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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.

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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 Principala party that has controlling authority & that engages an agent to act subject to the principal’s control& instruction.Agenta party that acts for, on behalf of, or as a representative of a principal.

• Information problems: Opportunistic behaviorwhen 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. PLANDefinition: 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.

MARKETa) Market economythe 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 planningthe market is the principal instrument for resource allocation, but a plan is prepared to guide decision-making

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PLAN MARKET

DECISION-MAKERS planners consumers

planners’ preferences consumer sovereignty

Disequilibrium Equilibrium

S (planned)

DP*

X* X**

DP’

X’

S

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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: Dictatorshippublic choices are made by a person or small group of persons who make the significant political decisions of a society

Democracy:Pureevery public choice is put to a vote and the majority carries the issue.Representativethe 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 OutcomesEconomic 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 Criteriaa. 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

consumer goods consumer goods

Economy grows when its production capacity increases

(outward shift of PP curve)

Capital Capital

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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 PCI (straight) PCI (PPP)

Switzerland $58,084 $41,128

Japan $34,312 $33,577

USA $45,845 $45,845

Norway $83,922 $53,037

Germany $40,415 $34,181

Brazil $ 6,938 $ 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.