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Economic Systems

Economic Systems. Chapter 3. Why are economic systems needed?. Rules of the game! Standard incentives Understanding of the rewards. Economic Systems can allow for _____. A. Specialization B. Comparative / Absolute advantage. Adam Smith. THE WEALTH OF NATIONS (1776)

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Economic Systems

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  1. Economic Systems Chapter 3

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

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

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

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

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

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

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

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

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

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

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

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

  14. HUH??? • Country B has an absolute disadvantage.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

  32. Market Economies • Also called • Capitalism • Free Enterprise • Private Enterprise

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

  34. Centrally Directed Economies • AKA • Command Economies • Marxist Economies • Communist Economies

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

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

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

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

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

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

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

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

  43. Incentives in Market Economy • $$$$$$$$$$$$$ • Psychic Income

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

  45. 2 Types of Markets • Product Market • Factor Market

  46. Product Market • Finished goods and services exchanged in product markets

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

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

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

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

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