Chapter 2:
The Economic
Organization of
Society
Prepared by:
Kevin Richter, Douglas College
Charlene Richter,
British Columbia Institute of Technology
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rights reserved.
1
Introduction
An economic system has to solve three
coordination problems:
What, and how much, to produce.
How to produce it.
For whom to produce it.
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2
Introduction
Every economy faces the problem of how to
make individuals do what society wants them
to do.
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3
Introduction
Sometimes the goals of society and
individuals conflict.
An example is the NIMBY (Not In My Back Yard)
phenomenon.
NIMBY is a mindset in which individuals approve
of a project so long as it is placed somewhere
else.
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4
Introduction
An economic system must provide the
incentives to do those things that alleviate
scarcity—produce more and consume less.
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5
Introduction
The two main economic systems of the past
50 years, capitalism and socialism, answer
these immense coordination problems
differently.
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6
Capitalism (Market Economy)
Capitalism is an economic system based
upon private property and the market in
which, in principle, individuals decide how,
what, and for whom to produce.
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7
Under Capitalism:
Individuals are encouraged to follow their
own self-interest, while market forces of
supply and demand are relied upon to
coordinate those individual pursuits.
Distribution of goods is to each according to
his or her ability, effort, or inherited property.
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8
Under Capitalism:
Government must allocate and defend private
property rights.
Private property rights – the control a
private individual or firm has over an asset or
a right.
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9
Reliance on the Market
Markets work through a system of rewards
and payments.
In capitalism individuals are encouraged to
follow their own self-interest.
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10
Reliance on the Market
Prices coordinate individuals' wants.
If there is not enough of something, its price goes
up.
If there is too much, price goes down.
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11
What’s Good About the Market?
Most economists believe the market is a
good way to coordinate individuals' needs.
The market is, however, not fair nor is it
always efficient.
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12
What’s Good About the Market?
The primary debate among economists is
about how markets should be structured, and
whether they should be modified and
adjusted by government regulation.
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13
Command Economy
Command economy is an economic system
that places the ownership of private property
in the hand of the state and coordinate all
production planning with a central authority.
More often than not, command economy
cannot achieve the right allocation of
resources.
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14
Mixed Economy
Mixed economy is an economic system that
seeks to maximize the welfare of its citizens,
while also allowing for the portion of the
economy to achieve proper allocation of
resources.
It’s a blend of a market and a command
economy.
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15
Production Possibilities Model
The production possibilities curve shows the
trade-offs among choices we make.
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16
Production Possibility Table
A production possibility table lists the
combinations of outputs (products) that can
be obtained from a given number of inputs
(resources).
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17
Production Possibility Table
Output – an output is simply a result of an
activity.
Input – an input is what you what you put into
a production process to achieve an output.
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18
Production Possibility Curve
A production possibility curve shows the
maximum combination of outputs that can be
achieved from a given number of inputs.
It slopes downward from left to right.
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19
Production Possibility Curve
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Production Possibility Curve
The production possibility curve not only
represents the opportunity cost concept, it
also measures the opportunity cost.
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21
Production Possibility Curve
The production possibility curve
demonstrates that:
There is a limit to what you can achieve, given the
existing institutions, resources, and technology.
Every choice made has an opportunity cost—you
can get more of something only by giving up
something else.
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22
Increasing Marginal Opportunity Cost
The production possibility curve is generally
bowed outward since some resources are
better suited for the production of some
goods.
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23
Increasing Marginal Opportunity Cost
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McGraw-Hill/Irwin
If the slope of the production
curve is -2 at A, the
A
opportunity cost
of 1X is 2Y.
2Y
.
1X
1
2
3
4
5
6
7
8
9
X
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Increasing Marginal Opportunity Cost
Comparative advantage explains why
opportunity costs increase as the
consumption of a good increases.
Some resources are better suited for the
production of some goods than to the production
of other goods.
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25
Production Possibilities Table
% of resources
% of resources
devoted to
devoted to
production
production
Numbers
Number
of burgers
of DVD’s Row
of burgers of DVD’s
0
20
40
60
80
100
McGraw-Hill/Irwin
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4
7
9
11
12
100
80
60
40
20
0
15
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12
9
5
0
A
B
C
D
E
F
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Production Possibilities Curve
DVD’s
15
14
12
A
B
C
D
9
5
0
McGraw-Hill/Irwin
E
4
7
9
F
11 12 Burgers
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Increasing Marginal Opportunity Cost
The principle of increasing marginal
opportunity cost states that opportunity
costs increase the more you concentrate on
an activity.
In order to get more of something, one must
give up ever-increasing quantities of
something else.
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28
Increasing Marginal Opportunity Cost
A
Slope is flat at A. Low
opportunity cost of
burgers.
Slope is steep at B. High
opportunity cost of burgers.
B
Burgers
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29
Efficiency
In production, we’d like to have productive
efficiency – achieving as much output as
possible from a given amount of inputs or
resources.
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30
Efficiency
Any point within the production possibility
curve represents inefficiency.
Inefficiency – getting less output from inputs
which, if devoted to some other activity,
would produce more output.
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31
Efficiency
Any point outside the production possibility
curve represents something unattainable,
given present resources and technology.
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Efficiency and Inefficiency
Unattainable point,
given available technology,
resources and labour force
10
DVDs
8
6
C
Efficient
points
B
4
2
0
Inefficient
point
2
4
D
A
6
Burgers
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8
10
33
Shifts in the Production Possibility
Curve
Society can produce more output if:
Technology is improved.
More resources are discovered.
Economic institutions get better at fulfilling our
wants.
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34
Shifts in the Production Possibility
Curve
More output is represented by an outward
shift in the production possibility curve.
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35
Shifts in the Production Possibility
Curve
Neutral Technological Change
DVDs
C
A
0
B
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D
Burgers
36
Shifts in the Production Possibility
Curve
Biased Technological Change
DVDs
C
B
0
A Burgers
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37
Distribution and Production
Efficiency
The production possibilities curve focuses on
productive efficiency and ignores distribution.
In our society, more is generally preferred to
less and many policies have relatively small
distributional effects.
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38
Shifts in the Production Possibility
Curve
Test your understanding:
A meteor hits the world and destroys half the
earth’s natural resources.
Nanotechnology is perfected that lowers the cost
of manufactured goods.
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39
Shifts in the Production Possibility
Curve
Test your understanding:
A new technology is discovered that doubles the
speed at which all goods can be produced.
Global warming increases the cost of producing
agricultural goods.
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40
Shifts in the Production Possibility
Curve
(a)
(b)
(c)
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(d)
41
Production Possibility Curve and
Economic Systems
The production possibility curve presents
choices in a timeless fashion but most
choices are dependent on previous choices.
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42
Production Possibility Curve and
Economic Systems
Sequential decisions can best be seen within
a framework of a decision tree—a visual
description of sequential choices.
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43
Production Possibility Curve and
Economic Systems
All decisions are made in context – what
makes sense in one context may not make
sense in another.
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44
Production Possibility Curve and
Economic Systems
Decisions are contextual.
What the production possibility curve for a
particular decision looks like depends on existing
institutions.
The analysis can be applied only in the
institutional and historical context.
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45
Production Possibility Curve and
Tough Choices
The production possibility curve represents
tough choices.
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46
Production Possibility Curve and
Tough Choices
Politicians make promises as though the
production possibility curve did not exist or
that the economy can operate outside the
economy's production possibility curve.
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47
Production Possibility Curve and
Tough Choices
Economists continually point out that
seemingly free lunches often involve
significant costs thus earning for themselves
the nickname, the dismal science.
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48
Comparative Advantage, Specialization,
and Trade
The production possibility curve is bowed
because individuals specialize in the
production of goods for which they have a
comparative advantage and trade with others.
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49
Comparative Advantage, Specialization,
and Trade
The comparative advantage argument used
to explain the bowed-out shape of the
production possibilities curve can be used to
show how trade makes society better off.
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50
Comparative Advantage, Specialization,
and Trade
Collaboration and specialization can make
society better off.
Total production can rise.
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51
Comparative Advantage, Specialization,
and Trade
The outward bow graphically represents the
potential gains from trade.
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52
Gains From Trade
Sunder can either write one economics paper
or four creative writing papers in a day.
Ti can either write one creative writing paper
or four economics papers in a day.
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53
Gains From Trade
Sunder has a comparative advantage in
creating writing and Ti has a comparative
advantage in economics.
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54
Gains From Trade
The following table and production possibility
curves demonstrate how output increases
when two individuals collaborate and
specialize in the activity for which each has a
comparative advantage.
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55
Gains From Trade
Sunder's and Ti's Individual Possibilities
Economics
Creative writing
papers per day papers per day
Sunder
1
4
Ti
4
1
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56
Gains From Trade
Sunder's and Ti's Joint Possibilities
Economics
Creative writing
papers per day papers per day
A
5
0
B
4
4
C
0
5
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57
Gains From Trade
Each individual's PPC is drawn by connecting
the number of papers each can write in a day
on a graph.
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58
Gains From Trade
5
4
3
2
(a) Ti
(b) Sunder
1
1
2
3
4
Creative writing
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5
59
Gains From Trade
The combined PPC curve is drawn by finding
three points and connecting them.
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Gains From Trade
5
A
(c) Combined with trade
B
4
3
2
(a) Ti
(b) Sunder
1
C
1
2
3
4
Creative writing
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5
61
Gains From Trade
Point A: This is the combined number of
economics papers they both can write in a
day.
If economics papers are on the Y axis, it is
point 0,5.
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62
Gains From Trade
Point B: This is the combined number of
creative papers they both can write in a day.
If economics papers are on the Y axis, it is
point 5,0.
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63
Gains From Trade
Point C: This is where each is focusing on
that activity for which he or she has a
comparative advantage.
Sunder writes four creative papers and Ti
writes four economics papers.
This is the coordinate 4,4.
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64
Gains From Trade
The combined PPC is bowed out because of
comparative advantage and specialization.
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Division of Labour
Markets allow specialization and the division
of labour.
They allow individuals to develop their
comparative advantages, thereby increasing
the production possibilities of society.
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66
Markets, Specialization, and Growth
Markets and specialization have led to
growth.
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Markets, Specialization, and Growth
The growth in per capita income (constant
1990 dollars) in the past 2 millennia has been
astonishing.
This owes largely to the introduction of
markets and democracy.
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Markets, Specialization, and Growth
As people are allowed to compete and
specialize, they get better at what they do,
develop new technologies and the market
grows ever larger.
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col17930_0207.eps
Per capita income
(in 1990 international dollars)
Growth in the Past Two Millennia
$6,000
$5,000
$4,000
$3,000
$2,000
$1,000
0
500
1000
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rights reserved.
1500
2000
70
The Economic Organization
Of Society
End of Chapter 2
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71
The History of Economic
Systems
Chapter 2 Appendix
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72
Evolving Economic Systems
Capitalism and socialism have not existed
forever.
Capitalism came into widespread existence in
the mid-1700s; socialism came into existence
in the early 1900s.
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73
Evolving Economic Systems
Before capitalism and socialism other
forms of economic systems existed:
Feudalism dominated the Western world
from about the 8th to the 15th century.
This owes largely to the introduction of
markets and democracy.
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74
Evolving Economic Systems
Feudalism gave way to mercantilism.
Mercantilism is an economic system in
which government determines the what, how,
and for whom decisions by doling out the
rights to undertake certain economic
activities.
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75
Evolving Economic Systems
Mercantilism remained the dominant
economic system until the Industrial
Revolution.
Industrial revolution – a time when
technology and machines rapidly modernized
industrial production and mass produced
goods replaced handmade goods.
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76
Evolving Economic Systems
Capitalism evolved from the Industrial
Revolution in 1700s.
Industrial revolution led to a decrease in
power of small producers and increase in
power of capitalists.
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77
The Need for Coordination in an
Economic System
Every economic system needs coordination.
In his 1776 classic, Wealth of Nations,
Adam Smith argued that markets could
coordinate the economy without the active
involvement of government.
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The Need for Coordination in an
Economic System
Markets coordinate economic activity by
using the price mechanism to direct
individuals' self-interest into society's interest.
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79
The Need for Coordination in an
Economic System
Markets coordinate economic activity by
using the price mechanism to direct
individuals' self-interest into society's interest.
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rights reserved.
80
Evolutionary Changes Within Systems
Both capitalism and socialism are constantly
evolving with changes in social customs,
political forces, and the strength of markets.
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Evolutionary Changes Within Systems
Capitalism evolved into welfare capitalism—
an economic system in which the market
operates but government regulates markets
significantly.
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82
Evolutionary Changes Within Systems
The opposite took place in some socialist
nations in the 1980s—socialism integrated
capitalist institutions into its existing
institutions.
In the 1990s, most of the former socialist
countries have undergone transition to
market oriented economies based on private
property.
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83
Blurring of the Distinction Between
Capitalism and Socialism
Recent events point to a blending of
economic systems.
If this trend continues, the 21st century will
see the emergence of a single general type
of economic structure; it will be a mix of
socialist and capitalist institutions.
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84
Feudal Society: Rule of Tradition
Feudalism developed in the 8th and 9th
century.
The Lord of the manor was the protector;
serfs were working the land.
Feudalism was a tradition based society.
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From Feudalism to Mercantilism
Mercantilism emerged with the development
of trade and markets in the 15th century.
The power of the society shifted from manors
to towns.
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From Feudalism to Mercantilism
In mercantilism, traders supported the king,
who in turn protected their interests.
The role of government increased during this
period.
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From Mercantilism to Capitalism
Industrialists or capitalists were the business
people who acquired large amounts of money
and used it to invest in business.
Craft guild members were artists in their
own crafts.
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From Mercantilism to Capitalism
The economic power base shifted from the
guilds to industrialists.
Coordination of the economy by government
was deemed necessary by the craftsmen.
Industrialists considered the market capable
of coordination on its own – no government
was needed.
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From Mercantilism to Capitalism
Laissez-faire policy is an economic policy of
leaving coordination of individuals’ wants to
be controlled by the market.
Adam Smith’s invisible hand supported the
industrialists’ view.
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Industrial Revolution
The invisible hand worked; capitalism thrived.
Machine production began to increase
enormously in the late 18th century, almost
totally replacing hand production.
This phenomenon has been termed the
Industrial Revolution.
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Industrial Revolution
Eventually, modern economic institutions
replaced guilds.
Modern capitalism evolved by the 19th
century.
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From Capitalism to Socialism
Capitalism was marked by significant
economic growth but also by human abuses
of the working class who were producing for
the elite few.
This led to criticism of the capitalist market
economic system.
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From Capitalism to Socialism
The best known critic of capitalism was Karl
Marx, a German philosopher, economist and
sociologist.
Marx developed an analysis of the dynamics
of change in economic systems, in the 19th
century.
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From Capitalism to Socialism
Marx saw an economy marked by tensions
between economic classes
The proletariat class – the working class and
The capitalist class (businessmen)
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From Capitalism to Socialism
The capitalist class made profits by exploiting
the working class.
Marx believed that this exploitation would
lead to revolt by the proletariat who would
overthrow the capitalists.
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From Feudalism to Socialism
Contrary to Marx’ predictions, capitalism did
not evolve into socialism.
Marx’ socialist ideas took root in feudalist
Russia instead.
State socialism was created – a system
based on central planning and command.
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From Capitalism to Welfare
Capitalism?
However, evolutionary changes brought
about regulation to protect the working class.
Economic safety net was developed in
capitalist economies. Examples are
Public welfare
Unemployment insurance
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From Feudalism to Socialism
Contrary to Marx’ predictions, capitalism did
not evolve into socialism.
Marx’ socialist ideas took root in feudalist
Russia instead.
State socialism was created – a system
based on central planning and command.
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Economic Transition
In the 1990s most Eastern European socialist
economies started a path of transition to a
market-based economic system.
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100
The History of Economic
Systems
End of Chapter 2 Appendix
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rights reserved.
101
