Economic
Systems
Chapter 2
Two Types of Economic System
1. Market-based economic system
Economic decisions are made independently by private firms and individuals
Unemployment
Inequality
2. Command-type economic system
Economic decisions are made by the Central Planning Agency
USSR: 500,000 items are planned
Low unemployment
Relatively equal distribution of incomes
Lack of variety
Low quality
Coordination problems
Central Plan: Coordination Problems
To produce more apartment buildings, the Central Plan must
decide:
• What kind of apartments people desire (size, look, location)
• Type of construction materials to use
• How to coordinate the acquisition and delivery of all inputs
• Who lives in the apartments (no market for apartments!)
As centrally planned economies grow more complex,
coordination problems increase exponentially
Relative Price
Definition. The price of one good in terms of another good is called
market price.
Example. Suppose you pay $2 for a hamburger and $10 for a movie
ticket. In this case:
The relative price of one movie tickets in terms of hamburgers is five
hamburgers per one movie ticket
Alternatively, the relative price of one hamburger in terms of movie tickets
is 1/5 of a movie ticket per one hamburger
Relative Prices as a Measure of Desirability
Relative market prices are the main tool of coordinating all
economic activities in a market-oriented economy.
 Relative prices are opportunity costs: if you want to go to see a movie you
must give up five hamburgers.
 When relative prices change, the opportunity costs change as well
 Relative prices increase for the goods that become more desirable
 Relative prices decrease for the goods that become less desirable
 Producers will tend to produce goods that are sold at higher relative prices,
and they will tend to decrease the production of other goods
Relative and Nominal Prices
Definition. The dollar price of a good or service is called its nominal
price.
When nominal prices increase on average, we call this inflation.
When there is inflation in the economy, relative prices for some goods
may increase or decrease.
Example. If all prices in the economy increased by 10%, but the price
of movie tickets only went up by 5%, the relative price of the movie
tickets went down.
Practice: Relative Prices
Increase in Nominal Prices vs Opportunity Costs
Example. Suppose a concert ticket is priced at $80, and the price of a DVD
is $20. In this case the relative price of a concert in terms of DVDs is 4
DVDs per concert.
Consider 3 cases:
1) The concert ticket nominal price doubles, all other nominal prices stay
the same
2) All nominal prices double, including the nominal price of a concert ticket
3) Erratic inflation: some nominal prices go up, some go down
Case 1: Only the Concert Ticket Price Doubles
Concert ticket price: $80$160
DVD price: $20$20
Opportunity cost of a concert: goes up
Relative price of one concert is 8 DVDs
Fewer consumers choose to go to concerts
Opportunity cost of a DVD: goes down
Relative price of one DVD is 1/8 of a concert
More consumers choose to buy DVDs
Case 2: All Nominal Prices Double
Concert ticket price: $80$160
DVD price: $20$40
Opportunity cost of a concert: unchanged
Relative price of one concert is 4 DVDs
Same number of consumers choose to go to concerts
Opportunity cost of a DVD: unchanged
Relative price of one DVD is 1/4 of a concert
Same number of consumers choose to buy DVDs
Case 3: Erratic Inflation
Concert ticket price: $80$160
DVD price: $20$80
Opportunity cost of a concert: goes down
Relative price of one concert is 2 DVDs
More consumers choose to go to concerts
Opportunity cost of a DVD: goes up
Relative price of one DVD is 1/2 of a concert
Fewer consumers choose to buy DVDs
Inflation and Coordination
• A change in relative prices is costly
 Consumers and producers must re-evaluate the opportunity costs of buying or producing
• The re-evaluation costs are not there in case of
 No inflation
 Regular inflation (all prices increase at the same rate)
• The re-evaluation costs are highest when inflation is erratic
Erratic inflation exacerbates coordination problems in a market economy
Private Property Rights
• Private property rights are virtually non-existent in a centrally
planned economy
• Private property rights are legally protected and enforced in a
developed market economy
Contract, criminal law
Protection against theft, fraud, counterfeiting
Government is the only agent capable of enforcing a transparent
property rights system: in a free market economy government is
important!
A Successful Market System
1. A system of private property and property rights defined, established, and protected by law
(private ownership).
2. Flexible prices that fluctuate in response to individuals’ voluntary decisions and exchanges
(market exchange).
3. Market incentives that are generated by a price system whose rewards and penalties
motivate decision makers.
4. Reasonably stable prices and a well-functioning monetary system that facilitates
voluntary exchange.
5. A culture with a climate of trust and in which a well-constructed and well-enforced legal
system is broadly obeyed.
What Does the Market Coordinate?
1. Methods of production
2. Quantities of production
3. Recipients of goods and services
4. Economic stability and efficiency
5. Economic growth
Methods of Production
• Technology
• Coordination of input provision
• Design decisions
Quantities of Production
• How much to produce in all?
• How many items of each design type to produce?
• What and how much will consumers want to buy in the future?
Recipients of Goods and Services
• Distribution of material goods creates incentives to produce more and
better
• Some people (e.g. physically challenged) cannot produce as much and as
good as the others: should they be allowed to receive the same type goods
and services?
• Efficiency versus fairness
 Unequal distribution of incomes is an impetus for the hard-workers to work more and better
 Equal distribution of incomes deprives hard-workers of incentives to work hard
Economic Stability and Efficiency
• Erratic inflation disorients consumers and producers: the
government pursues policies against erratic inflation
• High unemployment decreases incentives to produce: the
government adopts unemployment policies
• Governments are indispensable to dealing with the problems of
economic stability and efficiency
Economic Growth
• Economic growth is the major economic task faced by any government
• There exists conflict between long-term growth objectives and short-terms
incentives to be re-elected
• Natural resource curse
• Governments that help the market economy coordinate its activities contributes
greatly to sustained economic growth and development
• Market-oriented economies are not economies without government!
• Economic growth is greatly aided by division and specialization of labor
Specialization of Labor
Adam Smith: “[One worker] draws out the wire, another straightens
it, a third cuts it, a fourth points it, a fifth grinds it at the top for
receiving the head; ... and the important business of making a pin, is
divided into about eighteen distinct operations, which in some
manufactories are all performed by distinct hands.”
Daily production of hairpins making use of labor specialization of labor
exceeds that of individual producers by 4800 times. (Adam Smith estimate.)
Specialization of Labor
1. Specialization by individual workers
Oil changers
Car washers
Management
2. Specialization by firms
Fast-food business
Soda drinks
Car manufacturing
Importance of Specialization
• Becoming highly skilled in a
particular task
• Reduction of time wasted due to
task-shifting
Mental shifting of gears
Putting materials away
Locating new materials
• Specialized workers innovate more
Industrial Revolution: historical
evidence
Simple tasks are easier to improve on
• Downside
Monotony
Lack of sense of
achievement
Lack of ability to produce
everything one wants to
consume
• Specialization allows one to
exploit comparative
advantage
Absolute Advantage
Definition. The advantage that an individual has if he can
produce a good at lower cost than another individual is called
absolute advantage.
Example.
Sara
Jeff
Pizzas/week
10
6
Shirts/week
10
3
Sara has absolute advantage over Jeff in producing both pizzas and shirts.
Production Possibilities Schedule
A production schedule is
representing someone’s
production possibilities curve
(frontier) in a tabular form.
For instance, if Jeff produces 4
pizzas per week, the maximum
shirts per week he can produce
is 1 shirt.
Comparative Advantage
Sara gives up one shirt: she can produce one more pizza instead.
Jeff gives up one shirt: he can produce two more pizzas instead.
Jeff has a comparative advantage producing pizzas: he can produce more pizzas by giving up one
shirt compared to Sara.
Sara has a comparative advantage producing shirts: she can produce more shirts by giving up one
pizza compared to Jeff.
Definition. The advantage that an individual has if he can produce a good at a lower opportunity cost
than another individual is called comparative advantage.
Mind the difference with the absolute advantage: COMPARATIVE is about OPPORTUNITY
COSTS differences, ABSOLUTE is about COST LEVEL differences.
Comparative Advantage and Specialization
Sara: produces and consumes 6 shirts and 4 pizzas
Jeff: 2 shirts and 2 pizzas
Sara has comparative advantage producing shirts. If she specializes in
(produces only) shirts, the maximum shirts she can produce in 10
shirts. If Jeff specializes in pizzas, he produces the maximum of 6
pizzas.
Total production in case of specialization: 6 pizzas (as before) and 10
shirts (more than before by 2 shirts) with no sacrifices involved!
Comparative Advantage and Trade
By specializing, the two individuals together produce more than their economy
produced before.
Trade will happen because Sara needs to eat some pizzas, and Jeff needs some
shirts to put on.
Trade: Jeff gives Sarah 4 pizzas in exchange for 3 shirts.
Beneficial for Jeff: if he gives up 4 pizzas, the maximum shirts he can produce
according to his production schedule is 2 shirts, but he’s getting 3 from Sara.
Beneficial for Sara: if she gives up 3 shirts, the maximum pizzas she can produce
according to her production schedule is 3 pizzas, but she’s getting 4 from Jeff.
Effects of Comparative Advantage
• Specialization becomes possible because trade makes it
attractive
• Total production increases if individuals (or countries)
specialize
• Trade makes it possible for each individual (country) to
consume a combination of goods (services) that was technically
impossible to produce before trade had taken place
Practice: Comparative Advantage
When is Trade Undesirable?
Trade is based on voluntary exchange between the two parties.
Cases when the exchange is not voluntary:
1) Parties take unfair advantage of each other (e.g. adult vs child)
2) Both parties have asymmetric (unequal) access to information (doctor vs patient)
3) One party doesn’t have an alternative to exchange: a monopoly, a job in a country
with high unemployment rate
Harmful exchange for the third party: industrial pollution (negative externalities)
Price System as Coordinator
Main idea: prices adjust (go up and down) to make sure that the quantity
supplied be always equal to the quantity demanded in a competitive market
Competitive market: a market with many buyers and sellers
Supply: the provision of goods and services by the producers to the markets
Demand: the purchases of goods and services by the consumers in the markets
Market price: the outcome of an interaction between supply and demand
Quantity Demanded and Demand Curve
Definition. The quantity of a good that consumers are willing and able
to buy at each possible price, holding all other factors constant, is
called quantity demanded.
Definition. A curve showing the quantity demanded of a good for
each possible price, holding all other factors constant, is called a
demand curve.
We construct a demand curve by looking at the demand schedule, i.e.
a table correlating prices and their corresponding quantities
demanded.
Demand Curve: Construction
Demand Price and Law of Demand
Definition. The price at which consumers will just buy the exact
quantity on the market is called the demand price for a specific
quantity.
Note. Demand price is also the maximum price that anyone will pay
for the last unit.
Definition. A feature of consumer behavior whereby consumers prefer
to buy more units of a good (service) as its price decreases, is called
the law of demand.
Demand Curve and the Law of Demand
The law of demand ensures
that the demand curve is
downward-sloping.
Satiation: as you consume
more, the value of an additional
unit is going down.
Example: glasses of water in
the desert
Quantity Supplied and Supply Curve
Definition. The quantity of a good that producers are willing and able
to supply at each possible price, holding all other factors constant, is
called quantity supplied.
Definition. A curve showing the quantity supplied of a good for each
possible price, holding all other factors constant, is called a supply
curve.
We construct a supply curve by looking at the supply schedule, i.e. a
table correlating prices and their corresponding quantities supplied.
Supply Curve: Construction
Practice: consider point H
on the supply curve where
the price is $100. What is the
corresponding quantity
supplied?
Supply Price and Law of Supply
Definition. The price at which producers will just supply the exact
quantity on the market is called the supply price for a specific
quantity.
Note. The supply price exactly covers the opportunity cost of
producing the last unit sold at that price. It is the minimum price that
any producer will be willing to accept for supplying the last unit.
Definition. A feature of consumer behavior whereby consumers prefer
to buy more units of a good (service) as its price decreases, is called
the law of demand.
Supply Curve and the Law of Supply
The law of supply ensures that
the supply curve is upwardsloping.
Opportunity costs of
production increase as we
increase output.
Example. Resource
heterogeneity
Demand and Supply
• Market economy: prices and quantities are coordinated by
the market forces of supply and demand
Shortfalls and overproduction are rare events
• Command economy: prices and quantities are coordinated by
the Central Plan
Coordination problems are common, especially deficit (shortfalls)
Supply-Demand Coordination
P=$300: excess demand
P=$450: excess supply
P=$400: equilibrium
Definition. A situation in which quantity demanded exceeds quantity supplied at a given price is called excess
demand (shortage, deficit)
Definition. A situation in which quantity supplied exceeds quantity demanded at a given price is called excess supply
(surplus)
Definition. A state of rest for the economy occurring at the price at which quantity demanded equals quantity supplied.
Market Equilibrium
Excess demand: prices will RISE
Excess supply: prices will FALL
Definition. Prices and quantities at equilibrium are
called equilibrium prices and quantities,
respectively.
Market equilibrium ensures:
 Anyone can buy anything at the market price
 Anyone can sell anything at the market price
 No shortages, no surpluses (as a rule)
Practice: Market Equilibrium
D
$6.00
S
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0
5
10 15 20 25 30 35
1) If the price is set at the level of $5, the
market will be in a situation of
A. Shortage
B. Surplus
C. Equilibrium
D. None of the above
2) If the price is set at the level of $5, the
prices will
A. Not move
B. Go up
C. Go down
D. Fluctuate around the equilibrium level
Price System: Market and Central Plan
• In the Soviet Union, buying a car could take 10 years even if
one had the money because Central Plan did not order to
produce enough cars
• Market economy: shortage, prices get more expensive,
producers are motivated to produce more cars
• Command economy: “eternal” deficits (shortages)
Price-Setting Behavior
• Under competition, both consumers and producers are price
takers: nobody is too large to be able to affect the market price
• Under Central Plan, prices are set by the government planning
agencies
• Monopoly: a single producer has the power to change the price
• Market as a whole versus a single producer: market as a whole is
not a price taker!
Prices’ Roles in a Market Economy
1. Information
a. Population increases
b. Demand for apartments grows to
D1 from D0
c. Excess demand informs
landlords that they can increase
prices and still get their tenants
d. Shortage pushes prices upward
The market has informed the
landlords about the population
increase!
Prices’ Roles in a Market Economy
2. Rationing
Increase in population  increase in apartments’ scarcity
Scarcity creates shortage  higher equilibrium price
The price system rations apartments to those consumers who
are willing to pay more
Prices’ Roles in a Market Economy
3. Motivation
Suppose demand shifted to D1, but the
quantity hasn’t had enough time to adjust
staying at Q0.
Price P1 is the relevant price now.
At price P1 and quantity Q0, producing
one more apartment creates economic
profit.
Definition. A return to a producer in
excess of the minimum necessary to
induce the producer to continue to
produce the product is called economic
profit.
Price System’s Roles in a Command Economy
1. Informing Governments are unwilling to adjust prices for
political reasons and because too many calculations have to be
made.
2. Rationing Price increases must be approved by the government,
which does not happen often for the reasons above
3. Motivation A price rise (even if it happens) does not automatically
mean a rise in profits: wages and salaries are fixed!
Quality in a Command Economy
• Since prices are not motivating producers, quality suffers
• Persistent excess demand meant consumers would buy
anything anyway, no matter how low the quality was
Better a roof that leaks than no roof at all
• Competition could not improve quality
Number of firms regulated by the Central Plan
Foreign competition absent