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. Households2. Firms3. Markets4. Government

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1. 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

2. 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”

4. Government.

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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).

Overview of Socialism:

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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 reliablemoral 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”)

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Pure Socialism

Pure Capitalism

Mixed Economy

FormerSoviet Union

North Korea

Cuba Germany

Spain

U.S.U.K.

Hong Kong

Singapore

New Zealand

IsraelChina

Australia

CanadaSwitzerland

France

Poland

RussiaVenezuela

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. Hong Kong 9.01 (most free)2. Singapore 8.683. New Zealand 8.206. Canada 7.818. United Kingdom 7.7110. United States 7.6021. Germany 7.4542. France 7.1653. Poland 7.0054. Spain 6.9975. Mexico 6.7481. Russia 6.5592. China 6.4394. India 6.40125. Ukraine 5.70138. Angola 4.76139. Venezuela 4.28141. Zimbabwe 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. Sweden 8.5 (most) 43. Poland 6.21. Finland 8.5 (most) 60. China 5.53. Singapore 8.3 71. Egypt 5.24. New Zealand 8.2 87. Argentina 4.79. Canada 8.0 93. Russia 4.613. Germany 7.8 117. Ukraine 4.015. United Kingdom 7.7 125. Angola 3.618. United States 7.5 128. Zimbabwe 3.533. Spain 6.5 129. Venezuela 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. Singapore (easiest) 62. Poland2. Hong Kong 87. Italy3. New Zealand 91. China4. United States 120. Russia7. United Kingdom 132. India13. Canada 152. Ukraine19. Germany 171. Zimbabwe29. France 172. Angola44. Spain 177. Venezuela53. Mexico 183. Chad (most difficult)

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