Economic Systems: Capitalism versus Socialism
(“Economics” – Chapters 3)
Economic System – the rules and methods put in place by
a society to determine what goods are produced, how they
are produced, and for whom they are produced.
 The economic system determines how a society will
answer the “Three Fundamental Economic Questions”
 The “mechanism” by which an economy answers
these questions is referred to as an economic system.
Comparative Economic Systems – subfield of economics
that compares and contrasts the structure and performance
of different economic systems.
 The study of how economic systems differ across
societies and how such differences in systems lead to
differences in economic outcomes is the focus of
comparative economic systems.
Every economic system contains four primary institutions:
1. Households
2. Firms
3. Markets
4. Government
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1.
2.
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Households.
most fundamental part of every economic system
ultimate consumers of most finished goods/services
primary suppliers of labor
households are thought of as “rational decision
makers” who do their best to achieve their goals, given
the “rules” of the economic system in which they
operate
Firms.
 institutions that transform factors of production into
finished goods and services
 Economic Resources (or factors of production) – the
scarce things that are used to produce the
goods/services that we benefit from consuming.
 Three broad types of Economic Resources:
1. Natural Assets – natural resources, including
minerals (coal, oil, natural gas, etc.), naturally
occurring vegetation (forests), water resources,
topographical features (harbors, navigable rivers,
etc.), and available agriculturally productive land
2. Produced Assets – the currently available
machines, factories, and inventories of finished
goods available as industrial capital, as well as
social capital such as transportation and
communications infrastructure, and educational
institutions
3. Human Capital – the skills, education, and training
which individuals in the labor force possess
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 Quantity/quality of currently available resources
depends on both “natural events or chance” (e.g.,
mineral assets and climate of a country) and “past
actions of households, governments, and enterprises”
(e.g., industrial capital, social capital, and
education/training of workforce)
 Example: If we devote more resources to education
today, we expect to have a more highly skilled and
more productive workforce twenty years from now
 firms may be owned/operated either privately,
cooperatively (collectively, by a small group of
individuals – often the workers), or socially (by
society as a whole, through some government agency)
 firms are thought to behave as “rational decision
makers” – objective of privately owned enterprises is
“profit”
3.
Markets.
 a market is defined as the collection of all potential
buyers and all potential sellers of a good/service.
 the only institution of the four which is not a “decision
maker” => rather, “markets” are where much of the
interaction between the two primary institutions (of
households and firms) takes place
 in a subsequent topic we will develop and analyze the
model of supply and demand to explain how buyers
and sellers interact with one another in a “free market”
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4.
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Government.
decision making institution with the legal authority to
impose restrictions or mandates on the behavior of
other decision-makers (i.e., to use legal coercion)
at a minimum, government plays a critical role in
defining and enforcing property rights and contracts
(tasks which are essential for markets to function)
additionally, government often: regulates the behavior
of business; provides certain goods/services (e.g.,
education, health care); redistributes income
 “government versus markets” => as government
plays a larger role in economic matters, it very often
follows that fewer decisions are made by
households and firms in markets
 scope of government varies greatly across societies
(even in “free-market” societies government has a
key role in answering the “Three Fundamental
Questions”)
government is responsible for the establishment and
enforcement of laws => laws of significance for the
functioning of an economy include:
 Establishment/enforcement of contracts
 Definition of property rights
 Bankruptcy law
 Obligations under the tax system
 Environmental regulations
 Health codes
 Labor laws/regulations
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 As noted above, in order to markets to function
property rights and contracts must be clearly defined
and enforced (a task which can only be done by
government).
 Contract – a legal document which specifies what
different parties must do, whatever the external
circumstances, and provides enforcement or
compensation for non-performance.
 Recognize that many long term economic
relationships are possible only when agents can enter
into binding agreements
 Example: Airbus A380 (“superjumbo jet” that can
hold up to 853 passengers)
 began market research in 1991; manufacturing starts
in 2002; first unit delivered (to Singapore Airlines)
in 2007
 Airbus manufacturers the plane, but does so by
using many pieces made by others (Messier-Dowty
makes the forward landing gear; Rolls-Royce makes
the engines; Goodrich makes the body/wing landing
gears and evacuation systems)
 Without contracts, such mutually beneficial long
term relationships would not be possible
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Types of Economic Systems…
 The fundamental, defining attribute of an economic
system is the answer to the question of “Who owns
and/or decides how to use the means of (or factors of)
production?”
 The two predominant systems today are
Capitalism – economic system in which the means of
production are privately owned and operated for a profit
 i.e., capitalists freely decide how to use, and
subsequently get to keep the surplus generated by, the
factors of production that they own.
 e.g., Singapore, New Zealand, Hong Kong
Socialism – economic system in which the means of
production are owned by the government.
 i.e., the government decides how to allocate productive
resources across different, competing uses.
 e.g., Venezuela, Cuba, North Korea, former Soviet
Union
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Overview of Capitalism:
The precursor to Capitalism was Feudalism
Feudalism – economic system in which land ownership is
restricted to an aristocratic nobility
 ownership initially acquired by conquest or inheritance
 society divided between nobles at the top and
serfs/peasants at the bottom
 capitalism replaced feudalism as the “pool of potential
land owners” was expanded both formally and
informally
Capitalism is defined by private ownership of resources,
and relies upon decentralized decision making in free
markets to allocate productive resources
Private Ownership of Property – consists of the
following three interlocking sets of rights which are
collectively termed Property Rights:
1. “right to control” – the right to decide how to use
your property
2. “right to transfer” – the right to obtain ownership
of property from or relinquish ownership of
property to another person
3. “right to restitution” – the right to be compensated
by another person when he damages your property
or infringe upon your rights
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Capitalism relies heavily upon individual decision making
in free markets…
Consumer Sovereignty – the freedom for an individual to
choose to purchase (or to choose to not purchase) a good or
service at a price determined in a free, unfettered market
 example: 7,761 Chevy Volts produced/bought in 2011
 similarly, “firm sovereignty” and the “pursuit of profit”
are significant for determining what goods and services
are provided in a free market
Adam Smith
 18th century Scottish economist (1721-1790)
 “An Inquiry into the Nature and Causes of the Wealth of
Nations” (1776) => laid out the central arguments for
why private ownership/control of resources and trade in
free markets often result in “desirable outcomes”
 Invisible Hand: under certain conditions, the behavior
of self-interested decision makers interacting in free
markets will tend to lead to outcomes which are “better”
for all parties
 For each individual, the market outcome is better than
the outcome associated with “individual economic
isolationism”
 Any possible alternative to the market outcome would
be less desirable than the market outcome for some
individuals in society
 “Free Market Forces” are the “invisible hand” that
leads us to an outcome that is “efficient” (in that the
total economic surplus of society is maximized).
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Overview of Socialism:
Socialism is defined by government ownership of
resources, and relies upon centralized decision making to
allocate productive resources
Karl Marx
 19th century German philosopher, economist, and
revolutionary (1818-1883); the most influential
economist in the history of socialism
 Wrote “Capital: Critique of Political Economy, Vol. 1”
(1867) [a.k.a., “Das Kapital”]; co-wrote “The
Communist Manifesto” (1848) with Friedrich Engels
Following the industrialization of the early 1800’s, Marx
observed what he believed to be growing inequities
between the bourgeoisie (i.e., business owners) and the
proletariat (i.e., working class).
 Marx believed that the proletariat were exploited by the
bourgeoisie
 business owners were realizing an ever increasing
share of profits, even though the workers were the
ones actually creating the output
 counterargument: (i) relationships between workers
and firms were voluntary and (ii) firms could not even
exist if not for the risk taking and initiative of the
bourgeoisie
 solution was for government to abolish private
ownership of property => have the state seize the
wrongfully accumulated property and assets of the
bourgeoisie, thereby destroying the capitalist system
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Marx’s name is more commonly associated with
Communism (not Socialism). What is Communism? How
does it differ from Socialism?
Communism – Economic system in which the means of
production are collectively owned by all of the people in a
society (without intervention by a government or state).
 a stateless, classless economic system in which all the
factors of production are owned by the workers and
people share in production according to their needs
 “From each according to his ability, to each according
to his need” (quote by Louis Blanc in “The
Organization of Work,” 1839)
 Marx believed Communism was the natural, ideal system
and would evolve after Socialism replaced Capitalism
 people were naturally good and would not be
motivated by selfish greed once Capitalism was
destroyed
 long term, the state/government could simply fade
away once it was no longer needed
 Marx’s “communist ideal” remains a theoretical
construct, having never truly been implemented in
practice; systems of Cuba, North Korea, and former
Soviet Union more accurately match the definition of
Socialism
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In practice, the “essential feature” of…
 …Capitalism is decentralized decision making in free
markets, which relies greatly upon “individual choice”
 …Socialism is centralized decision making by some
branch of government, which requires “planning”
“Planning vs. Markets”
 “Planning” – the government determines (or imposes
policies which determine) the answers to the “three
fundamental economic questions”
 “Free Markets” – rational actions of self-interested
decision-makers lead to a set of outcomes, and therefore
indirectly answer the “three fundamental economic
questions
Two different “degrees” of planning:
 Command Planning: government directly controls
nearly all economic activity, and almost all production
takes place within enterprises owned/controlled by the
government. (e.g., former Soviet Union)
 Indicative Planning: government guides the behavior of
individuals in regards to economic decisions by
establishing policies which alter costs and benefits.
 Alec Nove described Indicative Planning as “when the
state uses influence, subsidies, grants [and] taxes [to
influence economic decisions] but does not compel.”
 Process often entails the establishment of guidelines,
regulations, and measurable targets, jointly formulated
by government and industry.
 Planification in France; “Ministry of International
Trade and Industry” in Japan; tax credits for Chevy
Volts in the U.S.
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Different types of Economic Incentives:
 Economic systems differ in regards to the types of
incentives they rely upon to influence behavior
Types of Economic Incentives – three different types of
incentives (“increased benefits from taking an action” or
“increased costs from not taking an action”):
i. material rewards – monetary rewards or direct
increases in consumption which result from engaging
in an activity [market economies rely heavily upon
material incentives]
ii. moral suasion – attempts to convince individuals to
behave in a certain manner because doing so is “the
right thing to do” [found to be quite effective in the
short term: soldier on the battlefield]
iii. coercion – the use of force or intimidation to obtain
compliance [between 1934-1953, 18.75 million
people spent time in forced labor concentration camps
in the former USSR]
Example: Attempting to obtain information regarding a
potential terrorist attack on our homeland. We could
conceptually use each of these three types of incentives:
material reward – offer a monetary reward to anyone
providing information that is found to be reliable
moral suasion – convince the citizens of our country
that providing information on suspected terrorists is
“the right thing to do” (i.e., doing so is your “patriotic
duty”)
coercion – inflict or threaten to inflict physical harm
on someone withholding useful information
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In practice, no society has an economic system which
exactly matches the above description of either Capitalism
or Socialism. Rather, almost every economy has some
elements of Capitalism and some elements of Socialism,
and is therefore better described as a…
Mixed Economy – economic system in which most factors
of production are owned and controlled by individuals,
while some factors of production are owned and controlled
by the state
 i.e., an economic system which contains some
elements of Capitalism and some elements of
Socialism => the use of some resources is determined
primarily by individuals, while the use of other
resources is determined primarily by government
 In reality, almost every economy is a “Mixed
Economy,” somewhere on the continuum between
“Pure Capitalism” and “Pure Socialism” (rather than
at “either extreme”)
Mixed
Economy
Pure
Socialism
Russia
Venezuela
Former
Soviet Union
Cuba
North Korea
Pure
Capitalism
Singapore
France
U.K.
U.S.
New
Zealand
Germany
Israel
Canada
China
Hong Kong
Spain Switzerland
Poland
Australia
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Measuring the Differences between Economic Systems:
How can we measure “where an economy is along the
spectrum between pure capitalism and pure socialism”?
Structural Measures – attempt to gauge differences in the
economic institutions, rules, or structure of the economic
system that a society has in place
“Economic Freedom of the World” (2009) – developed
by the Frasier Institute; four essential dimensions of
economic freedom (“personal choice,” “voluntary exchange
coordinated by markets, “freedom to enter and compete in
markets,” and “protection of persons and their property
from aggression by others”).
- Part of ranking reported in Table 3.1 on Page 37 of the
“Economics” textbook (total of 141 countries on list).
1.
2.
3.
6.
8.
10.
21.
42.
53.
54.
75.
81.
92.
94.
125.
138.
139.
141.
Hong Kong
Singapore
New Zealand
Canada
United Kingdom
United States
Germany
France
Poland
Spain
Mexico
Russia
China
India
Ukraine
Angola
Venezuela
Zimbabwe
9.01 (most free)
8.68
8.20
7.81
7.71
7.60
7.45
7.16
7.00
6.99
6.74
6.55
6.43
6.40
5.70
4.76
4.28
4.08 (least free)
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“International Property Rights Index” (2011) – attempts
to measure the “significance of both physical and
intellectual property rights and their protection for
economic well-being; three different dimensions (“legal
and political environment,” “physical property rights,” and
“intellectual property rights”)
- Part of ranking reported in Table 3.2 on Page 38 of the
“Economics” textbook (total of 129 countries on list).
1.
1.
3.
4.
9.
13.
15.
18.
33.
Sweden
Finland
Singapore
New Zealand
Canada
Germany
United Kingdom
United States
Spain
8.5 (most)
8.5 (most)
8.3
8.2
8.0
7.8
7.7
7.5
6.5
43.
60.
71.
87.
93.
117.
125.
128.
129.
Poland
China
Egypt
Argentina
Russia
Ukraine
Angola
Zimbabwe
Venezuela
6.2
5.5
5.2
4.7
4.6
4.0
3.6
3.5
3.4 (least)
“Ease of Doing Business” (2012) – study by the World
Bank the International Finance Corporation which
measures the costs (in both money and time) of complying
with bureaucratic regulations (e.g., paying taxes, enforcing
contracts, and obtaining construction permits)
- Part of ranking reported in Table 3.3 on Page 40 of the
“Economics” textbook (total of 183 countries on list).
1.
2.
3.
4.
7.
13.
19.
29.
44.
53.
Singapore (easiest)
Hong Kong
New Zealand
United States
United Kingdom
Canada
Germany
France
Spain
Mexico
62.
87.
91.
120.
132.
152.
171.
172.
177.
183.
Poland
Italy
China
Russia
India
Ukraine
Zimbabwe
Angola
Venezuela
Chad (most difficult)
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