDP.
we want to condnue increasing the living standards of the population in the long-term,
What factors can explain such a massive increase in a modem worker's
another source of growth besides extensive growth is necessary.
productivity compared to workers of the past? It obviously did not come from working
This observation is not to suggest that extensive growth is immaterial in world
history. Virtually all of the great empires that existed before the beginning of the harder. Does anyone believe that a modern farmer works physically harder than a farmer
Industrial Revolution were based on extensive growth. Consider the Roman Empire or did before modem machinery? So the source of the productivity must lie elsewhere.
the Ottoman Empire, both based on growth by conquest. Assume for simplicity's sake Let's start with changes in capital. The modern farmer doesn't add dozens of extra
horses (capital used in 1870) to his farm to get more output; he buys a diesel powered
that the emperor could sustainably extract 10% of the income of his subjects. As the
empire expands by conquering its neighbors the size of the economy is expanded as well. tractor that can pull the equivalent of a dozen horse drawn plows. He uses modem seeds
The king or emperor now collects 10% of a larger economy and therefore has the that have been carefully selected and bred to increase the output of corn per plant,z6 He
resources to support churches, art, magnificent public building programs, and other signs uses modern fertilizers and pesticides that further increase the output above what a farmer
of power and wealth, even while his subjects remain poor. He can also support a military in the 1870 could have produced All of these reasons for why a modern farmer is so
machine that is used to conquer morn territory. Of cnnrse this is also not sustainable, and much more productive than a farmer in the past can be grouped under the heading of
all the great empires of antiquity ultimately failed to grow and than collapsed.2( technology, which is the application of scientific and engineering principles to the
What is needed for a sustained, long-term increase in prosperity and standard of problem of production. Tractors are invented and improved by engineers, chemistry is
living for ordinary people is intensive growth, or growth brought about by increasing brought to bear on pesticides and fertilizers, agronomists improve the seeds, etc. This is
worker productivity. Productivity measures the amount of output that can be generated done in virtually all industries and has been going "full steam" ever since the beginning
from a specified amount of input. It can be increased by increasing either the quality of of the Industrial Revolution.27
the workers themselves, the quality of the capital they work with, or some combination of Not only has the physical capital (the machines, buildings, factories, and other
both. We can measure the productivity of workers by calculating output per worker- equipment used in the production process) that workers use improved over the last two
hour. Consider the following example: We compare a small community of 20 anm hundred years, but the workers themselves have been "improved" through Human Capital
farmers and their families in the 1870's to a farm on the same land today. Assume the accumulation. Human Capital encompasses the knowledge, education, skills,
experience, work ethic, inter-personal skills, and other attributes of workers which
z~ This pmblem was first d scussed m detail by the great classical economtst David Ricardo in his book, determine productivity. This form of capital, just like physical capital, is critical for
.
"On the Principles of Polifcal Economy and Taxation" which is available at:
httP:/'~l'W";econlib'°rrglibra'3'/Ricardo/ricPJu.r,r. See also Thomas Malthus, "An Essay on the Principle
of Population" available at: htn~:/Avww.econlib.ore/librarl,/Malthus/malPop.ht#d" For a Socialist critiquc In order to see the remarkable increase in output in agriculture in the U.S. going back to before the civil
see also: Marx, Karl (2007): Capital: A Critique of Pol#ical Economy: The Process of Capitalist
Production. Volume I part 2 Cos me Inc 708 w~ go to: htn~:/A¢a~w.ers~usda.~v/data-tJr~chwts/feed.grains~databct~e/~ed-gr~ins-cust~m-quera'asp~
an interactive for
data set. The authors leave the calculation of 2018 worker productivity to the student as
z3This ' -, pp. -709. an
exercise.
system PwTe~e~canca~t~lb~; .d~_..+cmatically un~.ed if a society has a col~mp t or poorly run economic and legal 16 Th- ts process has recently become more controversial with the introduction of GMO's, or genetically
may not resli~e'~'~'n~t~c~rear~e ~sn~i~l~°cated" Under these ctreumstanees workers moving to cities
24 For a readable non-speciahst
" account of the decline of the Ottoman Empire see: Bernard Lewis (2002): modified organisms. See: htm:/As~a~'.briton~iea.cpm/EBchecked/topi¢/89770~S/genetieall~.modt[ied
What Went Wrong: Western Impact and Middle Eastern Response, Oxford University Press. for an accessible discussion.
a~ Pun flatly intended, The radical impmvemeat of the steam engine by James Watt in 1769 was a major
factor in the start of the Industrial Revolution.
Chapter #7- Gross Domestic Product and Economic Growth Chapter #7- Gross Domestic Product and Economic Growth

defining how much output a worker will produce. Recall, as illustrated in the Circular capital goods in the future. Consequently, the future PPF will be further from the origin
Flow Diagram, increases in production a~ equivalent to increases in income. Therefore, than it otherwise would have been, revealing greater economic growth.
mereases in Haman Capital generally lead to higher standards of living. Looking at Figure 7.6, in 2018 this society is faced with tmdeoffs between
In technologically advanced modern societies very few workers make their living consumption goods and capital goods as illustrated by the PPF closest to the origin. If
strictly from their physical strength. Most jobs require the ability to read, calculate, they choose "Point A" in 2018, they will achieve moderate economic growth over the
reason through problems, and other higher order skills that were not highly valued before
next two decades and in 2038 be faced with the dark PPF in the middle. If instead (all
the advent of the Industrial Revolution. If you are reading this book you are probably
other factors fixed) they were to choose "Point B" in 2018 - a choice characterized by
training to be a knowledge worker of some kind. Even the modern farmer in our example
lower consumption but higher investment in capital goods in the present period - they
needs a great deal of education to be able to understand how to work on the diesel engine
in his tractor, to read and understand the price infonuation available for the various crops will achieve high economic growth over the next two decades and in 2038 have the light
that he might produce, or to make choices between various chemical fertilizers that he PPF furthest from the origin. Comparing the two outer PPFs we can see the extra
will use. Most farmers who operate at the scale in our example have been to college in "reward" to this society from making the higher initial investment in capital goods
order to understand all that is involved. (which was only possible by making a larger initial sacrifice in consumption in 2018).2s

Figure 7.6- Impact of Investment in Capital Goods on Economic Growth


Relating the Sources of Economic Growth to Outward Shifts of the PPF Capital Goods
Recalling that economic growth can be ilinstmted by an outward shift of the 2038 PPF, if
Production Possibilities Frontier (PPF) allows us to recognize that the factors which lead / " a " i s c h o s e n
to growth are those which would cause the PPF to shift outward over time. As discussed
within Chapter 2, the shape and placement of the PPF is determined by the amount of
scarce resources and the technology (i.e., production techniques) available to a society. ~ -. 20,sPpF,f
~; sequently, the curve will shift outward over time (reflecting economic growth) when
of these things increase. More precisely, economic growth, as measured by an
~ . ~ ~ i n 2 0 1 8 . . .

increase in the value of Reai GDP, can result from: (i) increases in the quantity of labor 2018--, B'~ ~ z" \ in2ol8...
(i.e., having more workers); (ii) increases in the quantity of physical capital (i.e., having
more machines, factories, and other equipment used for production); (iii) improvements
in the quality of labor (i.e., having workers become more highly educated or skilled); and
(iv) improvements in technology. Note the parallel between these factors and the
o * \ \ Goods
definition of Industrially Advanced Countries (such as the United States, Germany, and
Japan)- high
- ' income
. .
countries with
. pnmarily
, market based economies, large stocks of
technologically advanced industrial capital, and a highly educated and skilled workforce. Similarly, growth could be achieved by realizing improvements in technology
Logically, then, all it takes to make a society more productive with a higher which fundamentally change either the type of capital available (e.g., replacing manual
average level of income is to increase the quantity and quality of available physical and typewriters with computer word processors) or the production process (e.g., sending
human capital. This could be done by making deh'berate investments toward this end. documents or making payments on-line instead of by regular mail). Unfortunately all of
For example, consider a society that is making the broad choice between these suggestions for how to achieve growth are more easily said than done. In practice,
goods" and "capital goods," as illustrated in v; ....... "consumption several impediments to achieve growth exist.
r J S t u c r. O D C l O W.
In this figure "Capital Goods" encompasses not only investments in human At a basic level, achieving growth by making investments in capital can be very
capital and physical capital, but also investments in overhead capital, defined as difficult for a poor couna'y to do, precisely because it is poor. As illustrated by Figure
infrastructure such as railways, roads, telecommunications networks, electricity supply 7,6, to make greater investments in capital today requires a greater sacrifice of
systems, and water supply systems. Such investments could either be made by individual consumption today. Such sacrifices
- -m present day consumption are probably much more
households and firms or (particularly in the case of overhead capital) by government on difficult for poor countries to make, A high income country like the U,S. (with Per
behalf of society. The important point to recognize is that if a society devotes more
resources to investments in capital goods today (at the expense of p~ent day
consumption), this leads to having a greater amount and/or more highly productive ztN , .
°tetheparalleltoaaindividual'schoiceofconsuatpdoax~.sussavingso~xaiifetime
Person A young
that saves more must sacrifice consmnpuoa to do so, but the vewa.rd Is baying more money available
when old. " " " "
Chapter #7 - Gross Domestic Product and Economic Growth Chapter #7 - Gross Domestic Product and Economic Growth

Capita GDP of $59,500) could much more easily afford to invest $1,000 per person in the
Finally, poor legal, political, and economic institutions can each present barriers
construction and maintenance of roads and railways than could a low income country like to development for many countries. As we saw in Chapter 3 there are two major
Kenya (with Per Capita GDP of $3,500). This example illustrates the vicious-cycle-of- competing ideologies regarding how to organize the economy of a society (i.e.,
poverty hypothesis, which claims that poor countries are destined to remain poor since
Capitalism and Socialism), and how this conflict is resolved can make a tremendous
they do not have sufficient resources available to make the investment in capital which
difference in economic outcomes for a country. In Figure 7.7 we compare three countries
are necessary for economic growth. While this observation has a great deal of merit, it
from 1900 to 2016.32 In 1900, Real GDP Per Capita was $8,542 in Argentina, $5,536 in
clearly is not universally true - if it were, then no country would have ever been able to
escape poverty and develop on its own. After all, every modem, advanced economy of Germany, and $2,439 in Singapore. The mixed economy of Germany experienced solid,
today was poorer in real terms 200 years ago than Kenya is today. steady economic growth over these years, so that by 2016 Real GDP Per Capita stood at
This problem is exacerbated for many poor countries by capital flight, which $46,841 (over 8 times higher than its value in 1900). Argentina, held back by poor
refers to the tendency for wealthy people in poor countries to invest their financial capital economic institutions, had Real GDP Per Capita of $18,695 in 2016 (not much more than
abroad instead of at home. For example, many wealthy people in less developed double its value from 116 years earlier). Singapore experienced explosive growth after
countries choose to invest the money they do have in the U.S. or Europe (richer countries ardently embracing market based economic institutions during the second half of the 20th
Century. Consequently, Real GDP Per Capita in the country was $67,180 by 2016 (over
with more stable legal and political institutions). They choose to do so precisely because
investment in these foreign countries is likely to provide a higher expected return and less 27 times higher than its value in 1900). That is, by 2016 Germany was still the middle
risk than investment at home. But this choice compounds the problem of having country of these three in terms of Real GDP Per Capita, but now Singapore was the
sufficient investment made in the poor country in order to spur development and growth. richest and Argentina was the poorest. Moreover, while Singapore's Real GDP Per
Similar difficulties are present when it comes to developing human capital. Major Capita started out as less than a third of Argentina's in 1900, by 2016 it was well more
health epidemics can make it difficult for some poor countries to develop human than three times as large as Argentina's.
resources. For example, Life Expectancy at Birth is 50.6 years in Chad, 52.8 years in
Somalia, and 53.8 years in Nigeria.29 Many poor countries (particularly in Africa) suffer Figure 7. 7- Real GDP Per Capita in Singapore, Germany, & Argentina, 1900 to 2016
from large numbers of deaths due to malaria and AIDS. In 2016, approximately 445,000
people in the world died from malaria, with 91% of these deaths occurring in Africa.30 70,000
Similarly, in 2016, one million people died of AIDS-related causes, with 730,000 (73%

~
Singapore
of the total) of these deaths occurring in Africa 3a These observations are tragic on many 60,000
levels. From an economic development perspective, recognize that when confronted with
such short lifespans and health problems, investments in human capital have much lower So,000
returns (reducing the incentives for individuals and society to make such investments). Germany

~
Another difficulty that many low income countries face when it comes to 40,000
developing human resources is the "brain-drain," which refers to the tendency for the
30,000
most highly talented individuals to become educated and then move to an already
wealthy country. A talented doctor, engineer, or computer scientist can earn a much
20,000
higher salary in a developed country like the United States, Germany, or Japan than she
could ever hope to earn in India, Nepal, or Thailand. Very often this brain-drain occurs
when the individual first moves to the wealthy country (such as the United States. where l O . O 0 0 ~ A r g e n t i n a
the top-tier of higher education is better than anywhere else in the world) o
choosestoremainthere dtion.......topuo
IILI SKIneu .
peop] eare essentially skimmed off the top - of the labor
i . U S force
U l t , u ]of
e mthe
ost
poor country, making the development of human resources and ultimate economic
growth all the more difficult.

~ I n COntrast, ,tt s 85.3 years


. m Japan. See t
"//ww~v. io. ov/l~ ~a The data used to construct Figure 7.7 (as we as Figures 7 8 7.9, and 7. l 0) are again from the Maddison
~J ot Sm e le ~ " u ii otto /the-~gr/d.
Project Database verston 2018, Bolt, Jutta, Robert lnldanr, Herman de Jong and Jan Luiten ".'an Zanden
31 ~: ~ediaAt~orld-mal#ria-reoorl.20 I 7/c,,,'. (2018), "Rebasing 'Maddisan': new income comparisons and the shape of long-run economic
...... ~ ~ U N ~ I ~ c , h e e , . development," available at hltl~'w/A~t~v.~te, nl/t'~d~istoricaldewk)pmem/m~xtdison/re/easfs/ma~klison.
~. DoI" lar amounts are measured in 2011 LI.S. Dollars.
Chapter #7 - Gross Domestic Product and Economic Growth
Chapter #7 - Gross Domestic Product and Economic Growth

irresponsible monetary policy - during this time led to a steady decline in Real GDP Per
Next consider China, India, and Zimbabwe. Real GDP Per Capita in each country Capita to $1,729 in 2016, which is lower than where it started in 1950.
between 1950 and 2016 is plotted in Figure 7.8. Starting in 1978, under the leadership of
Finally consider two additional comparisons between groups of countries that
Deng Xiaoping, China instituted economic reforms which gradually made its centrally
share a great deal culturally, but chose very different economic systems. Real GDP Per
planned socialist economy more market oriented. Similarly, in the 1990s India moved
Capita in Puerto Rico, Panama, and Cuba between 1950 and 2015 is plotted in Figure 7.9.
away from socialism and toward free markets, with an emphasis on reducing government
In 1950 Real GDP Per Capita was $4,742 in Puerto Rico, $3,841 in Cuba, and $2,073 in
bureaucracy and regulation. Both of these countries realized extraordinary growth
following these shifts away from planning toward markets. Real GDP Per Capita in Panama. By 2015 these figures stood at $35,384 in Puerto Rico (about 7.46 times its
China increased only slightly from $757 in 1950 to $1,413 in 1977, but then exploded to 1950 value), $20,809 in Panama (about 10.03 times its 1950 value), and $7,889 in Cuba
$12,320 by 2016. In India Real GDP Per Capita actually decreased from $1,417 in 1950 (about 2.05 times its 1950 value). Thus, the socialist economy of Cuba seriously
to $1,297 in 1991, but, following its free market reforms which began in the early 1990s, underperformed relative to Puerto Rico and Panama.
Real GDP Per Capita reached $5,961 in 2016.
Figure 7.9 - Real GDP Per Capita in Puerto Rico, Panama, & Cuba, 1950 to 2015
Figure 7.& - Real GDP Per Capita in China, India, & Zimbabwe, 1950 to 2016

~.2,0o0 China

10,(X)0

S,000

6,0GO
India
4,000

~O
r - - - ~ ~ Z i m b a b w e
0

Lastly, a comparison between North Korea and South Korea is provided in Figure
In contrast, as noted in Chapter 3, the economy of Zimbabwe is presently
characterized by poorly defined property fights (ranked 120 out of 127 countries in the 7.10. Before World War II, these two countries were one single county with a combined
International Property Rights Index), a low overall level of economic freedom (ranked area of roughly 85,232 square miles. After World War II they were split into two
144~ out of 159 countries in the Economic Freedom of the World study), and high costs separate occupation zones. Attempts at reunification failed, followed by the hostilities of
of conducting business (ranked 159 out of 190 countries in the Ease of Doing Business the Korean War from 1950 to 1953, after which the Korean peninsula was split into two
study). Zimbabwe, which started out as the richest of Ihase three countries in 1950 with countries: North Korea (with an area of 46,541 square miles) and South Korea (with an
Real GDP Per Capita of $1,967, actually realized a couple of decades of solid economic area of 38,691 square miles))~ At the time when these countries were split in two, they
growth leading In Real GDP Per Capita of $4,341 in 1974. Following a guerrilla war shared an identical history and culture and were very similar in terms of demographics,
which lasted from 1975 to 1979, Robert Mugabe came to power as Prime Minister of human capital, and natural resources, but with the north being more advanced
Zimbabwe, a position he held from April 1980 through November 2017. Under his industrially.
leadership respect for property rights and the role-of-law declined dramatically. The
resulting poor economic institutions - in particular high levels of corruption and ,
1 F or Comparison, ,
North Carohna and South Catohna
, have a combined area of 85,839 square miles (neatly
identical to the 85,232 squar~ mile atca of the total Korean peninsula). However. at 32,020 square miles,
South Carolina is a bit smaller than South Korea, while North Carolina (53.819 squar~ miles) is slightly
larger than North Korea,
Chapter #7 - Gross Domestic Product and Economic Growth Chapter #7- Gross Domestic Product and Economic Growth

At the time of the split in 1953, Real GDP Per Capita stood at $706 in North countries (in terms of culture, demographics, natural resources, and other important
Korea and $1,385 in South Korea (i.e., the value was 1.96 times large in South Korea factors) at the time of this arbitrary split. When the two countries diverged economically,
than in North Korea). A socialist economic system was establish in North Korea, the important way in which they differed from one another was their ebosen economic
modelled heavily upon and supported by the former Soviet Union. South Korea was system. As South Korea embraced free markets and Capitalists institutions, it achieved
crrated as a constitutional democracy, which would ultimately embrace free market
remarkable economic growth which raised living standards tremendously. In euntrast, as
Capitalism starting in the early 1970s. When South Korea made this transition toward
North Korea remained under a system of Socialism with command planning, GDP
markets its Real GDP Per Capita began to increase dramatically, while North Korea
remained constant.
(which continues to this day to rely upon command planning) remained stagnant. Recall,
as stated in Table 7.6, South Korea experienced annual GDP growth which averaged Collectively, looking across Figures 7.7, 7.8, 7.9, and 7.10 we can begin to
I0.45% in the 1970s, 8.78% in the 1980s, and 7.13% in the 1990s. By the time when appreciate the importance of institutions for achieving economic growth and prosperity.
North Korean Real GDP Per Capita peaked at $2,564 in 1985, the corresponding figure in All of the countries charted in these graphs have been combining capital and labor to
South Korea had increased to $7,322 (i.e., the value was now 2.86 times larger in South produce goods and services but have achieved varying results. The astounding
Korea than in North Korea). Over the next three decades, the economy of South Korea differences in long-run economic performance are in large part due to differences in
continued its impressive economic growth while that of North Korea remained stagnant. economic and political institutions and the chosen economic system.
By 2015, Real GDP Per Capita in market oriented South Korea was 20.53 times grcatcr In Chapter 3 we discussed measures of economic freedom, protection for property
than in socialist North Korea ($35,316 versus $I,720). Such differences in incomes have rights, and the ease of doing business across a multitude of countries.3s In Chapter 11 we
real world consequences. For example, South Koreans are now approximately three will discuss the concept of Government Failure, or the reasons why governments oRen
inches taller than North Koreans, even though they are of the same racial and ethnic fail to deliver economic efficiency to their countries. As we have already discussed
stock.~ earlier in this chapter, in order for an economy to grow someone needs to invest in capital
and in workers' skills in order to increase worker productivity. In Capitalism this role is
Figure ZlO-Real GDP Per Capita in North Korea & South Korea, 1953 to 2015 shared between the government and private entrepreneurs or capitalists. But even in
market oriented economies, Governments make the bulk of investments in overhead
capital such as highways, dams, and other forms of infrastructure that increases
3s,tx~
South Korea productivity. Governments also run schools and colleges that raise student's knowledge
30,000 and skills, ultimately increasing their human capital and making them more productive
workers.
~,000 Just as importantly though, the government sets the rules that govern property and
contract. The government can conduct itself by following the rule-of-law, where
20,000 property rights and contracts are respected and administered fairly and transparently,
without favoritism - or government can do the opposite. Countries with poor track
I~,o00
records in maintaining the rule-of-law have generally had a very difficult time achieving
J-o,oo0 long-term eennomic growth. Honest entrepreneurs are afraid to invest for fear of losing
the!r money through the arbitrary actions of government officials who are either corrupt
s,0oo or Ignorant of the negative effects of their law making. Foreign investors fear that the
government could expropriate (that is, seize) their assets at any time for no legitimate
o mason. Creditors fear that they will not be able to collect on debts or foreclose on
m m ~ " -North Korea
property when debtors don't pay.
Additionally, unscrupulous business people oRen use corrupt political systems to
their advantage by becoming crony capitalists, where they can get, among other things,
In summary, when South Korea and North Korea were split in two in 1953 Real
GDP Per Capita was less than twice as large in South Korea - by 2015 it was over 20 preferential treatment from government through rigged government contracts, subsidized
times larger in South Korea than in North Korea. As noted, these were nearly identical government loans, or government provided bail-outs when the firms suffer losses. The
possibilities are endless when it comes to the ways that government power can be
See, "Are North Komam really three inches shorter than South Koreans?" by Richard Knight, BBC manipulated to reward insiders and punish outsiders. Under these conditions the honest
News, April 23, 2012, ~b~:.com/news/mag~.

Within Chapter 3, see tables 3.1, 3.3, and 3.4 and the accompanying discussion for more details.
Chapter #7- Gross Domestic Product and Economic Growth Chapter #7 - Gross Domestic Product and Economic Growth

business person falls by the wayside and the country is overrun with government officials
C H A P T E R # 7 M U LT I P L E C H O I C E Q U E S T I O N S
and the business elites that are tied to them making self-serving decisions that lower the
productivity of the entire society. Examples of this kind of behavior can be seen in the
1. The Expanded Circular Flow Diagram builds upon the Basic Circular Flow
corruption of former dictators like Ferdinand Mareos of the Philippines and General
Suharto of Indonesia, as well as the shady business practices of the Russian Oligarchs Diagram by
after the fall of the Soviet Union. A. eliminating the illustration of the role of households.
The poor performance of the sociaiist economies of the formerly communist B. adding an illustration of the role of labor unions and monopolies.
countries of Eastem Europe, the former Soviet Union, China before its reforms, present C. adding an illustration of the role of government and the foreign sector.
day North Korea, and present day Cuba are all examples of countries that had problems D. adding an illustration of the role of the central bank.
generating long-run growth. Government ownership of the means of production removes
one of the most important tools for getting managers of productive assets to use them 2. The phase of the business cycle that refers to the point in time at which overall
wisely - namely the individual self-interest to pursue profit and avoid loss. Without economie activity reaches its minimum is the
private ownership the fruits of good management am turned over to the government, with A . R e c o v e r y.
very little of the gains going to the person who came up with the technical invention or B. Peak.
business innovation. Likewise, bad decisions am paid for by "socializing" the losses C. Recession.
through subsidies and bailouts for govemment owned firms (or firm controlled by D . Tr o u g h .
"cronies"). We see this currently in the U.S. Postal Service, which loses billions of
dollars every year and yet no one is personally responsible. There is no identifiable 3. High income countries with primarily market based economies, large stocks of
owner who will lose this money personally and therefore have an incentive to fix the technologically advanced industrial capital, and a highly educated and skilled
problems. This could go on indef'mitely. Long-term growth inevitably suffers. workforce (e.g., the United States, Norway, Australia, Germany, and Japan) are
referred to as
A. Commercially Dependent Countries.
B. Less Developed Countries.
C . Industrially Advanced Countries.
D. Economically Superior Countries.

For questions 4 and 5, consider a country with consumption expenditures, private


investment expenditures, government purchases, imports, and exports as summarized
in the table below (each measured in millions of dollars):

teexpenditures
°°s$u8m
97
p°nIexpenditures
'nv$e2s1e2n'tg°[vpurchases
e$rnmeut[ imports
335 $196
exports
$234
For this country, "net exports" are equal to 1
A. $38 million.
B. $234 million.
C. $430 million.
D. $1,874 million.

FAor this
$897country,
million.Gross Domestic Product is equal to
B. $1,482 million.
C. $1,678 miUion.
$1,874 million.
Chapter #7 - Gross Domestic Product and Economic Growth
Chapter #7 - Gross Domestic Product and Economic Growth

10. In 2016 there were ~ deaths from malaria world-wide, with __ of these
6. The U.S, economy grew for an uninterrupted 10 year period from
occurring in Africa.
A . May 2005 through May 2015.
A. 195; 8.
B . March 1991 through March 2001.
B. 445,000; 91%.
C . September 1979 through September 1989.
D . June 1967 through June 1977, C . 32.7 million; 63%.
D . None of the above answers are correct (since malaria was eradicated in 2012).
7, Gross Domestic Product can be expressed by the following formula:
A . Y=MX+B 11. Qihong was born in China. Throughout his entire life he has excelled academically.
B. Y=C+I+G+NX After earning a Master's degree from the China University of Mining and
C . V = (cxF) + (Gk'NX) Technology in Beijing, he came to the United States to pursue a Phl). Upon
D . V = (C- I)(G-NX) completion of his PhD he was hired by a prestigious research university in
Oklahoma, where he works to this day. This story provides an illustration of the
A. Rule of 72.
For Questions
Goods" 8 and 9,Goods"
and "Capital considerwhich
a society facing the tradeoffs
are illustrated between "Consumption
by the Production Possibilities B. catch-up effect.
Frontier below. The curve labeled '1993 PPF' illustrates the PPF of this society in C. brain-drain.
1993. In 1993 this society chose 'Point .4' on this curve. As a result, by 2018 the D. vicious-cycle-of-poverty.
society faced the PPF labeled '2018 PPF.'
Capital Goods 12. Consider a country with a population of 3,485,000 people and Real GDP of E88A 32
billion. It follows that Real GDP Per Capita
A. is also equal to ~88.132 billion.
B. is roughly equal to E25,289.
C. is roughly equal to ~307,140,020.
D. cannot be determined from the given information.

13. During the most recent recession in the U.S. (which officially lasted from
2993 December 2007 through June 2009) Real GDP
A. increased by 1.6%
B. decreased by 0.5%
C. decreased by 4. l%
~j 0 Goods D. decreased by 8.5%
0 2 8
8. The "outward shift" of the PPC (from '1993 PPF' to '2018 PPF') which occurred
between 1993 and 2018 could be best described as 14. Growth due to bringing new land into cultivation or building new manufacturing
A. an increase in demand. facilities is ~_; growth due to increased worker productivity is
B. inflation. A. extensive growth; intensive growth,
C, economic growth. B. linear growth; exponential growth.
D. net exports. C. intrinsic growth; extrinsic growth.
D. capital growth; labor growth.
9. If this society had instead chosen 'Point B' in 1993, then the relevant PPF in 2018
would likely lie ~ 15. Per Capita GDP in the European Union is approximately $39,200. In comparison,
A . somewhere below the curve labeled' in the graph above.
1993 PPF' the value of Per Capita GDP in the U.S. is approximately
B . SOmewhere between the curves labeled '1993 PPF' and '2018 PPF' A. $32,190 (about 17.9% lower than the value in the E.U.).
C . exactly on the cutwe labeled '2018 PPF' B. $39,420 (roughly the same as the value in the E.U.).
D . somewhere beyond the curve labeled '2018 P " C . $59,500 (about 51,8% higher than the value in the E.U.).
PF ( .e., further from the origin)
D. $79,150 (just over double the value in the E.U.).

i 178
Chapter #7- Gross Domestic Product and Economic Growth Chapter #7- Gross Domestic Product and Economic Growth

16. Johnny has worked for Amy for the past twenty years. In 2005 his annual salary 21. Focusing on GDP Growth Rates between 1970 and 2016, ~ grew at an
was $38,500. The value of the price index in 2005 was 123.2, and the value of the average rate of 9.19% per year over this entire 47 year period.
price index in 2017 was 156.9. His real income in 2017 would have been exactly A. The World as a whole
the same as in 2005 if his nominal annual salary in 2017 was __ B. The United States
$30,230.72 C . Japan
B . $49,031.25 D . China
C . $51,474.50
D . $60,406.50
22. Consider two countries that each have a Per Capita GDP of $10,000 in 2018.
17. Country A realizes a constant 3% increase of Per Capita GDP, while Country B
In 1900, Real Per Capita GDP was $8,542 in Argentina and $2,439 in Singapore.
realizes a constant 12% increase of Per Capita GDP. Given these constant rates of
By 2016, Real Per Capita GDP was in Argentina and
A . $39,963; $41,387. in Singapore. increase, in 2042 (i.e., 24 years in the future), Per Capita GDP in Country B will be
- - - - -
B . $31,893; $17,592. Per Capita GDP in Country A.
C . $18,695; $67,180. A. 2 times greater than
D . $7,281; $107,593. B. 4 times greater than
C. 8 times greater than
18. In order to include many different goods and services in a single aggregate measure, D. 16 times greater than
GDP is computed by valuing goods according to
A. Consumer and Producer Smpluses. 23. The vicious-cycle-of-poverty
B. dollar amounts based upon telephone surveys of consumers. A. suggests that poverty is self-porpetuating, because poor countries do not have
C. market prices. sufficient resources available to make the investments in capital which are
D. production costs. necessary for economic growth.
B. is apparently true, since every country that was poor a century ago is still poor
19. refers to the tendency for wealthy people in poor countries to today.
invest their financial resources abroad instead of at home C. has no merit whatsoever, since even poor societies typically have an
A. Capital flight overabundance of financial capital.
B. The brain-drain D. More than one (perhaps all) of the above answers is correct.
C. The vicious-cycle-of-poverty
D . Government failure

20. Maurice is a citizen of Canada, but lives, works, and attends college in the United
States. Last year he went on vacation to Mexico during Spring Break. He works at
a daycar¢ in Roswell, GA. Last year he provided "daycare services" valued at
$22,500. The value of these services would be included in the calculation of GDP
for
A. only Canada, since he is a Canadian citizen.
B. only the United States, since that is where the production took place.
C. only Mexico, since that is where he went to relax on vacation (which was a

necessary activity for him to be able to work hard in school and on the job
D. throughout the rest (i.e.,
all three countries of the year). Mexico, and the United States) since he has
Canada,
n econounc tie to each of the three countries.
Chapter #7 - Gross Domestic Product and Economic Growth

Impact of Policy Decisions


on the Rate of Inflation
"Inflation is always and everywhere a monetary phenomenon."
- Milton Friedmanj

Inflation is defined as an overall increase in the level of prices prevalent in an


economy over time. Virt-aally all modem economies experience inflation, with some
suffering fi'om rates so high that we call it hyperinflation. Within the present discussion
we explore the causes of increases in prices, explaining why so many countries have
suffered from inflation. The effects of hyperinflation can be especially devastating, even
beyond the economic realm - hyperinflation in Germany following World War I not only
devastated the economy, but also led the way for Hitler's rise to power.2
How does inflation impact macroeconomie performance? Why is hyperinflation
so devastating? Could the United States ever suffer from hyperinflation? Once the
causes of inflation are recognized, can we identify remedies (i.e., either maeroecnnomic
or mieroeconomie policies) that could be implemented to reduce or eliminate inflation?
We will address all of these questions and more in the following discussion.

T H E D E F I N I T I O N A N D M E A S U R E M E N T O F I N F L AT I O N

Inflation does not refer to an increase in the price of just one item or even several
items, but rather an increase in the prices of thousands of items such that we all recognize
that the overall level of prices for most goods has changed. To have inflation, not all
prices must rise. For instance, over that past few years the prices on smart phones like
the Apple iPhone have plunged, but we all see food prices rising and fuel prices rising,
etc. The rising prices of these items swamp the few items that are falling in price, so we
can say the price level as a whole has increased.
In the U.S., the Department of Labor's Bureau of Labor Statistics tracks the
inflation rate by calculating the value of the Consumer Price Index (CPI) on a monthly
basis. The Consumer Price Index provides a "measure of the average change over time
in the prices paid by urban consumers for a market basket of consumer goods and

i F"nedman, M.,,What Price


, Guideposts?" in Guidelines Informal Controls, and the Market Place (edited
by G. Shultz and R. Aliber) Ch cago: University of Chicago Press, 1966, page 18.
2See Yergm, D, and J. Stares aw, "The Commanding Heights: the Battle for the World Economy," Simon
and Schuster, 2002, Page 322.
Chapter #8 - Impact of Policy Decisions on the Rate of Inflation Chapter #8 - Impact of Policy Decisions on the Rate of Inflation

services."3 To compute the value of the CPI, the government employs an army of"secret Money and its use go way back into history, with documented accounts in the
shoppers" who are given a list of items that the average family of four living in a metro Bible and other ancient texts. Money originated as the solution to the problems of barter
area (such as the city of Atlanta and its surrounding counties) would purchase on a exchange, which is the most primitive of economic transaetians. Barter is the exchange
regular basis, and the "shoppers" then "fan out" across the country to price the items on of one good for another between two people. For example, assume that you are a full-
the list. As you might imagine, it is a monumental task to send people to Walmart,
time shepherd and that you would like some wheat to bake into bread. You can't settle
Costco, Publix, Target, Office Depot, Home Depot, McDonalds, the local Mexican
down on a farm to grow the wheat yourself since you are constantly wandering around
restaurant, the local Toyota dealer, and myriad other retailers, until you have a good
picture of what the average family has to spend to maintain their standard of living. This with your sheep to find fresh pasture. A friend of yours is a wheat farmer after settling
is done every month, and the CPI is routinely reported on the news to reveal the change down and giving up his sheep. He would like some meat to eat but can't leave his farm
in prices in percentage terms. For example, between 2016 and 2017, the value of the CPI to tend a flock. What are you and your friend to do? Obviously you could meet and
for the United States as a whole increased from 240.007 to 245.120, indicating an annual agree to exchange some wheat for some sheep.
inflation rate of2.13% for 2017.4 In Chapter 4 we discussed the model of Supply and Demand to describe the
Of course the price level need not always rise. If a society instead experiences interaction between buyers and sellers, which gave rise to an equilibrium price. That
declining prices over time (i.e., realizes a negative inflation rate), this is known as discussion assumed transactions were taking place with money us a medium of exchange
deflation. While rare, it is not unheard of in U.S. history. For example, during the last (also note that we used money as a unit of account when quoting equilibrium price in
century, prices declined on an annual basis in 1921 and 1922, 1927 through 1933, 1938 dollars). In our barter example however, our shepherd would have to offer to trade one
and 1939, 1949, 1955, and most recently in 2009.s Other than these years and a few sheep for a certain number of bushels of wheat, not money. The wheat farmer would
other instances of deflation before 1920, we have realized positive inflation rates. Within counter with an offer of fewer bushels for the sheep, and this would continue until a
Chapter 9 a more complete summary of realized inflation rates in the U.S., on both a bargain is struck. Perhaps an agreement was ultimately reached that one sheep equals
monthly and annual basis, is provided in order to get a better idea of typical outcomes. five bushels of wheat.
Commerce went on this way for millennia until civilization had advanced and
production had specialized to the point that there were many items for trade. Under
barter traders face the problem of Dual Coincidence of Wants, which is the technical
THE INVENTION OF MONEY way of saying that for a barter trade to take place, one side of the transaction has to want
As the quote at the start of this chapter suggests, inflation and deflation are what the other side has, and vice versa. In a simple society this is easy since there are
closely linked to money. Thus, to understand the causes of these phenomena we fu'st only a few goods, tastes are simple, and everyone wants what the other person has to
need to understand what money is and how it works. We all think we understand money trade. However, as society advances specialized tastes can develop due to an expansion
because we use it daily, but it is more mysterious than it at first appears. As defined in of the economy. What happens if the shepherd meets a court scribe who wants to eat
Chapter 4, Money is as an asset that is socially and legally accepted as a medium of meat, but the shepherd does not need a book written? How does the transaction go
exchange (i.e., as a payment for goods or services). In addition to this defining forward? Money - that is, a medium of exchange - is the solution
characteristic, money also serves as a store of value (i.e., an asset that serves as a means The scribe offers a token good that does not have any intrinsic value of its own,
of holding wealth) and a unit of account (i.e., a "yardstick" that can be used to measure but is recognized by everyone as a universal trading good. Historically we did not jump
economic activities; e.g., in the United States prices, incomes, and GDP are all quoted straight to a pure token good, but passed through the stage of commodity money where
most naturally in dollars). something of physical value like gold and silver was money. People in modern
economies use paper money to facilitate transactions, but the money itself is of no
intrinsic value.
To illustrate this point imagine that you were a wealthy Iraqi businessman with
S e e : ~ . h t m
' s e e : ~ m o ~ , . ~ A s _ _ . ~ three million Iraqi dinars in a safety deposit box in early 2003 (worth about one million
value ~Q..~e~, ~, the CPl Is normalized to take on era~,e U.S. dollars at the time). The U.S. invades Iraq, Saddam Hussein is defeated, and his
reveals that overall vriees .,i..1, ...... ".lnus, theraportcdvnlueof245.120imm government destroyed. How much are your three million dinars worth now and why? In
- for"2017
inflation rate of 1.26% umteoommsaroatmost2.Sdmashi~her
is calculated as the percentage increase in the value
n.i.*h....,
of theL~listely
CPI between
this example you can see that the money itself is of no intrinsic value; it only has value as
2016 uad 2017:(245.120_240.007)/(240.0071
s Between 2008 and 2009 the value of the CPI=decreased
(5.113)/(240.007),
by 0 36% which is approximately
(i e the .021336%)
inflation rate was--0 or 2.13%.
long as poople believe that Saddam Hussein's regime will survive and support the
from 215.303 do~ to 214.537. On a monthly basis, a negative annual inflation rate was realized as currency. When his regime is toppled the money associated with it has no meaning and
recently as September 2015, during which time prices decreased at an annual rate of.-.0.04%. is therefore worthless. What if instead of dinars you owned an ap~ent building worth
three million dinars? Assuming your building is not bombed, you are still a wealthy
Chapter #8 - Impact of Policy Decisions on the Rate of Inflation
Chapter #8 - Impact of Policy Decisions on the Rate of Inflation

person afler Saddam's defeat, since your wealth is in a form that has intrinsic value. This supply multiplied by the velocity of money must be equal to Gross Domestic Product.
is an extreme example to illustrate the point that modem paper based monies are not This relationship is an Identity, that is, a relationship that must be true by definition.
inherently valuable, and their value can be destroyed or diminished quite easily. All of But, why must it be true?
the U.S. money in your wallet and bank account could similarly evaporate in value if Start by recalling that GDP measures the total value of all goods and services
something ever disrupted our belief that the U.S. economic and political system was solid produced in our country in a year, valued at their market prices. Assume this adds up to
and functional. $24 billion. If a society has $3 billion of money in circulation, how many times would
Now that we have a basic understanding of what money is, how it evolved, and each dollar have to be spent in order for people to purchase the $24 billion of goods and
what functions it serves, we can begin to develop an understanding of how services that are produced? Clearly the answer is that each dollar would have to be spent
mismanagement of money by a government can cause either inflation or deflation. The on average 8 times. This allows us to see why money supply multiplied by the velocity
opening quote for this chapter will guide us in our search. of money must be equal to Gross Domestic Product: ($3 billionX8) = ($24 billion). In
order for the economy to be in equilibrium, the total amount of goods produced at market
prices would have to equal that $24 billion spent.
M O N E Y A N D I N F L AT I O N lfGDP were $30 billion, there would be a huge surplus of unsold goods left since
we are spending only $24 billion. Firms would either have to cut back their production
The relationship between the Money Supply, the amount of muney in circulation, or decrease prices far enough for the $24 billion worth of purchasing power to equal the
and the level of prices in society can be represented by a simple equation. This equation, value of the goods being produced. Likewise, if firms only produced $20 billion worth of
called the Equation of Exchange, ties together the amount of money created by a goods for a country with the buying power of $24 billion, then there would be a general
government and the prices charged by busincsspeople in general. From the discussion of shortage of goods and services. Firms would either raise their prices or increase their
Supply and Demand in Chapter 4, we have a model to explain how prices for individual production until the total value of all the goods and services produced equaled $24
goods and services am determined in distinct markets. As a result of the outcomes in billion.
these distinct markets, relative prices emerge for different goods and services. The Returning to the Equation of Exchange, P denotes the economy's overall price
relative price of a good is an expression of the price of a unit of the good in terms of level (in some sense, the average of all the prices of every good and service produced for
number of units of some other good. For instance, if in the U.S. the market price of a sale), and Q denotes the real level of aggregate output of fmished goods and services
shirt is $30 and the market price of a hammer is $10, then the relative price of a shirt is during the present period. Thus, the second identity in the Equation of Exchange states
three hammers. Consequently, a person would have to work three times as many hours to that an economy's real level of output multiplied by its overall price level must be equal
buy a shirt than a hammer.
to GDP. Continuing with the previous numerical example, suppose that the $24 billion
Suppose that in Japan a shirt costs 15,000 yen and a hammer costs 5,000 yen. worth of goods and services produced resulted from the production of 2 billion different
Since (by assumptmn) the relative price of a shirt is also three hammers in Japan, we see
items. If the dollar value of all 2 billion items totaled to $24 billion, what must the
that a person in Japan would also have to work three times as long to buy a shirt than a
average price tag on each item have been? The obvious answer is that the average price
hammer. But we have no explanation as to why the magnitude of the numbers is so
of each unit must have been $12. Thus, we see why real output multiplied by the price
different between the two countries.
level must equal GDP: (2 billion)($12) = ($24 billion).
As the equation of exchange helps to illustrate, the money supply (determined by
the government) greatly influences the overall priee level within which supply and Why couldn't the answer have been $9 per item? If it were $9 per item and 2
demand operate, ultimately causing the price level to be different between the U.S. and billion items were produced, then the total cost of all goods taken together would only be
$18 billion. We have already determined that with our money supply and velocity
Japan. The Equation of Exchange is:
together we have $24 billion of spending this year, so the $9 price would cause a shortage
M×V=GDP=p×Q. when all people with money try to spend it. Confirm for yourself that a price level above
To fully comprehend this equation, it is necessary to understand each of its different
$12 would cause a similar imbalance. This $12 price tag that equates GDP with the
components. M denotes the money supply, which refers to the total amount of dollars in
number of items produced is the price level we mentioned earlier (i.e., the CPI measured
eireulatiun in our wallets, savings accounts, ebeaking accounts, and other dollar
by the Bureau of Labor Statistics),
denominated assets that can be used to easily make purchases. V denotes the velocity of
money, which measures the number of times that the typical dollar is used in a If beth M×V and PxQ must equal GDP, then it must be that:
mmsaetiun (i.e., "changes hands") in a given year. GDP refers to annual Gross Domestic M×V=PxQ.
Product, as defined and discussed in Chapter 7. The first equality states that money The recognition revealed by this equation ties together the production side of the
economy with the amount of money available to spend on goods and services. It can be
Chapter #8 - Impact of Policy Decisions on the Rate of Inflation Chapter #8 - Impact of Policy Decisions on the Rate of lnflation

thought of as specifying an equilibrium in the macro economy that links the amount of We initially had V=8, Q=(2 billion), and M =($3 billion), for which we noted the
money produced by the government to the total value of all goods and services produced
corresponding value of P would have to be P=$12. When we double the money supply
at the current level of prices. In our nmnericai example we have:
to M=($6 billion) (with velocity and quantity of output fixed at V=8 and Q=(2 billiun),
($3 billion)(8) = ($12 per item)(2 billion items).
What would happen to this equilibrium if the government doubled the money supply? for the reasons discussed above), the identity becomes:
How would the other variables have to adjust to bring things back into balance? Let's ($6 billion)(8) = P (2 billion items).
work through an example, Solving this equation for the price level, we obtain P =$24.
Since the velocity of money is determined primarily by technical factors such as
So, what did the increased money supply accomplish? The left hand side of the
how often people are paid and how quickly banks can process checks, it remains fairly
equation, the Demand side if you will, has expanded to $48 billion worth of purchasing
stable and is not easily changed, at least not over a short run time period. On the other
side of the equation, the ability to change the amount of goods and services produced in power, but there are only 2 billion things to buy. At the old price level of $12 per item it
an economy is determined in the loug-ran by how many factories a nation has, how well would only cost $24 billion to buy everything that was for sale If people have $48
Irained its workers are, and the availability of naturai resources (recall the discussion of billion worth of purchasing power there will be excess demand in the system and prices
factors of production introduced in Chapter 2). This can rise over time at a slow rate as will rise. How high will prices go? Prices will go as high as is necessary to absorb all of
new technology is introduced or the population grows, but in any short-ran time period is the excess purchasing power created by the new money. That is, prices rise up to an
not easily changed. So that leaves two variables that can change to maintain equilibrium, average price of $24 (so that the 2 billion items are now worth $48 billion, exactly equal
M and P. The money supply is just paper and can easily be increased by turning on the to the $48 billion worth of purchasing power). Once prices have risen to this level, the
printing press. The price level can also be changed easily. Just think of employees at a economy is back in balance.
gas station changing the pump price - it is done in minutesl Let's go back to the question of whether the country is wealthier or not. As you
can see, the average person now has twice as much money as before. But, all prices are
Now, in the example above, if the government printed enough paper money6 to
double the money supply from the original $3 billion to $6 billion would the eountty be now twice as high, so you cannot buy any more goods with the $6 billion printed than
richer? This is partly a trick question because it depends on what you mean by "richer." you could before with the $3 billion printed. Once the system has time to adjust, printing
If richer is defined as having more money, then you would be richer. But, if richer is excess money simply leads to inflation; in this case a doubling of the money supply leads
instead defined as having more ability to consume goods and services, then you would to a doubling of prices.
not be richer. Economists label the former notion as nominal wealth or nominal Of course, the opposite is true as well. If the government reduces the money
purchasing power and the latter notion as real wealth or real purchasing power (the supply (we will discuss shortly how the money supply can be increased or decreased at
distinction here is essentially the same as that which was drawn between Real GDP and will by the government) what will happen to the overall level of prices? Let's work
Nominal GDP in Chapter 7).~ Recognize that your real through an example. Now suppose the government cuts the money supply in half from
money supply is increased from $3 billion to $6 billion, wealth does not increase as the
Let's see why. $3 billion to $1.5 billion. When this is done (with velocity and quantity of output again
Start by recalling the Equation of Exchange:
fixed at V =8 and Q=(2 billion), for the reasons discussed above), the identity becomes:
MxY =PxQ.
($1.5 billiun)(8) = p (2 billion items).
s Paper money/s used in our explanation so that you have a physical object to comprehend. In the digital Solving this equation for the price level, we obtain P=$6. Since the only variable that
age the money supply/s mostly created by hitting a computer key with no actual physical reality behind it can change to keep both sides of the equation in balance is the overall price level, when
at alL When you receive your paycheck by direct deposit, buy something with a credit card, and pay bills the money supply falls from $3 billion to $1.5 billion, the price level falls from an
or check your bank account balance on-line, you do not see any physical cash involved in these activities average price of $12 to an average price of $6. This decrease in the overall price level is
but you still believe that the money is real.
necessary to restore the system to equilibrium.
~Th "
e diflb,
of rence
a mealbetween a nominal
in two different va ue end
countries. a years
A few real value
ago,can
oneeasily
of thebe lllustnned
authors by considering the
of this This model provides a simple explanation for how it is possible to have inflation
" bookwentto in some periods and deflation in others, as well as why some countries have higher
matavathhlswife. During this lrip
. they sr~.nt 2, 000inn:._~ .
out ts more expeustve. m .India
. than tt. ts m- ~the
- -O.S., ~ ~upces
since un a currency
it lakes 2.000 dmncr. Inunits
nominal
to buyterms eating
a dinner in inflation rates than others, and why a $40 dinner in the U.S. costs 2,000 Rupees in India.
It all comes down to bow much or little money is in circulation in any particular counla'y
India" whcaens
astrounmJcal a comparable
difference, menl
unnl you in the U.S.
reeogmze wunld
that only
at the cost
time you40could
currency units This
exchange may
$1 for 50Sound
Rupeeslike an
Cunvertmg Dollars into Rupees at this foreign exchange rate, we see that $40 are worth: ($40X50 Rupees
per Dollar) = (2,000 Rupees). ' real terms the dinner in India costs the exact same amount as the
dinner in the U.S. Thus, m

188
189
Chapler #8- Impact of Policy Decisions on the Rale of Inflation Chapter #8 - Impact of Policy Decisions on the Rate of Inflation

at any point in time. Those countries that print lots of money will have higher inflation mid-November 2008.n2 The dubious distinction for highest inflation rate ever is held by
rates than countries that do not) At a fundamental level, it really is this simple!
Hungary, which realized an annual inflation rate estimated at 41,900,000,000,000,000%
What is not so simple to explain is why countries choose to print enough money
(i.e., 41.9 quadrillion percent) around July, 1946)~
that they cause inflation in their country, especially once it is recognized that inflation
can have undesirable consequences for an economy. To recognize a fwst cost of At an annual rate of 100% inflation, prices double every year. For example, a $40
dinner for two would cost $80 next year, $160 by the end of the second year, $320 by the
inflation, recall that in the discussion above it was noted that prices can often be changed
at low cost. While this is tree in many markets, there arc still some costs associated with end of the third year, and $640 by the end of the fourth year. We are talking about an
increase from $40 to $640 dollars to take a date to Applebee's in the time it takes for an
changing prices. Economists refer to the costs of changing price as menu costs (think of
a restaurant that mast literally print a new menu for no other reason than to increase incoming freshman to reach graduation! Returning to the example above of a couple
prices). Such costs stem from a use of real resources to create nothing of new value, and nearing retirement, an annual inflation rate of 100% would make their $1,020,000 worth
therefore generate an inefficiency for society.9 only $510,000 one year later. That is, there initial life savings of $1,000,000 is
A second undesirable consequence of inflation can be seen by focusing on how essentially cut in half.)4 This illustrates just how devastating hyperinflation is to the
rising prices impact personal savings. Suppose your parents are near retirement age. savings of individuals.
They have worked hard their whole lives, saved up $1 million for retirement, and Just imagine what prices would do if the inflation rate was measured in thousands
(following what seems like good financial advice for someone near retirement age) they of percent.Is Germany experienced hyperinflation in the early 1920s, with an annual rate
have most of this money invested in relatively risk flee assets (e.g., municipal bonds). that peaked around 29,500% in October, 1923, for which prices would double every 33
Perhaps they are guarantecd a 2% annual return, so that in one year their $1,000,000 will days)6 As described in the "Commanding Heights" documentary, this "hyperinflation
become $I,020,000. If the realized inflation rate is 0%, their purchasing power is wiped out the savings of the middle class," "it took a basket full of paper money to go
actually greater one year from now. If instead the inflation rate is 2% (exactly the same shopping," "money was cheaper than wall paper," and "shoes that cost 12 million Murks
as their rate of return), then their purchasing power is exactly the same in 1913 sold for 32 trillion Marks in 1923.''t7 Further, the political and historical impact
now (they have 2% more money and ; ...... one year from was immense, since this hyperinflation "was one of the reasons for the success of the
,
- , ,~ ~,~,m, gooos - ann
, services
- cost 2% more).
However, if the inflation rat~ is above 2%, then their purchasing power is actually lower Nazis, of Hitler," who "got support from tbesc people who lost their fortunes."Is
one year from now. What this reveals is that inflation is clearly bad for people with With hyperinflation, money no longer functions as a store of value, to the point
savings (more precisely, an inflation rate above the nominal rate of return erodes the real where any normalcy in markets vanishes. If prices are doubling on a weekly or even
value of the saved wealth).'s daily basis, consumers have a strong incentive to immediately spend any money that they
On the whole, moderate inflation is likely undesirable for an economy. This do have. In such an environment Transactions Costs, which refer to costs that must be
being said, most modem economies can likely tolerate moderate inflation rates with incurred in order to participate in a market (e.g., search costs to find out who is selling a
minimal d/smption and minimal adverse ffects. In contrast, Hyperinflat[on, which good and for how much, and transportation costs to and from the point of sale), are
refers to an extremely high rate of inflation, generaUv greater than I00% per year, is dramatically increased. For example, think of how much more costly it would be to
devastating for multiple reasons. Several CounUies experienced hyperinflation in the make three trips per day to the grocery store as opposed to one trip per week.
1980s, including Argentina, Bolivia, and Poland, with annual inflation rates peaking Consequently, the social benefits from market transactions are substantially reduced.
around 20,000%, 24,000%, and 17,000% respectively.t| More recently, Zimbabwe
experienced one of the most extreme instances of hYperinflatlon ever recorded, with an
annual inflation rate that reached roughly 79,600,000,000% (i.e., 79.6 billion percent) in t2Th'
Is figure ts reported on page 354 of Hanke, S. and A. Kwok. "On the Mcasttmment of Zimbabwe's
Hyperlnflalion," CATOJournal, (Spring/Summer 2009) Vii. 29, No. 2, pages 353-364, which is available
~3
at: Ibid., page 356.
~*://~biect~cat~rg/sites/qa~`~rg/?7~e4/s¢ria~s/~es/cat~-/~ur~a~/2~9/3/ci29n2~`pdf.
4 Ifthey had nsteed earned no return (perhaps by keeping the money in a shoebox in their closet), then the
tR . . 100% inflation would have reduced the real value of their savings by exactly half,
.r5~z~_
~ of 1
eonomists
from the d~-'nssmn
agreed thatof"Infla
vinws of economists in Chapter l, across two differem studies ~sIn the morn extreme examples of hyperinfletion noted above, prices obviously double much more
0 Further the ---- - t/on is caused ptimadlv by too ~..^~. ~. an average of rapidly. As noted by Hanke and Kwok, at the time of peak inflation in Zimbabwe, it only took nboot 24.7
chano, '-'- ~,~.~'nce m menu costs explains why -ri~ .--'o-"---- ""~"..gr°wth m the money supply" ",
bour~ for prices to double., while nt the time of peak inflation in Hungar/ it only took nbout 15.0 hours for
l 0~ ' o - - ) ~ U ~ e S ~. t h ~ mr s - - L - . . 1 - - J I . J r v ~ & z m y l ] U [ m m e o m t e l y a d l u, s~ t a s ~ . ,. ~. tm. ~.t.~. ;.o. P. a t O n s prices to double. Ibid., page 356.
" m Yu ¢ s r J C K Y n s O
Batno|ethatthlssuggeststhatinflation.._~.a ~ ~ guoo°P~t°PerfecflYBatdormstantaneousl
mr some ~--onle s~^ c.._ . . y enable). v"
cummdy
I1~___~ have a sul-o.--~-, is Ibm, pase 35b.
~-,alamountofdebtt~.~;col..,..~.L .---r , ~'"~aYthnsemdividualswho 7S the v dee segment "A Cupid/st Collapse" C'Comman~ng Heights: the Battle for the World
,,,~ ~.gures are r~pact/ve]y from mues'~4"3": ~'~' ? ?m.e m~.e~=s, t rote on the debt is fixed -'- Economy," (2003), episode l, chapter 4). which can be viewed on-line at:
~ ° m m a n n m g H e l o h ~ ' t h - n . . . ." "
¢ ' , ; o a n l e t o t t h e W o r l d ' E" #
c'&
..q
. .u z~lmon
u.umy,
/ D o l Y e r R i n D a n d ] e°t~gllSlaw,
," ~" and - Schuster,
- t . . .2002.
.
, - _ , , ! ' 'The

htto:/Av~t"¢'t~h~.orvAv~blV~'Ommondir~beiv~t~/.~harcdA,i,~qt~in~
't/bid PO~ 04 ,~OO i~tm~"
Chapter #.8- Impact of Policy Decisions on the Rate of Inflation Chapter #8 - Impact of Policy Decisions on the Rate of Inflation

Further, in the face of hyperinflation incentives to save are so drastically reduced that accepted as deposits. That is, the bank is allowed to lend out some of the money that
firms have virtually no ability to make any investments in capital - the financial funds households and businesses have deposited to other households and businesses.2o When
necessary to do so are just not available. this money is loaned out it ends up in the checking and savings accounts of the
Before we get into the economics and polities of why countries would ever borrowers, thereby raising the total amount of money in circulation. Under such a
choose to cause inflation in their own economies, we need to take a detour and examine
system, the commercial banks essentially alter the money supply by way of these lending
how the money supply is increased or decreased. Knowing how it is changed also
presents a solution for preventing inflation in the first place. decisions - if a bank has $500 million in deposits and lends out $465 million instead of
$450 million, then the overall money supply is $15 million greater.
Reserve Requirements refer to minimum restrictions on the amount of money
that a bank must keep on hand at any point in time, in the form of either cash in its vault
I N C R E A S I N G A N D D E C R E A S I N G T H E M O N E Y S U P P LY or deposits with the central bank. These requirements are typically stated in terms of a
percentage of total deposits with the bank. For example, in the U.S., a bank that has
In a modem economy, the central bank is the entity which has the ability to alter
accepted more than $122.3 million of deposits must maintain reserves of at least 10% of
the money supply of an economy (i.e., the ability to essentially create or destroy money).
The central bank in the U.S. is the Federal Reserve System, hereafter referred to by its total deposits.2~ Since revenue is generated by charging interest on money that is lent
nickname: the Fed. All countries now have a central bank, with the U.S. actually coming out, a bank often has an incentive to loan out money to the point where this reserve
to the game rather late - the Fed was created in 1913, whereas the Bank of England (the requirement is binding. Thus, the Fed could indirectly alter the money supply by altering
central bank of the United Kingdom) was created in 1694.19 The central bank of any the reserve requirement. The Fed can increase the money supply by decreasing the
country is a real bank that is owned by and is an arm of the government, with the power reserve requirement and can decrease the money supply by increasing the reserve
to print money. While the Fed is a bank, it does not make home loans or car loans or requirement To see this, consider the impact of a change in the reserve requirement on a
even business loans to large corporations. The Fed's primary task is to control the money bank with deposits of $500 million. When the reserve requirement is 10%, this bank will
supply in the U.S., a task which it achieves by using three primary policy tools. These likely want to keep $50 million in reserves, thereby lending out $450 million. If the Fed
three policy tools are conducting Open Market Operations, setting Reserve Requirements, decreases the reserve requirement to 7%, then the bank would want to instead keep only
and setting the Discount Rate (these final two impact the decisions made by other banks $35 million in reserves, implying that they would lend out $465 million. Thus, by
regarding the degree to which they will take out discount loans from the Fed). Let's decreasing the reserve requirement, the Fed has induced this one bank to lend out an
examine each of these three policy tools in detail. additional $15 million, thereby increasing the money supply by this amount.
Open Market Operations refer to the buying and selling of U.S. Treasury debt In practice, at the end of any given day, a bank may come up short of its reserve
securities (i.e., pieces of the U.S. national debt) on open markets such as Wall Street. requirement. When this is the case, they have the option of taking out a short term loan
The Fed can inject money into the economy by "printing up" some money and then from the Fed in order to meet the requirement. But, they have to pay interest on this
shopping for U.S. debt securities. When it strikes a deal to purehase the securities it pays money that they borrow from the Fed. The Discount Rate refers to the interest rate that
for them with the newly printed cash, thereby increasing the amount of money that the the Fed charges banks to borrow money on a short term basis. Recognize that the higher
seller of the security possesses. Thus, this transaction has increased the amount of money the discount rate, the greater the cost of borrowing money from the Fed to meet the
in oireulation. That is, the value of M in the equation M×F =p×Q has been increased. reserve requirement. Thus, when the discount rate is raised, the bank is less inclined to
Conversely, if the Fed sold some of its accumulated U.S. debt securities from its portfolio borrow from the Fed and re-lend the money out to its customers. As a result, the money
on the open market, a purchaser would have to pay for them by writing a check to the supply is lower than it otherwise would be.
Fed. The Fed would cash the cheek at the buyer's bank and then bring the cash back to Conversely, when the discount rate is lowered, the cost of borrowing money from
the Fed and shred it. The total amount of money in circulation has just fallen by the the Fed is lower. Banks now find it in their interest to borrow from the Fed cheaply and
amount oftbe securities sale. re-lend the money to their customers. Consequently, the Fed can increase the money
To understand the final two policy tools available to the Fed, we must first supply by decreasing the discount rate. When the discount rate is lowered banks find it in
recognize that the U.S. (and nearly every other modem economy) operates under a their interest to borrow more money from the Fed and therefore have more money to loan
fractional reserve banking system Under a fractional reserve banking system, at any out to their customers. In the extreme, if the discount rate were 0% (i.e., if a bank could
point in time a commercial bank is only required to retain a portion of the money it has
leTh .
.e 1,mac r w.o.rkmgs - and potential failings - of this system are alluded to in a memorab
movie nsawonderfulLfe,,(see, htw./&ntav.~ ~t-L- l ~. t-~ ~ , w h c2 le scene
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Chapter #8 - Impact of Policy Decisions on the Rate of Inflation
Chapter #8 - lmpact of Policy Decisions on the Rate of lnflation

borrow money from the Fed at no cost), then the reserve requirement would be rendered That is, both sides of the equation are equal at the origin, al price level of $12.
meaningless - each bank could essentially lend out as much money as they want, and at So, if you have a growing economy you can pnnt more money without triggering
the end of the day take out a loan from the Fed (at no cost) to meet the reserve inflation. In fact, printing new money is actually a more stable, superior approach to the
requirement. alternatives of getting all firms to engage in a price war with each other or laying-off
This ability of the Fed and other countries' central banks to alter the money workers to reduce output to restore equilibrium. As long as the money supply is
supply is an awesome power and responsibility, one which has not always been handled gradually increased at a rate equal to the growth rate of the economy, then the price level
well by both our own country or by other countries. We will see that this almost will remain constant over time (i.e., the inflation rate will be equal to zero) This
effortless method of creating money, if not well controlled, eunld lead to inflation or provides a justification for giving eantral banks the authority to alter the money supply.
hyperinfiation, as it has in many countries around the world. Doing so allows the Fed to be able to provide stability in prices when there are real
changes in a society's economic capacity. The only controversy in this case would be
how to limit the central bank to only the correct amount of new money printing, since
Altering the Money Supply to Accommodate Growth real economic growth is not perfectly predictable and the central bank could make a
Now that we see how the money supply can be altered by the Fed we also see genuine mistake in its decision of how much to alter the money supply As will be seen,
bow inflation can easily be avoided: stop lending to banks or buying securities on the greater difficulties potentially emerge when we examine the second justification for
open market and inflation is virtually impossible. So why don't all countries just stop altering the money supply.
printing new money and save themselves from inflation? The reason they don't is
because there are two beneficial aspects to increasing the money supply.
First, if the economy is growing in real terms (i.e., its ability to produce actual
Altering the Money Supply for Economic Stimulus
goods and services is increasing over time), then increasing the money supply can
Unfortunately, economies do not grow at a constant rate over time. As noted
actually keep prices stable. This justification for increasing the money supply can be
within the discussion of the business cycle in Chapter 7, at some points in time an
understood by again examining the equation of exchange. For instance, reconsider the
economy expands (reflected by an increasing value of real GDP), while at other points in
first example that was given to explain this equation:
time an economy contracts (reflected by a decreasing value of real GDP). For numerous
MxV=PxQ reasons, most businesses and households would prefer a stable, constant rate of economic
($3 billinn)(8) = ($12 per item)(2 billion items) growth - that is, a growth path with less fluctuation over time. As will be argued below,
$24 billion = $24 billion. the Fed may be able to minimize fluctuations in economic activity (e.g., stimulating the
Suppose that over the course of the next ten years, this economy is able to realize
economy during a recession) by manipulating the money supply.
econenuc growth which allows it to produce 4 billion items (i.e., twice as much output).
At the original price level of $12 per item, these 4 billion items are worth $48 billion. Recall the phases of the business cycle disctlssed in Chapter 7. During a
recession - when real GDP is declining - business is slow, sales fall off, and workers are
However, we can see that the $24 billion of parehasing power created by $3 billion being
laid off (causing a rise in unemployment). Both personal and business bankruptcies rise
spent 8 times per year is not enough money to purehese the $48 Billion of goods now on
store shelves at current prices. That is, at a price level of $12 there would be a huge as people find it hard to pay their financial obligations. Eventually, the economy
surplus of unsold goods. If the money supply is not altered, then the economy would "bottoms-out" - when business conditions are at their worst we have reached the trough.
. . . , After this point in time the economy enters into a period of expansion. As illustrated in
need to.rea!lze.elther
prunuetmn m line with masswe pnce
the amount of cuts or massive
money layoffs
available. Eitherinoforder
thesetowould
get the
bevalue
very of Figure 8.1, this period of expansion can be decomposed into two distinct phases:
disruptive and costly to overall economic performance. Of course, an easier approach recovery and prosperity. During the recovery phase - which starts at the trough and lasts
which would facilitate stable economic growth would be to increase the money supply by until the economy has surpassed its previous peak - new fn'ms are started and older firms
$3 billion, bringing the total money supply up to $6 billion. Tiffs $6 billion spent 8 times that survived the downturn start to increase their sales and rehire workers. Once real
per year would give us enough purchasing power to buy up exactly the amount of new GDP goes above its previous peak, the economy has entered the phase of prosperity
goods produced at the currently existing price level of $12 on average. If we did this the (which ends at the next peak). The phase of prosperity can lead to over-optiraism, or in
equation of exchange would now be: the words of the former chair of the Fed, Alan Greenspan, into "irrational exuberance.,,~2

MxV=PxQ
($6 billionXg) = ($12 per item)(4 billion items) This phrase was first used by Alan Greanspan in a speech given on December 5, 1996 (see:
$48 billion = $48 billion. ht~lt)://~l~',federalrfser~.gov/h¢~rddocs/speeehe~/i
investors m Interaet related stocks, whtch drove the996/19961205.htm) in referenceto
share pnc~ of such compames tolevels
the behavior of felt
which he
were artificially high. His view was validated when the composite values of numerous stock markets
Chaplet. $8 - Impact of Policy Decisions on the Rate of lnflation Chapter #,,8 - Impact of Policy Decisions on the Rate of lnflation

During this phase, investors take risks that are not warranted and businesses over-expand, SUVs. The new factory will have to be shut down and workers will have to be laid.off
ultimately setting up the economy for a correction. This correction is the next recession, since consumers are no longer looking to buy these new vehicles. The laid-off workers
and the cycle starts all over again.
will cut back on their own expenditures, leading to a fall in demand for many other
products. This in turn will cause the business owners in those industries to lay-offsom¢
Ftgmre & i - Phases of the Business Cycle
of their workers, causing a decline in business activity which ripples through the
economy. This downward spiral is finally stopped when people adjust their spending and
businesses adjust the types of products they produce, allowing the economy to begin to
recover. Fortunately, the phases of economic expansion have historically been longer
than the phases of contraction (see Table 7.5 in Chapter 7). Thus, as illustrated in the
stylized graph in Figure 8.1, the peak of the second boom is significantly higher than the
peak of the previous one, If this can go on for several decades, we would see an
, ~ R c a l G D P economy wide increase in income and living standards, even for the poorest members of
society. This recognition in encapsulated by President Kennedy's observation that "a
rising tide lifts all the boats.''24
Is there some way to avoid the downturn in the business cycle? Can we avoid all
of the unemployment, bankruptcies, and disruptions inherent in a recession? For many
[I decades, since the creation of the Fed in 1913 in fact, we have searched for a way to
I
I moderate or eliminate the downturns in the business cycle. It turns out that short-am
0' I increases in the money supply, like a tonic or drug, may be just what the doctor ordered
; time to cure the economy. Let's examine how this might work.
There is a connection between the supply of money and the interest rate in the
loanable funds market in the short-run. The Ioanable funds market conceptually
encompasses all loan markets in which borrowers and lenders interact, including, for
recovery~ , . example, the car loan market, mortgage market, and industrial loan market. The
~ prosperity foundations of Supply and Demand (introduced in Chapter 4) can be applied to the
market for loanable funds to show that an increase in the money supply can temporarily
"expansion drive down market interest rates. Such an increase in supply in this market is illustrated
in Figure 8.2.
Over-optimistic behavior on the pa~ of investors is only one possible cause of a Logically, if the Fed creates a large amount of new money that has never existed
downturn. A recession could alternatively be triggered by a supply shock, that is, a before, either through open-market operations or by inducing banks to take out more
drastic and significant change in supply of a good that is essential for economic activity, discount loans, we will ultimately have a system ~dde increase in the size of savings
For example, during the 1970s, oil production was disropted multiple times by decreases accounts and checking accounts. This is an increase in supply of Ioanable funds. Banks
in supply of this nature - most notably in 1973 when OPEC declared an oil embargo on will attempt to lend this money out since cash sitting in the vault earns nothing. As all
the U.S. during the Yam Kippur War betWeen Israel and a coalition led by Egypt and b a n k s "increase their" landmg flora the level that it was before the Fed action, there wiU be

Syria, and again in 1979 during the Iranian Revolution~ Such supply shocks in the an excess supply of loans at the initial interest rate. Individual banks will start to cut their
market for oil can trigger a recession by disntpting financial markets and throwing loan rates to get the business, and as more and more of them do so, the remaining banks
investment plans askew as people adjust to the new, higher fuel prices, have to go along as well or risk losing customers, This description shows that
Thinking of the impact of such a change in the price ofoil in more present terms, conceptually the market for Ioanable funds is no different than the market for
perhaps an automsker will now regret just completing a new factory dedicated to building hamburgers. If supply goes up, the price (which in a market for loans is the interest rate}
has to be cut in order to find the new equilibrium and get rid of the surplus that would
ar°und the w°rld, m°~I notably the .< NASDAn
-, .,~ ~.o..;.,,~u
,k-,tatar
~ evatu¢~
L .......¢nmatlcally decline during the exist at the original equilibrium price afro. As you can see in the graph, the loan n~rket
bunztinll of the "doz,.com bubble" of the late 1990s.
~ S~,' Ye'~m, ' D, and 1. Slumzla,,v, "The Commanding Heights: the Battle for the World Economy" Sunoa
and Schu.~er, 2002, P~Ie~ 46,47,
. Remarks m Heber Spcmgs, Arkttnsa.~ at the DedicaLion of Grc¢~ Fen,,/Dam," October 3, 1963,
U" I " , , .
Chapter #8- Impact of Policy Decisions on the Rate of Inflation Cilapter #8 - hnpact of Policy Decisions on the Rate of Inflation

moves from the original interest rate of 5.5% (i.., Re) down to the new lower interest The motivating justification for the present discussion was a recognition that
rate of 3.25% (i.., RL). households and business have a preference for stable economic growth with minimal
What is the logical result of these artificially lowered interest rates? Interest rate fluctuations in economic activity. Just like a marathon runner, an economy has an
sensitive markets, such as housing, automobiles, and capital goods (i.e., plant and
optimal pace If you run too slow you never win, but if you run too fast you will burn out
e.qulpmant purchased by businesses to produce other goods and services), find more
before the race is finished. If you maintain the right pace (and you are in shape!) you can
willing customers since the cost of ficancing these goods is now lower. Thus, the lower
go forward at a higher average speed for many miles. As a metaphor this is a good
interest rates stimulate these induslries. These sectors expand and hire more workers,
description of what the Fed wants for the economy. Think of the Fed as a coach for a
who in turn spend more on everything from restaurant meals to clothing to entertainment.
marathon runner. He gives encouragement and tries to stimulate his runner when the
As a result, the economy as a whole expands. This increase in overall economic activity
runner is going too slow, but gives him signals to slow down if he is maintaining too fast
is naturally accompanied by greater overall output, larger profits for firms, fewer
bankruptcies by finns, reduced levels of unemployment, and increased incomes for a pace. If this metaphor has any value, what should the Fed do during a boom? It should
households. This whole process was initiated by an increase in the money supply by the decrease the money supply by conducting open-market operations or by inducing banks
Fed. That is, it was caused by expansionary monetary policy - an increase in the to take out fewer discount loans. Let's show how each would be used in practice.
money supply which provides a short term stimulus to the macro economy, resulting in If the Fed sold securities on the open-market it would remove the currency used
higher levels of output, employment, and incomes. by investors to pay for those securities from the banking system, lowering the ability of
banks to lend. Since there would now be a shortage of money available to lend we would
Figure $.2- Change in Supply in the Market for Loanable Funds find interest rates rising to bring the market back into balance. Of course the same thing
could be accomplished by raising the discount rate or increasing reserve requirements.
Interest
As you should now be able to easily recognize, this shortage of loanable funds causes
Rate
interest rates across the economy to rise
Low Supply We can see the impact of this process by again focusing on Figure 8.2,
recogmzmg that the policy now under consideration results in a decrease in the supply of
Ioanable funds (e.g., from High Supply down to Low Supply). This decrease in the
money supply drives up the interest rate in the market for loanable funds from 3.25%
(i.e., RL) to 55% (i.e., R.~). These higher interest rates reduce the desire of homebuyers,
High Supply
car buyers, and investors to purchase as much as they otherwise would.
Ra = 5.5% ...........
If the Fed can get this increased interest rate to just the right level they can take
the "excess steam" out of the economy but leave enough business activity to keep the
RL=3.25% ) economy moving forward at a stable, sustainable pace (which is the ideal outcome for
i - - households and businesses). This deliberate attempt by the Fed to slow an economy
suffering from a "boom" is known as eontraetionary monetary policy - a decrease in
~ D e m a n d the money supply which dampens overall economic activity, resulting in lower levels of
o output, employment, and incomes in the short term (but greater stability in the long term).
J I Quantity
QL Qn Because of these insights, many economists believe that the government should
take advantage of this fact and artificially stimulate the economy during a recession and
0
restrain it during a "boom." While not universally accepted in the Economics profession,
Obviously the Fed could also this concept is currently the dominant way of thinking about dealing with a recession.2s
money supply and slowing down economic take these actions in reverse, thereby decreasing the
activity in the short run. While at first it may
seem like the Fed would never want to do this, a strong case can be made that such
actions are in fact prudent during an expansion. Recall from our carlrer discussion that an " J T h e a ternatlve approach advocated by some macroeconomlsts is the use of active fiscal policy to

economy can get stahthze macrt~onormc activity (by recurring deficns dunng a recession and running suzpluses during an
expansion). This notion of having government "spend against the wind" is often ~soeiated with the ideas
investing too much°verhcated'
and payingwhen m'atmnally
too high a priceexuberant investors
for business and households
property and homes.are This of John Maynard Keynes - s¢ the video segment "Global Depression" ("Commanding Heights: the Battle
boom, if carried to extremes, becomes unsustainable. for the World Economy," (2003), episode 1, chapter 5), which can be viewed on-line at

~tn:/Ata~nv'°bs'°rlcA~'eh¥~"°mmandin~lhei~hts/share(l/vtdeo/qt/mini
discussion of views among economists in Chapter 1, pOI 05300.ht,,d. From the
70.4%
business cycle should be I¢1~ tu the Federal Reserve; of economists
activist fiscal policyagreed
shouldthat "Management of the
be a'.,oided."
Chapter #8 - Impact of Policy Decisions on the Rate of Inflation
Chapter #8 - Impact of Policy Decisions on the Rate of Inflation

Most disagreements revolve around tactical issues such as the timing and duration If such a mn on the vaults occurs, the government will quickly find itself in a
problem of when to start and when to stop such policies, or around issues like the financial crisis as people withdraw their implicit support of the currency. As we
magnitude of the intervention by the Fed. In contrast, those who disagree with this discussed earlier in our discussion of money, paper money has no intrinsic value and
approach believe that the problems of man/pulating the money supply in this way depends crucially on the faith people have that the government is properly handling
outweigh its benefits, and the government should take a more passive stance in regards to financial and economic affairs. Such a "run" on the gold supply of a country operating
monetary policy during recessions, perhaps relying more heavily upon fiscal policy.2s on a Gold Standard could cause the entire economic system to collapse as people refuse
What could the problems of increased money supply be that would lead someone to accept the government's printed money in transactions. Since no government would
to voluntarily give up stimulating a depressed economy? As we discussed earlier in this want this to happen, a country on the Gold Standard feels constrained to maintain the
chapter, the increase in money supply, if not matched by increases in physical output, supply of paper money in balance with the quantity of gold in the vault. Thus, the Gold
would lead to inflation. Politicians are under constant pressure by their constituents to Standard effectively serves as a commitment device for the Central Bank to limit its
"produce" a good economy, and they take credit whenever business is doing well since expansion of the money supply.
there is a very strong correlation between re-election and the state of the economy. Since The discipline that a Gold Standard imposes chokes off inflation quite nicely.
the benefits of lower interest rates are immediate, but the costs of higher inflation do not
Let's remember our Equation of Exchange, starting again with the numerical values from
become evident for some time, the leaders of a country often find it in their political the original example.
interest to "inflate" their economies in the short-term, even at the expense of long-terra MxV=PxQ
problems (which may even arise once they are no longer in office).
($3 billion)(8) = ($12 per item)(2 billion items)
$24 billion = $24 billion.
Assume the eoantry is on a Gold Standard, promising that every $3 will have one ounce
T H E G O L D S TA N D A R D of gold to back it up.2s Therefore, the government must have 1 billion ounces of gold in
One potential solution to the problem of government initiated inflation is the its vaults to back a printed money supply of $3 billion. This leads this particular
adoption of the Gold Standard, where a country fixes the value of its currency in terms economy to have an overall price level of $12, given its current productive capacity.
of a specific amount of gold. To back money with gold in this manner means that a So, how does this prevent inflation? Remember in our first example using the
country agrees to two major requirements: the first is that no paper money will be printed equation of exchange we doubled the price level from $12 to $24 by doubling the printed
without gold in the government's vault as security; and the second is that anyone holding money supply to $6 billion. Can the government, now that it is on a Gold Standard,
paper money has the right to redeem it for a fixed quantity of gold from the issuing expand the money supply so easily with only 1 billion ounces of gold on hand? Gold is
difficult and expensive to mine, so a government cannot just double the amount of it on
.government The first requirement is enforced by the seeund. If a government tried to
Issue an amount of currency well in excess of the amount of gold it had on hand, then it hand by whim. It might take decades to accomplish such a feat. So, the government is
would open itself up to a "run" on its vaults, by which we mean a situation where many now constrained from issuing the paper money that would have triggered inflation (after
people choose to redeem their paper money for the gold at the same time but there is not all, if it were to print the money without having the gold on hand, it would open itself up
enough gold for everyone to do soy to a run on its vaults as described above).
In contrast, without the restraining influence of the Gold Standard there is no
u Again from the.discussion ofwews among economists in Chapter I across three studies an average of natural limit on how large a money supply a nation can print, and so therefore no natural
88.6*/, of eeonotmsts agreed that "Fiscal policy has a significant stimulative impact on a less than fully limit on how high inflation can go. The only limit without a Gold Standard is the self-
employed eeooorny." This can be nw..oncLled with the observation in the previous footnote (that 70 4% discipline of the political leaders of a country, which is always under pressure from those
think "activist fiscal policy should be avoided") by recognizing that both fiscal policy and monetary policy groups in society that want the government to constantly stimulate the economy (which
likely have both benefits and costs. The statement which garnered 88.6% agreement focused only on the can enhance the re-election prospects of the politicians themselves). Without the Gold
benefits of fiscal policy, while the one which oarne...~ 7r, ~o/ ........ . . . _
e ,~ v.~/o
of the two alternative policies to be made, presumably basedn~.t=at
uponImp
both|cthe
Ily asgeo
benefitsIOr
and It the
COmparison
costs of each. Standard, governments are under constant pressure to inflate, and many have done so
27The ~
zofces at play* In such a. pan" on the vaults of the Central Bank are identical to those of a '*bank run" with devastating consequences for their countries. Further, since printing money is one
(recaLl the scene fi'om "It's a Woaderful Life," t_/././././.~o..//wv.~,,.youtube.eomA,ateh?vffiEOzMdEwY~Dt/3 way to pay off debt, governments that have accumulated an insurmountable amount of
Kenneth Randall (Chairman of the FDIC from 1964 to 1970) described this phenomenon as follows: "A
debt may see no other way to meet their obligations other than turning on the printing
rim, on s bank means lines through the lobby and out the front a~. and d
wmtmg day and night to sen ifth~ could .-~'~ .... own around the block- voonle
Collapse" ("Commending Heights: ~: the Battle
w,usumw for thetnctr cesn.
World ~' Again
"
Economy," see the video
(2003), segment
episode "A'Cap'italist
I, chapter 4):
t ://wwa~ bs.o /)t. h~ cram t~ h/hts/~h red/vld¢o/ql/mini pO] Q4 ~O0.hJR~l, 2a AS
t h , s e x a m p l e t u s t r a t e n , t h e r e i s n o r e q u i r e m e n t t h a t o n e o u n c e o f g o | d i s e q u a l t o $ 1 . R a t h e r, t h e
requirement is that the government promises to exchange currency for gold at a published rate.
Chapter #8- Impact of Policy Decisions on the Rate of Inflation Chapter #8 - Impact of Policy Decisions on the Rate of lnflation

presses, All of the recorded instances of hyperinflation have been the result of sudden believe that they will be able to reap the rewards if their investments pay off, then they
and drastic increases in the money supply.~ will start building new factories and the economy will recover. If there is no hope that
If the Gold Standard solves a major economic problem, why did the majority of the government will change course, then the money supply increases will just add
major economies abandon it?3° From the discussion above, we can see that adherence to inflation to the problems of decline that the nation already faces.
the Gold Standard prevents discretionary money printing by the Fed. While this
eliminates inflation, it can also prevent the Fed fi-om enacting expansionary monetary
policy during a recession. If a recession happened while a country was on the Gold PRICE CONTROLS
Standard the government would b¢ forced to take a passive approach to the problem,
since it could not influence interest rates and short term economic activity by The discussion thus far has focused on the macroeconomic causes of and
manipulating the money supply. The economy would be expected to recover in time, but
remedies for inflation. We conclude by analyzing price controls, a microeconomic policy
only after a prolonged period of higher than normal unemployment and lower than
that has commonly been used in an unsuccessful attempt to combat inflation. A price
normal economic growth.
control refers to a legal restriction on the price at which trade can take place. Such
This leaves all countries with a dilemma: is inflation a bigger problem than
unemployment? Can the leaders of a country be counted on and trusted to act mandates commonly come in one of two forms: a price ceiling ora price floor. A price
responsibly in regards to the money supply and only print it when truly needed? ceiling refers to a legally established maximum price at which trade can take place; a
Recognize why this is so difficult - inflation only rears its ugly head sometime in the price floor refers to a legally established minimum price at which trade can take place.
future, but the stimulus of lower interest rates are: experienced in the present. That is, Based upon the discussion of Supply and Demand in Chapter 4, we have an
expansionary monetary policy often has short term benefits but long term costs. This has understanding of how prices are set in a free, unfettered market. Under such a system,
caused many countries to pursue stimulator,/ monetary policies when they were not market forces determine the prevailing price. Subsequently, the individual decisions of
appropriate. Leaders have used their central banks powers to solve problems that are buyers and sellers indirectly determine who produces and who consuxnes the good
beyond the scope of what monetary policy can ever accomplish. (thereby addressing the distributional decision discussed in Chapter 2). At the other
For instance, what ifa leader whips up a populist hysteria against business owners extreme, under a system of command planning, the government directly sets prices.31
in order to win approval in his counl~3, and starts to seize (or tax at punitive rates) their But, even in societies with primarily market based economic systems, we can
assets. What do you think will happen to the level of investment in the affected country? identify examples of markets in which government imposes price controls, legally
As investors reduce their presence in the country the economy starts to dec " restricting price instead of letting market forces determine price. For instance, since
terms, for reasons not associated with the b,,o;---- ' +., October 24, 1938, the federal government in the U.S. has mandated that workers must be
~,-~ cycle, in thzs case . line m real
increasing the
money supply will only have a limited success since the underlying deterioration of the paid a wage rate greater than or equal to a certain minimum level - that is, the
bns.iness climate is not just waiting for a "jolt" of low interest rates to get things moving government imposes a price floor,n The rent controls that have been imposed in New
again. Business people will be very wary ofinveating new resources in their country and Yo r k C i t y c o n t i n u a l l y s i n c e 1 9 4 3 p r o v i d e a n e x a m p l e o f a p r i c e c e i l i n g . T h e s e
will instead "hunker down," starving the economy of new investment in equipment and restrictions effectively place an upper limit on the price of certain housing units.33
technology. What will be the result ofthn newly printed money used by the government In the case of the minimum wage and rent controls, the likely aim is to have
to offset this decline? Lots of inflation, but limited stimulation to real economic government establish a price that is better (i.e., more equitable or fair, based upon some
performance. normative criteria) for people on one particular side of the market. For example, if the
What is needed in this ease is not a dose of money supply, but a reversal of market wage rate were only $5.60 per hour, one might argue that such a price is too low
misguided government policy and a restoration of the protection of property rights. Only for the worker to achieve a reasonable standard of living. To improve the outcome for
these actions would restore the confidence of the investing public. If business people the worker, suppose we impose a minimum wage of $7.25, with the intention of making
sure she is paid at least this amount. We will ultimately analyze the impact of price
As noted by Hanke and Kwok in the aforementioned stud
occon'ed...whan paper ronney was Cony y (~age 353),-HYparinflaUons
. have never
reared its ugly head when the supply of ~.t,)e
~,ranney :_,_-
a commo~ty.
had no natural
The consmunts
cta'se ofhypcrinflation
and was governed
hasbyonly
a 31For a di~ussmn
" " of bow this ~ dou¢ in the former Soviet Union, see: Gregory, p. and R. Stuart,
discretionlry paper rnoney standard. ~o.orv/sitex/COfp.org/files~
~ 2 - 8 Rusaian and Soviez Economic Performance a~ SWa~mre. 7~ ¢dirion, Bonton: Addison Wesley "~001
~ orFlurllmr
o r mszgh
f u ~mtu the prac,
. hcal.and.historical implementation ofth pages 124.-132.
world, ple&.~e see Michael Bordo s smcle *'Gold Standard" - ~- ~ e Gold Standard around the Or the historical rs,~ ofLl~, mtmmum wage, see: h~p;//~vwdol, got,:~t,hd.min~t~a~w,t. (.hOrl, h~.i," AS of
July 24, 200% the fedend minimum wage is $7.25 per hour.
htt :/A~w. i /Pb ~./ / Id ! ~m , "~nc~°nc~eEncycl°l~lia°fEc°nomica
nS
~¢eehrm"//www'n~h~r°rs"/RenL:2Ol2"4nmmlRo'i~'PL~(Page
regulations. " 5) for a brief disc " ozthe
usston ~ history of
Chapter #8 - hnpact of Policy Decisions on the Rate of Inflation
Chapter #8 - lmpact of Policy Decisions on the Rate of Inflation

controls, using the model of Supply and Demand, to clearly see how such restrictions After the initial ninety day imposition, the controls were gradually relaxed.
alter the realized outcome and impact the well-being of both buyers and sellers. However, inflation began to again creep up in 1973, prompting the Nixon Administration
In terms of combating inflation, price controls were imposed on a large scale with to "re-impose a freeze in June 1973. 39 During this time the effects were quite disntptive
this explicit aim in the U.S. under the leadership of President Nixon in the early 1970s. to economic activity, as "runebers stopped shipping their cattle to the market, farmers
The argument is rather intuitive - we can make sure that the overall price level does not drowned their chickens, and consumers emptied the shelves of supermarkets.'~ The
increase too much by having the government impose price ceilings on a wide array of attempt to combat inflation with price controls was abandoned in early 1974. But, once
goods. However, this argument overstates the degree to which guvemment decree can these artificial constraints on prices were lifted, prices soared and the U.S. economy
influence market behavior and fails to recognize the detrimental effects of price controls. experienced one of the most severe instances of inflation in its history. The annual
As noted by Milton Friedman when commenting on the experience of Germany inflation rate was above 10% for fifteen consecutive months, fi'om February 1974
following WW-II, "there were extensive wage and price controls, supposedly to control through April 1975.
inflation, but of course wage and price controls never control inflation.''34 Most To understand exactly why the imposition of price controls is so disruptive to
economists agree with this assessment. In Chapter 1 we saw that across two different market activity, we analyze the impact of such policies within the model of supply and
studies, an average of 73.0% of ecunomists agreed that "wage and price controls are NOT demand. As will be seen, when a price control is imposed, less trade takes plane. Thus,
a useful policy option in the control of inflatinn." if such a control is put in place in an otherwise efficient market, it will create a positive
In spite of this, during President Nixun's time in office, price controls were Deadweight Loss resulting from too little trade (recall the discussion of Deadweight Loss
imposed in an attempt to combat inflation.35 During his first term in office, the overall from Chapter 5). Further, if the intention of the policy is to ensure a fairer price (thereby
performance of the U.S. economy began to decline. In particular, inflation was becoming improving the market outcome) for participants on one side of the market, we will see
a problem. The annual inflation rate had been below 2% in every single month between why imposing a price control has at best mixed results in achieving this outcome.
December 1958 and January 1966 (86 consecutive months). During the late 1960s the Consider a market with supply and demand as illustrated in Figure 8.3. Perhaps
rate gradually increased, to the point that by the start of 1970 the annual inflation rate was
this is the market for two bedroom apartments in a major metropolitan area, such as New
over 6%j~ The ever politically aware President Nixun viewed a poorly performing York City. lfwe let market forces determine the outcome, we know (from our discussion
economy as a potential liability heading into his 1972 re-eleetiun campaign. He was
in Chapter 4) that 4,425 units would be Waded, each at a price of $5,000. We can easily
faced with the dilemma of "how to bring down inflation without slowing the economy
see (from our discussion in Chapter 5) that at this outcome buyers realize a Total
and raising unemployment" - Nixon's attempted solution was the establishment of "a
Consumers Surplus equal to "areas (a)+(b)" and sellers realize a Total Producers Surplus
Wage-price review board, composed of distinguished citizens who would pass judgment
equal to "areas (c)+(d)+(e)." Suppose that we think $5,000 is too high of a price, and we
on major wage and price increases.,,37 In August 1971, with inflation sitting at an annual
impose a price ceiling of $3,600 in order to make housing more affordable for renters in
rate of 4.62% (the 39t~ consecutive month with a rate above 4%), Nixun announced a
this market. What is the ultimate impact of imposing this policy, and by how much have
"New Eeunomie Policy, which would temporarily - for a ninety day period - freeze
we improved the outcome for renters?
wages and prices to check inflation.',3s The newly created Cost of Living Council, led by
D~rector Donald Rumsfeld and Assmtant Director Richard Cheaey, was charged with the Start by recognizing that at the artificially low ceiling price of $3,600, consumers
task of implementing these price euntrols. now want to "buy" 6,775 units, while producers want to "sell" only 2,650 units. The
price control has artificially created excess demand (i.e., a shortage). 41 When this ceiling
is imposed, the realized level of wade will be the lesser of these two amounts: 2,650
See the wdeo segment "Germany s Bold Move ( 'Commanding Heights: the Battle for the World units:2 These wades will take place at the controlled price of $3,600. So, how does a
Economy," (2003). episode l, chapter 9), which can be viewed on-line ae
3~ Thlsapproach to fighting. mflatton
.
t~:/Avww'°bs-°rr'At~bh/commandineheiehts/sharedA#deo/qt/minl 09
pot around
was also attempted in Great Britain 300.3,t.,1.
the s~une time under the
leadership of Prime Minister Ted Heath with the passage of the Counter-In flatinn Act of 1973 ' 39 Ibid., page 45.
~° lbid., page 45,
(h!tP://www-le~iMation~utaTea/1973/9/pdfs/u£7~ea
Mixed Economy Flounders" ("Commanding Heights: the19730009Battle for theen.pd~. See the videosegment-A
World Economy," (20031. episode 41 In the context of Nixon's wage and price controls, this decrease In quantity traded and a~ificial shortage
l, chapter 13): ~s.or~At~bhlcommondin " . was described by Daniel Yergin as follows: "The economy went out ofwhack~ People couldn't cover their
..
~Tbescvaln~(andoth~simi~valn,.:_.L. ~ ~hewhts/xharcd/vtdco/(ct/mml pot 13 ~O0.hL. costs,.,instead of controlling inflation, [the price controls] were creating shortages," See the video segment
U.S. since 1914, available at: -~l~:/linflal/ondata.com/lnlTation/lnflation
n m m l $ Q i s c o s s l O n ' t ~ . fa~mnary . . . . . .Ratc/Hismriealln~.
r o fi l . . . ozthe .mflanon' 'rate ' the A
~ / ' in "The Specter of Stagflatien" ("Commanding Heights: the Banle for the World Economy," (2003), episode
more complete diseassico ofinflatian and unemplo .ymcot rates in the U.S. is presented in Chapter 9. l,chapter 12):http://www.nbs.ore/w~bh/commandin~hei2hts/shared/video/qumini 1301 12 300.html
3 7 See ' D. and J. Stanislaw, The Commanding Heights: the Banle for the World ECOnomy," Simon
: Yergm, Th s observation on the positive (as opposed to normative) impact of a price ceiling on quantity of trade
and SchuSter, 2002, page 43. rs accepted by a vast majority of economists. In fact, within the ~scussion of views of economists in
~/bin(, page 44. Chapter t, the statement with the highest agreement is: "A ceiling on rents reduces the quantity and quality
of hcosing available" (average agreement of 95.5%, over two different studies),

204
205
Chapter #8- Impact of Policy Decisions on the Rate of Inflation Chapter #8 - Impact of Policy Decisions on the Rate of Inflation

situation in which 2,650 units are traded at a price of $3,600 compare to the flee market
Consumers Su~lus. However, with the price ceiling in place, fewer units are traded.
outcome?
The loss of"area (b)" results from the fact that units 2,651 through 4,425 are no longer
Focusing first on Total Social Surplus, recognize that if 4,425 is the efficient level
of trade, then imposing the price ceiling has created a Deadweight Loss equal to "areas consumed, thereby precluding the previous consumers of these units from enjoying
benefits from consumption.
Co)+(d)." Since these units arc no longer being trade, society must forego the net benefits
which could result from these transactions. The presence of this Deadweight Loss Recognize that in the context of a market for something like an apartment (where
nearly all consumers will acquire at most one unit), this price ceiling (which was likely
provides a strong argument against imposing the price ceiling.
enacted to improve the outcome for renters) has clearly made Some individual buyers
Figure &3 - Impact of Imposing a Price Ceiling worse off. For example, consider "Renter number 4,000" (i.e., the individual who is
represented by the 4,000th unit along the demand curve). We know that the buyer's
reservation price of this individual is above $5,000, since at the free market outcome she
would choose to rent an apartment at this seemingly high price. Given a choice between
renting an apartment for $5,000 and renting an apartment for $3,600, she would
obviously prefer the latter option. While the person advocating the price ceiling is likely
doing so with the intention of giving her this second outcome, it is important to
understand that this is not what the price control actually does. With the price control in
place, this person is no longer be able to rent an apartment (only 2,650 units are supplied
at the artificially low price). Thus, in practice, the price control gives her the outcome of
not being able to rent an aparm~ent for $3,600. Given a choice between renting an
5,000 .......... ,
apartment for $5,000 (which is what the free market outcome gives her) and not renting
3 , 6 0 0 , : . . . . . an apartment for $3,600 (which is what the price control actually gives her), she prefers
the former option. For this reason, this individual buyer is actually made worse offwhen
the price ceiling is imposed.
2 , 0 0 0 , ~ D e m a n d
' Finally note that it is actually possible for a price ceiling to result in a decrease in
0 [ '
I I quantity Total Consumers Surplus. As illustrated in Figure 8.3, it appears as if "area (c)" is
greater than "area (b)," in which case Total Consumer Surplus increases as a result of
0 2,650 4,425 imposing the price ceiling of $3,600. But it is possible for a price ceiling to be set at a
6,775
level for which the gained surplus of buyers from paying a lower price (corresponding to
Switching focus to the impact of the policy on sellers, recognize that when 2,650 "area (c)") is less than the lost surplus of buyer from decreased consumption
units are traded, each at a price of $3,600, Total Producers Surplus is equal to "area (e)." (corresponding to "area (b)"). tf this is the case, then the price ceiling actually decreases
In contest, at the free market outcome Total Producers Surplus was "areas (c)+(d)+(e)." Total Consumers Surplus (which, recall, is presumably the side of the market that
Thus, the price ceiling has decreased Producers Surplus by "areas (c)+(d)." The sellers proponents of the policy are try to help out). As an extreme example, consider the impact
lose "area (d)" because they no longer sell units 2,651 through 4,425. The sellers lose of imposing a price ceiling of $2,000 in this market. At such a low price, quantity
"area (c)" because they now receive only $3,600 per unit instead of $5,000. In the supplied is equal to zero units - thus, with the price ceiling in place, no trade takes place.
context of rent controls, this restriction makes landlords unequivocally worse off. But, if The decrease in Total Consumers Surplus resulting from less trade taking place is now
Someone supports imposing rent controls, they likely would not be Swayed by an equal to "areas (a)+(b)," while the increase in Total Consumers Surplus from paying a
observation that the policy makes landlords worse off. lower price is now equal to zero (since no trade takes place at such an artificially low
To determine the impact of the price ceiling on buyers, start by recognizing that price). Thus, imposing a price ceiling of $2,000 decreases Total Consumers Surplus fi'om
when 2,650 units are traded, each at a price of $3,600, Total Consumers Surplus is equal
"areas (a)+(b)" down to zero, clearly making consumers worse offas a group.
to "areas (a)+(c)." Recall, Total Consumers Surplus at the free market outcome is equal
to "areas (a)+(b)"Thus, when the price ceiling is imposed, compared to the free market ~articuINar°t~onsider th, e.marke.t illustrated in Figure 8.4. Perha s thi '
outcome, consumers collectively gain "area (c)" but lose "area (b)." The gain of "area 1~ ~ tYl:~ OI tOW SKltlea labor V/he ..... , taoor
- - Pmarket
s ~ s using
a m athe
r k e t f o rofa
supply and demand, the workers .are theu sellers
uuamyzmg(anda are represented alongmodel
the supply
(c)" arises because for the 2,650 units purchase, the price paid is lower (only $3,600
instead of $5,000). This lower transaction price directly leads to an increase in Total curve) and the firms are the buyers (and represented along the demand curve). At the
free market outcome, 2,160 workers would be hired, each at an hourly wage rate $11.50.
Workers realize a Total Producers Surplus equal to "areas (d)+(e)," while firms realize a
Chapter #8- Impact of Policy Decisions on the Rate of Inflation Chapter #8- Impact of Policy Decisions on the Rate of Inflation

Total Consumers Surplus equal to "areas (a)+co)+(c)." Suppose that we think a wage rate
Focusing on the impact of the policy on buyers of labor (i.e., businesses),
of only $11.50 is toe low for workers, and we impose a price floor (i.e., a minimum
recognize that Total Consumers Surplus has decreased by "areas (b)+(c)." These buyers
wage) of $15,00 with the intention of increasing the incomes of these workers.
lose "area (c)" since they no longer hire workers 1,381 through 2,160. They lose "area
(b)" because they now have to pay $15.00 per hour to the workers that are hired (instead
FIgRre 8.4 - Impact of lmposing a Price Floor
of only $11.50 per hour). With the price floor in place, buyers are unequivocally worse
$ off. But again, the primary concern of an advocate of a minimum wage is likely not the
well-being of the firms hiring the workers.
2 8 . 0 0 " ~ Supply Switching attention to the impact of the price floor on sellers (i.e., workers), start
by recognizing that when 1,380 units are traded at a price of $15.00, Total Producers
Surplus (in this case the workers' surplus) is equal to "areas CO)+(d)" (as opposed to a
surplus of "areas (d)+(e)" at the free market outcome). When the minimum wage is
imposed, workers collectively gain "area Co)" but lose "area (e)." The gain of"area (b)"
results from the fact that the 1,380 workers hired are each paid $15.00 per hour instead of
ii.5o .... ~- .... ~ :--~-':,~e~ : only $11.50. This increased wage rate was the intended result of the policy and leads
directly to an increase in surplus for these workers. But, with the price floor in place,
fewer workers are hired. The loss of "area (e)" arises because workers 1,381 through
-- ~"~" Demand 2,160 are no longer hired. When workers must be paid at least $15.00 per hour, it is no
longer worth it for a Fn'm to hire these workers (i.e., the buyer's reservation price for the
potential buyers of these units is less than $15.00). For example, if I can pay Someone
quantity $ I 1.50 per hour to cut my lawn, I will do so - but, if I have to pay them $15.00 per hour,
I will cut my lawn myself.
1,380 2,160 2,835 Similar to the market for apartments (in which someone either rents one
apartment or none), workers in a labor market either have a job or not. Thus, as
At this artificially high price of $15.00, even more people would like to work - suggested in the discussion above, the decrease in quantity traded from 2,160 units down
quantity supplied is now 2,835 instead of only 2,160. However, at this higher wage rate, to 1,380 units corresponds to some individual workers no longer having jobs. The
finns do not want to hire as many workers - quantity demanded is only 1,380 instead of minimum wage clearly makes these people worse off. For example, consider "Worker
2,160. When this price floor is in place, the quantity of mute will be the lesser of these number 1 300 "0.e., the. mdivldual
. . .who. is represented by the 1,700th unit along the supply
two amounts: 1,380 units. Thus, in the presence of a minimum wage of $15.00, the curve). We can infer that the seller's reservation price of this person is less than $11.50,
realized outcome in this labor market is for 1,380 workers to be hired, each at a wage of since even at this seemingly low wage rate she would choose to take a job. Given a
$15.00 per hour. How does this outcome compare to the flee market outcome? choice between having a job that pays $15.00 instead of$11.50, she would clearly prefer
With the minimum wage in place, fewer workers arc hired. This is why there is a the former option. But, contrary to the intentions of the advocate of the policy, this is not
strong consensus among economists that "a minimum wage increases unemployment what the minimum wage does for this worker. With the price floor in place, this worker
among young and unskilled workers,,43 If 2,160 workers is the efficient level, then no longer gets hired (the pOtential buyer of her labor time is not willing to pay the higher
having this price floor in place creates a Deadweight Loss equal to "areas (c)+(e)." wage of $15.00). In practice the minimum wage gives her the outcome of not having a
Again, the presence of this Deadweight Loss provides a strong argument against job. Given a choice between having a job that pays $11.50 an hour (which is what the
imposing this policy. free market gives her) and not having a job (which is what the price control actually gives
her), she prefers the former option. From here, we see why imposing the minimum wage
43 From the discussion in Chapter l, across three different studies an averaoe ofgt~ oo/ actually makes this individual worker worse off.
with :his statement. Note that we are focusing on a labor market in wL' 8 L.,
uv.o--,0 economists agrend Further recognize that imposing a price floor could either increase or decrease
otherwise be below the proposed minimum wage of $15.00. mco me nee market wage rate would Total Producers Surplus. To see this, consider the imposition of a minimum wage of
to be unskilled or youn8 (i.e., lacking experience). The workers in such markets are more likely
If we instead focused on a market in which the free $28.00 per hour in the labor market illustrated in Figure 8.4. This price is above the
m~rket Wage rate is above $15.00 (e.g., the market for physicians), then the price control is not binding and
vail have no dtrent lrapect on the market. For this reason, it follows that the undesired effect of reduced reservation price of every single buyer. With such a high minimum wage in place, no
employment created by this policy is borne by young and unskilled worke~. workers are hired. As a result, imposing such a high minimum wage decreases Total
Producers Surplus by "areas (d)+(e)." Workers lose "areas (d)+(e)" as a direct result of
Chapter #8- Impact of Policy Decisions on the Rate of Inflation Chapter #8 - Impact of Policy Decisions on the Rate of Inflation

2,160 workers no longer having jobs. Further, since no people are hired, there is no C H A P T E R # 8 M U LT I P L E C H O I C E Q U E S T I O N S
benefit to any worker of being paid a higher wage rate than before. That is, imposing a
minimum wage of $28.00 decreases Total Producers Surplus from "areas (d)+(e)" down 1. said that "Inflation is always and everywhere a monetary phenomenon."
to zero, clearly making sellers (i.e., workers) worse offas a group. A. Richard Nixon
The discussion above identified distinct ways in which a price floor impacts three B. Donald Rumsfeld
different segments of socinty.44 Specifically, imposing a minimum wage causes: C, Milton Friedman
(1) firms hiring workers to be worse off (since they will have to pay a higher D. Barrack Obama
wage to the workers they do hire, and since they will hire fewer workers),
(2) some sellers of labor to be better off (those workers who still have jobs and
2. Last weekend Brenda won $1,500 at a casino in Biloxi, Mississippi. She decided to
are now paid the minimum wage instead of the previous, lower wage), but
use the money to purchase a new TV from Walmart. She was able to use the
(3) some sellers of labor to be worse off(those workers who no longer have jobs
money to acquire the new TV since money serves as a
with the minimum wage in place).
So, is a minimum wage a good policy'/ Recognize that this is a normative (as opposed to A. dualcoincidence of wants.
B. medium of exchange.
positive) question. Any answer depends upon the values and priorities of the person
assessing the policy. C. store of value.
If your values are such that you want to maximize Total Social Suq~lus, then D. unit of account.
imposing a minimum wage is not a good policy (since it creates a positive Deadweight
Loss). Suppose instead that your aim is to simply "help workers" - that is, your 3. Inflation is defined as an increase in
normative beliefs are such that you disregard the loss to farms associated with effect (1) A. average household income.
above. What our analysis partly reveals is that even with such standards you may or may B. the total market value of all goods and services produced within an economy
not favor the minimum wage. Even if you completely discount effect (1), you should over a specific period of time.
only favor the minimum wage if the value you place on the gain from some workers C, the price of any one single good in an economy.
being paid a higher wage - that is, the benefits associated with effect (2) - is greater than D. the overall, general level ofprieas for goods in the economy.
the value you place on the loss from some workers no longer having jobs - that is, the
costs associated with effect (3). Thus, two different people with different values and 4. Suppose that the value of the Consumer Price Index in Canada increased from
priorities can reasonably come to different conclusions regarding whether this policy is 178.3 up to 184.8 between 2017 and 2018. Based upon these values, Canada's
good or not. inflation rate for 2018 was
A. approximately 1.04%
B. approximately 3.65%
C. 6.5%
D. approximately 8.30%

5. The Equation of Exchange is


A. Y=C+I+G+NX
B. MV = pQ
C. D(p) = SO>)
D. GDP Per Capita = GDP + Population

6. One of the principle functions of money is that it serves as a "store of value," This
role could be described by recognizing that money
A. is used as a basic unit of measuring economic activity,
(4 Recall, these distinct effects on thee three different segments of society were noted in Chapter 1 within B, is an asset used as payment when purchasing goods and services.
the disettssion of views of economists. C. is an asset that can be used as a means to hold wealth.
D. None of the above answers are correct.
Chapter #8 - Impact of Policy Decisions on the Rate of Inflation Chapter #8 - Impact of Policy Decisions on the Rate of Inflation

13. is defined as an increase in the money supply which provides a short


7. Which of the following countries experienced hypcrinflation that peaked at an
term stimulus to the macro economy, resulting in higher levels of output,
annual rate of 79,600,000,000% in mid-November 2008 (at which time prices
would approximately double every 24.7 hours)? employment, and incomes.
A. Peru A. Contractionary monetary policy
B. Germany B. Expansionary monetary policy
C. Zimbabwe C. A supply shock
D . None of the above answers are correct (since no country has experienced D . Hyperinflation
hypcrinflatinn since the United States at the and of the Revolutionary War).
Answer Questions 14 through 16 based upon the information conveyed in the graph
8. Which of the following is NOT one of the primary policy tools used by a central below. Suppose the free market outcome is efficienL
bank? price a ~ Supply
A . Loaning money to low income home buyers at below market interest rates (in
order to make housing "affordable for all").
B . Setting the "discount rate."
C. Setting"reserve requirements." 24.00 = ............
D . None of the above answers are correct (since each of the choices listed is one i i
b i e ~ J i
of the primary policy tools used by a central bank).

9. The central bank of the United Kingdom


A. is the Bank of England, which was founded in 1694.
9 50 ' Demand
B. is the Federal Reserve, which was founded in 1913.
C. is the Bank of Parliamant, which was founded in 1981.
D. None of the above answers are correct, since the United Kingdom does not
have (and has never had) a central bank.
0 quantity
10. As depicted in Figure 8.1, the expansion phase of the business cycle can be further 1,400 2,650 3,615
0
decomposed into periods of
A. peak and trough. 14. Imposing a price floor of $18.00 would
B. acceleration and deceleration. A. make all sellers worse off.
C. recession and depression. B. make all buyers worse off.
D. recovery and prosperity. C. not have any impact on the market whatsoever.
D. More than one (perhaps all) of the above answers is correct.
I I. Widespread price controls were implemented in the U.S. in an unsuccessful attempt
to reduce inflation during the time whan 15. Ifa price ceiling of $9.50 were imposed in this market, then
was President. A. 3,615 units would be traded.
A. Lyndon Johnson
B. Consumers' Surplus would be equal to "areas a+b+c+e+f."
B . Richard Nixon
C . Jimmy Carter C . Producers' Surplus would be equal to "area d."
D. More than one (perhaps all) of the above answers is correct.
D . Ronald Reagan
16. Imposing a price floor of $24.00 would results in a Deadweight Loss equal to
12. The Fed can increase the Money Supply in the U.S. by
A. "area b+c+d."
A. selling U.S. Treasury debt securities to the public.
B. "areas e+f"
B. decreasing the discount rate.
C . "areas e+f+g."
C . increasing the reserve requirement.
D . "area h,"
D . More than one (perhaps all) of the above answers is correct.
Chapter #8 - Impact of Pollcy Decisions on the Rate of lnflation

Observations on Inflation
and Unemployment Rates
in the United States
In Chapter 7, Gross Domestic Product was defined as the total market value of all
final goods and services produced within a society over a certain period of time. At the
start of Chapter 8, inflation was defined as an overall increase in the level of prices
prevalent in an economy over time. These two concepts provide a great deal of insight
on the overall performance and health of a society's economy. A third important
macroeconnmic measure is the unemployment rate, defined as the percentage of the
labor force that is currently unemployed.
Within this chapter we make chronological observations on the inflation rate and
the unemployment rate in the United States, in order to gain further insight into past
macroeconomic performance. Building upon these concepts, a composite measure called
the "Misery Index&quo