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)


“bible” of Capitalism
Let the people
decide the 3 basic
economic questions

Profit and PSYCHIC
INCOME will make us
work.
Specialization

Adam Smith’s PIN
EXAMPLE:


Specialization leads
to increased
production
Specialization leads
to the need to trade.
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)
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.
Absolute Advantage
Orlando has
absolute advantage
over Lincoln in citrus
production.
 Zambia has absolute
advantage over the
US in copper
production.

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.
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.
Ricardo: The tricky road of
comparative / absolute advantage

Some have an
absolute
disadvantage.
They are
inefficient in
producing
anything, relative
to their trading
partners
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.
HUH?????

Country A has an
absolute
advantage in the
production of
both maize and
wheat.
HUH???

Country B has an
absolute
disadvantage.
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.
HUH????

Perhaps common
sense tells us that
Country A should
produce both
goods and export
surpluses and
Country B neither.
BUT

However, when
comparative
advantage is
considered a
different story
emerges.
CONSIDER THIS:

Consider the
opportunity cost
of Country A
producing one
more unit of
maize. Half a unit
of wheat has
been foregone.
CONSIDER THIS:

When country B
produces one
more unit of
maize two units
of wheat are
foregone.
REMEMBER:

Economics is
concerned with
the allocation of
scarce resources.
If we assume that is true,
THEN ….

Fewer resources
are foregone if
Country A
concentrates its
resources in the
production of
maize
Now consider …

the opportunity
cost of Country B
producing one
more unit of
wheat. Two units
of maize have
been foregone.
Now consider …

When Country B
produces one
more unit of
wheat only half a
unit of maize is
foregone.
So if that is true ….

Fewer resources
are foregone if
Country B
specializes in the
production of
wheat
CONCLUSION OF
COMPARATIVE ADVANTAGE

In the above case
Country A should
produce maize
and Country B
wheat. The
surpluses produce
should then be
traded.
Comparative Advantage
creates
A. Headaches
 B. Interdependence
 C. Coordination
problems
 D. Only B and C

Interdependence
Makes producers
dependent on others
for the goods they
don’t produce.
 Creates PEACE

BUT: Interdependence can
create coordination problems
Specialization causes
interdependence.
 Interdependence
requires an
economic system to
coordinate
everyone’s various
activities.

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.
Consider:
What countries does
the US / Europe
have “troubles”
with?
 How much trade do
we have with these
countries?




North Korea
Iran
Middle East
What are the Principal Types
of Economic Systems?
Market Economies
 Centrally Directed Economies
 Traditional Economies
 Mixed Economies

Market Economies

Also called



Capitalism
Free Enterprise
Private Enterprise
Market Economies:
Fundamental Principles
Private property
rights
 Right to freely trade
or sell property
 Pursue self-interest.

Centrally Directed Economies

AKA



Command
Economies
Marxist Economies
Communist
Economies
Features of Central Planning
Decisions made by
central planning
commission
 Draws up “master”
plan
 Government
employs workers

Features of Central Planning

Decides what, how
and for whom to
produce.

Determines how
output is to be
distributed
Features of Traditional
Economies
Relies on custom
and tradition to
decide the 3 basic
economic questions.
 Very strong in nonindustrialized
countries.


India is not a great
example in 2005.
Mixed Economies
AKA: Socialism
 All economies are
mixtures of
government control
and individual
motivation.

Mixed Ecnomies

US: BASICALLY
market economy

SOME government
regulation and
ownership.
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.
Mixed Economies

Former Soviet Union


Economy in
transition.
Return of
centralization???

But under Communist
control or the Mafia?
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
Incentives in Market Economy
$$$$$$$$$$$$$
 Psychic Income

Incentives in a Market
Economy

Price changes give
incentives to change
current production
2 Types of Markets
Product Market
 Factor Market

Product Market

Finished goods and
services exchanged
in product markets
Factor Markets

Land, labor, capital
resources
exchanged in the
factor markets.
Circular Flow of the Economy
Resource owners
provide land, labor,
and capital to
business firms.
 Business firms
provide finished
goods and services
to households.

Circular Flow of the Economy

Firms pay
households for
factors of
production.



Rent for land
Wages and salaries
for labor
Interest for financial
capital
Circular Flow Diagram

Outer circle shows
flow of “real” inputs
and outputs.
Circular Flow Model

Inner circle shows
money payments for
imports and outputs.