Economic System-Definitions,
Classification and Evaluation
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I. Definitions:
1) Institutions
Institutions keep society from falling apart, provided that there is
something to keep institutions from falling apart.
---Jon Elster, Nuts and Bolts for the Social Sciences, ch. 15
a) Definition
“rules of the game” under which econ decisions are made.
b) Institutions include households and the family, government policies
and instruments, enterprises (or firms), labor organizations, and
markets.
c) Rules include the legal framework and the extent of enforcement,
organizational rules, procedures, customs, culture, and tradition. 2
2) Organizations
a) Forms
• businesses, churches, governmental organizations and clubs, charitable
organizations.
b) Characteristics
• how to deal with info, behavior rules, decision-making arrangements, & their
ownership arrangements.
c) Public choice
• the process of making decisions about taxation & spending policies.
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3) Econ. System
– “An economic system is a set of mechanisms and institutions for
decision making and the implementation of decisions concerning
production, income, and consumption within a given area.”
– ES are multidimensional, I-institution or characteristics.
– ES=f(I1, I2,…,In), n=5
II. Functions of ES.
· Resource allocation
· Distribution of income
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III. Characteristics of ES.
1. Ownership of property, and the role of individual
rights:
Property rights:
Definition- Property rights are defined in terms of rights to use (control),
dispose of (transfer), and/or benefit (residual income) from the objects
generated from the property in question.
Forms
– Public (state/government)
– cooperative
– private
Private rights are never complete.
Examples:
taxes limit residual income;
zoning laws prevent many uses of private property.
Other aspects of individual rights: Civil rights and labor mobility
Marx saw ownership as the fundamental condition.
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2. The organization of decision-making arrangements.
Are economic decisions centralized or decentralized?
Centralization and decentralization are defined in terms of:
a) the distribution of authority (consumer sovereignty vs planner's
preferences)
perfectly centralized organization—single central command that issues orders
to lower units of organization (planners).
perfectly decentralized —households & individual firms
In real world, authority is typically spread through various levels in the
hierarchy.
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b)The utilization of information in an economic system:
• “informationally decentralized” system generates, processes, & utilizes info at the
lowest level in the organization w/o exchanging info with higher levels in the
organization.
• “informationally centralized” system generates, processes, & utilizes info by
superior agencies & transmission of only limited pieces of info to lower subunits.
Decision-making levels:
– centralized
– decentralized
– mixed
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Problems of organizations:
• Principal-agent problem
– differing goals and problems of monitoring
Principal
a party that has controlling authority & that engages an agent to act subject to the principal’s
control& instruction.
Agent
a party that acts for, on behalf of, or as a representative of a principal.
• Information problems:
Opportunistic behavior
when agents use their info advantage (local circumstances) against the interests of their
superiors.
Forms:
– Moral hazard
•
agents exploit an information advantage to alter behavior after contract has been made
– Adverse selection
• agents conceal information from principals, making it impossible for their superiors to
distinguish among them
Transactions costs (Coase)
· substitute directives when transactions costs of market too high
· organization of activities within a firm versus contracting out
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3. Mechanisms for providing information and for
coordination: plan versus market.
PLAN
Definition:
a planned economy is one where agents are coordinated by specific instruction or
directives formulated by a superior agency (planning board) and disseminated
through a plan document.
MARKET
a) Market economy
the market through the forces of demand and supply provides signals & triggers
organizations to make decisions on resource utilization & decision making authority
is vested at the lowest level of the ES.
b) Indicative planning
the market is the principal instrument for resource allocation, but a plan is prepared
to guide decision-making
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DECISION-MAKERS
PLAN
MARKET
planners
planners’ preferences
consumers
consumer
sovereignty
S (planned)
S
P*
D
X* X**
Disequilibrium
P’
D
X’
Equilibrium
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4. Incentives:
– How do you motivate people to do what you want?
• Material incentives—promote desirable behavior by giving the recipient a
greater claim over material goods (money); wages, profit. Used in all ES.
• Moral incentives—reward desirable behavior by appealing to the recipient’s
responsibility to society & accordingly raising the recipient’s social status
within the community (medal, awards). Used least in capitalism and most in
planned socialism.
5. Organization of public choice:
Dictatorship
public choices are made by a person or small group of persons who make the
significant political decisions of a society
Democracy:
Pure
every public choice is put to a vote and the majority carries the issue.
Representative
the voters elect representative to make their public choices for them.
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6. Classification:
• Capitalism
–
–
–
–
–
Factors of production privately owned
Decentralized decision making
Decentralized information and Free Market Coordination
Primarily material incentives
Democracy
• Market socialism (cooperative model)
–
–
–
–
–
Non-labor factors state owned
Enterprises cooperatively owned by the workers
Decentralized decisions
Decentralized information and Coordination by markets
Primarily material incentives, but frequent use of moral incentives
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• Planned socialism
–
–
–
–
–
Non-labor factors state owned
Centralized decision making
Centralized information and Coordination by plan
Primarily material incentives with heavy use of moral incentives
Dictatorship
• Mixed economy
– combination of markets and state intervention (indicative planning)
7. Alternative ESs -- Islamic model; Latin American Model.
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IV. Comparing and Assessing Economic Systems
How can we judge how well an economic system performs?
1) Forces Influencing Economic Outcomes
Economic system, (ES)
Environmental factors-(ENV)
Policies-(POL)
O=f (ES, ENV, POL)
O=outcomes:
Economic Growth
Economic Efficiency
Income Distribution
Macroeconomic Stability
Long Term Viability
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2).The Performance of ES.
–
–
Which system works best?
Two steps involved
•
•
select criteria to be used to compare performance
assign weights to these criteria
--according to one’s own preferences
--according to system’s preferences
Max. O s.t. (ES, ENV, POL)
where O=∑ajoj
The ”success criteria problem” is when there are multiple
objectives with multiple weights assigned to each by different
observers; it is difficult to establish a single criterion by which one
system can be assessed relative to another system.
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3). Performance Criteria
a.
•
•
•
•
Economic Growth
increases in the volume of national output generated over time.
Output levels: must be adjusted for inflation, population,
comparable currencies.
Growth rates: change over time. But lesser-developed economies
have the potential to grow at faster rates, since they start at a
lower initial base
Output composition: civilian or military goods; consumption,
investment, or government goods; food vs. housing vs. luxury
goods.
Measures of output
GDP = the final market value of goods and services produced
within a country during a given year.
Real GDP = value at prices of a given base year
Per capita real GDP
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Growth
Increased Output without Growth
Capital
consumer goods
Capital
consumer goods
Economy grows when its production capacity increases
(outward shift of PP curve)
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b. Economic Efficiency
• Production Possibilities Frontier-(PPF) AB illustrates all possible combinations
of producer and consumer goods that a particular ES is capable of producing at a
particular time by using all available resources of maximal efficiency. Shape of
PPF-convex from the origin.
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• Economic efficiency
– the effectiveness with which a system utilizes its available resources at a particular time
(static) or through time (dynamic)
– No wasted resources
– Getting the most output for given inputs
– On production possibilities curve
• Efficiency is a more perfect measure of performance than GDP, but it is also much
harder to measure and not easily available.
• Static Efficiency (short run, a snap shot at any given point of time)
– Allocative efficiency
• distribution of resources to the right producers, and in the best mix.
– Technical efficiency
• using the most productive technology
– Consumption efficiency consumption of the best mix of goods and services
• Dynamic Efficiency (long run, performance over time)
– p to p’’ the ability of ES to enhance its capacity to produce goods & services over time
without increase in capital & labor inputs.
– Maximizing the long run value of output
– Technological progress, savings, investments.
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The PPF moves outward due to:
• Intensive econ growth
– economies may grow by increasing efficiency (technological progress) or more
human capital (skills and education); output increases without any change in
inputs or in ES.
• Extensive growth
– occurs by having more resources; output increases because capital or labor
grows.
• “Negative” institutions (trade barriers, corruption, excessive regulation)
– might be improved allowing output to expand without any increase in inputs or
technology.
• Measurement
– Static efficiency
• ratio of output to inputs
– Dynamic efficiency
• ratio of the growth of output to the growth of inputs
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c. Economic Equality--Distribution of Income
• How equally is income distributed?
• The Lorenz curve and Gini coefficient
– The bottom 20% of households receive 10% of income.
– Gini coefficient=Area B/Area A
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d. Macroeconomic Stability
• Various measures
-volatility of business cycle
-unemployment
-inflation
e. Viability
• Is the economic system adaptable? Does it maintain or destroy itself?
4). Measures of Institutions and Economic Performance.
• Scatter diagrams
– plots two variables taken from the same point in time for different countries
to show relationships b/w the two variables.
• Index
– Economic Freedom index, Corruption index
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5). Difficulties Assessing Systems:
a) How do you weight these criteria? Assigning weights is highly
subjective.
b) There are always tradeoffs.
c) You should be careful comparing actual to ideal systems.
d) Statistics are usually not available, not objective, or not comparable.
e) The source of performance differences may not be Economic System.
Difficult to distinguish between effect of system on performance and
effects of other determinants of performance such as:
– level of econ development (size and structure of the economy, capital and
technological development, etc.)
– population differences
– educational differences
– natural environment—climate, resources
– politics
– proximity to other systems
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NATION
Switzerland
Japan
USA
Norway
Germany
Brazil
PCI (straight)
$58,084
$34,312
$45,845
$83,922
$40,415
$ 6,938
PCI (PPP)
$41,128
$33,577
$45,845
$53,037
$34,181
$ 9,695
Source: 2007—International Monetary Fund
PCI-per capita income; PPP-Purchasing Power Parity
Determining some basket of goods purchased in a nation, and then seeing the $ cost to
purchase that same basket in the US.
The PPP adjust for the cost of living.
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Economic System-Definitions, Classification and Evaluation