Chapter 4. The Mixed Economy

Chapter 4The Mixed EconomyCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.4-1The three questions of economicsProfit motive, price mechanism, and capitalThe circular flow modelMarket failure and externalitiesThe economic role of capitalThe importance of specializationThe major “isms” capitalism, fascism, communism, and socialismThe decline and fall of the communist systemChapter Objectives4-2Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Three Questions of EconomicsWhat shall we produce?How shall these goods be produced?For whom shall these goods be produced?Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.4-3The Invisible HandThe Price MechanismCompetitionThey all go together . . . You cannot have one without the others4-4Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Adam Smith coined this termThe invisible hand is a kind of economic guidance system that makes everything work outThe invisible hand is made possible by people pursuing their own self-interestThe bottom line is the “profit motive”The Invisible HandCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.4-5The price mechanism is based on the law of supply and demandPrices send signals to both consumers and producersThe Price Mechanism4-6Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.To have real competition, you need many firms in a particular industryYou need so many that no one firm is large enough to have any influence over priceWhen sectors of American industry are not very competitive the price system doesn’t work wellThe invisible hand becomes less active and more ineffectiveThe forces of supply and demand are distorted CompetitionCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.4-7In ConclusionThe United States of America has an imperfectly functioning price systemIt functions in a less than competitive economyIt is guided by a not too vigorous invisible handCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.4-8Equity and EfficiencyDoes this system allocate limited resources efficiently?Most economists agree that this system leads to a very efficient allocation of resources4-9Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Equity and Efficiency(Continued)Does this system lead to a fair distribution of income?NoThe case for equityTax money from the rich and middle class and redistribute it to the needyThis raises the questionsHow much do we tax and who do we tax?Will “handouts” lessen incentives to work?Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.4-10The Circular Flow ModelBusinessFirmsHouseholdsLand, labor, capital, entrepreneurial abilityWages/salaries, rent,interest,profits(Resources)(Income $)Goods and ServicesConsumption Expenditures $4-11Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Federal governmentFifty state governmentsTens of thousands of local governmentsEachCollects taxesProvides servicesMake laws and regulationsThis somewhat alters the outcome of the three questions: What? How? For Whom?The Economic Role of GovernmentCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.4-12Market FailureWhen our resources are not allocated efficiently, we have market failureTwo basic classes of market failure areExternalitiesPublic goodsBoth provide an opportunity for government to improve on Adam Smith’s “invisible hand”Another cause of market failure is “monopolies”4-13Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Market Failure(Continued)External costThis is where the production or consumption of some good or service inflict cost on a third party without compensationWhen you drive your car you cause a certain amount of pollution and congestionMillions of drivers wear out the highwaysThis results in costs for the maintenance and construction of highwaysCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.4-14Market Failure(Continued)External BenefitsAn external benefit occurs when some of the benefits derived from the production or consumption of some good or service are enjoyed by a third partyIt is not uncommon for these additional socially beneficial things to be an unintended consequenceIf you paint your houseYou add beauty to the neighborhoodYou increase property values4-15Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Market Failure(Continued)The private market Is governed solely by the forces of supply and demandDoes not take into account external costs and external benefitsMarket failure occurs when resources are not used efficientlyWhen a market failure imposes a high cost on society, we demand that the government do something about itCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.4-16Government Action on External Costs and BenefitsIf you are doing something that provides external benefits the government may provide you with a subsidy to encourage you to continue For example, the government subsidizes farmers to help keep them from going out of business4-17Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Government Action on External Costs and Benefits(Continued)If you are incurring external costsThe government can tax you to encourage you to discontinue or change what you are doingThe government can impose stringent regulations and impose heavy fines for noncomplianceCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.4-18Public Goods and ServicesA public good is something whose consumption by one person does not prevent its consumption by other peopleSome examples are national defense, a court system, police and fire protection, the construction and maintenance of streets and highways, bridges, water and sewer mains, environmental protection, public parks, public schools, and public libraries 4-19Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Public Goods and Services(Continued)Tend to be indivisibleUsually come in large units that cannot be broken into pieces for purchase or sale in the private marketOften can’t be provided by private enterprise because there is no way to exclude anyone from consuming the goods even if she or he did not pay for them Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.4-20CapitalCapital is the CRUCIAL element in every economic systemCapital consist of plant & equipmentCapital is the key to every country’s standard of livingCapital comes from –Cutting consumption by saving [Americans are now consuming too much and saving too little.] –Increasing production4-21Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Specialization and Its ConsequencesSpecialization can make it possible to be more productive and efficientSpecialization is worthwhile only if someone wants what you make or dospecialization is made possible by moneySpecialization sometimes causes worker alienationThis can lower productivityCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.4-22The “Isms”CommunismThere is no private propertyThe state owns everythingGovernment planning committees dictateWhat is producedHow it is producedFor whom it is produced4-23Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The “Isms”SocialismThere is government ownership of some means of productionThere is a substantial degree of government planningThere is a large scale redistribution of incomeCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.4-24The “Isms”CapitalismThere is private ownership of most means of productionThe profit motive moves individuals to produceThe price system guides productionThe government’s role is kept to a minimumCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.4-25The “Isms”FascismProduction is in private handsThere is varying degrees of government interferenceThose in power are highly nationalisticThe government is intolerant of any political opposition 4-26Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Winston Churchill“The vice of capitalism is that it stands for the unequal sharing of blessings, whereas the virtue of socialism is that it stands for the equal sharing of misery.”Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.4-27An Internet JokeSocialismYou have two cows. State takes one and gives it to someone elseCommunismYou have two cows. State takes both of them and gives you milkFascismYou have two cows. State takes both of them and sells you milkCapitalismYou have two cows. You sell one and buy a bull4-28Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Decline and Fall of the Communist System1920s – 1960sEconomic growth was very rapidGovernment planers concentrated on capital goods at the expense of consumer goodsThe government purposely set prices on consumer goods very lowThey wanted even the poorest people to be able to buy the basic necessities, but they ended up with constant shortagesCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.4-294-30Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Price CeilingThe market price if there was no price ceilingHypothetical Demand for and Supply of butterThe early 1970sBoth the Soviet Union and China were facing economies that were faltering The heavy weight of bureaucratic planning was stifling both economiesThe late 1970sChina began to gradually evolve toward a more market-oriented economyThe Soviet Union’s economy continued to stagnateMost of its capital and talent was devoted to the militaryThe Decline and Fall of the Communist System (Continued)Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.4-311989The Soviet Union was dismembered into 15 separate nations (the largest was Russia)Democratically elected governments replaced Soviet dictatorshipsMovement away from government central planning to market economies began There were two basic problemsInflation High unemploymentThe Decline and Fall of the Communist System (Continued)4-31Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Will the former Soviet Union countries go capitalist?The collapse of communism is not a vote of confidence in American capitalismThey could evolve into socialist or capitalist democraciesThey could swing back toward communist autocracy The Decline and Fall of the Communist System (Continued)Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.4-33China: The Premier Communist Power1949 -1979The Chinese economy was dominated by Soviet-style central planning1979 -1984The government shifted the responsibility of operating huge collective farms from government bureaucrats to the families that lived on the farmsFamilies could lease the land for 15 yearsOutput above government quotas could be soldOutput jumped from 2.5 percent to 7 percent4-34Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Late 1970s – early 1980sReform began in the industrial sectorState firms were allowed to sell any surplus outputFamily-run enterprises were allowed 1978 – 2000Exports rose from $5 billion to more than $200 billion China: The Premier Communist Power (Continued)Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.4-35Old credo“From each according to his ability, to each according to his needs”New Credo“More pay for more work; less pay for less work”China: The Premier Communist Power (Continued)4-36Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.A Last Word: The Mixed EconomyCommunism Socialism Capitalism Fascism The United States is a mixed economyEvery nation in the world has a mixed economyCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.4-37