1. Chapter 3
The Mixed Economy
Chapter 3

2. Learning Objectives After this chapter you should be able to:
List and explain the three questions of economics.
Explain the concepts of the profit motive, the price mechanism, competition, and capital.
Analyze the circular flow model.
Describe and illustrate market failure and externalities.
Describe and explain government failure.
Discuss the economic role of capital and its importance.
Define and describe the “isms”: capitalism, fascism, communism, and socialism.
Summarize and explain the decline and fall of the communist system.
Discuss the economic transformation of China.

3. The Three Questions of Economics
Because scarcity is the central economic problem, an economy cannot produce everything for everybody.
Every economic system therefore must provide mechanisms to answer these three questions:
What shall we produce?
How shall these goods be produced?
For whom shall these goods be produced?
These are questions about how to allocate scarce resources.
The first two questions involve production.
The third question is about distribution.

4. How Capitalism Answers the Three Economic Questions
What to produce?
The private sector is guided as if by an “invisible hand,” a metaphor for the way markets operate.
This does not include central planning! Government does not decide (except for public goods and services).
How to produce?
Competition among sellers leads to efficiency.
For whom?
Most goods and services are distributed based upon the ability to pay.
Those who can afford, purchase the goods and services that they value.

5. What the U.S. Economy Produces Has Changed Over Time

6. The Invisible Hand Adam Smith coined this term.
The invisible hand is a metaphor for an economic guidance system that leads to desirable economic outcomes.
Desirable outcomes are defined as efficient production to maximize production (on the Production Possibilities Curve).
The invisible hand is made possible by people pursuing their own self-interest.
Businesses pursue profits and consumers pursue satisfaction of their wants.
The price mechanism guides the invisible hand.
Prices send signals to producers and consumers.
When consumers want a product, the price goes up, providing the incentive to businesses to increase production.

7. Competition
Competition forces firms to be as efficient as possible. They can charge the lowest possible prices to get people to buy their goods and services.
This process answers the question, “How to produce?”
To have competition, you need many firms in a particular industry.
You need enough so that no one firm is large enough to have any influence over price.
When sectors of American industry are not very competitive the price system doesn’t work well.
The invisible hand becomes less active and more ineffective.
The forces of supply and demand are distorted.

8. The U.S. is a Mixed Economy
The United States:
has an imperfectly functioning price system.
functions in a less than competitive economy.
is guided by a not too vigorous invisible hand.
Rather than a pure form of capitalism, we use governments as well as markets to allocate resources.

9. Trust Capitalism is based on trust.
Lenders expect borrowers to pay back loans.
Buyers and sellers expect contracts to be honored.
Workers expect to be paid by employers.
If we do not trust that these agreements will be honored, the economy will not function.
Self-interest can lead economic actors to behave in a trustworthy manner, so they can continue to do business.
The legal system reinforces trust by providing consequences for dishonest behavior.

10. Equity & Efficiency Markets can be efficient, without seeming “fair.”
The threat of poverty provides incentives to work hard which can lead to efficiency.
Too much inequality can be a disincentive to hard work.
Efficiency can be balanced by equity.
Should we tax those with higher incomes and redistribute to the needy? How much and who do we tax?
Should we allocate some goods and services regardless of the ability to pay? Examples include public schools, public housing, & food stamps.

11. Questions for Thought and Discussion
Does it make sense that self-interest is enough to create a well-functioning system?
What rules need to be in place to allow the invisible hand to work its magic?
How were the three economic questions answered by hunter-gatherer societies?
Can you think of goods or services that are not allocated according to our ability to pay? What is the reasoning behind these alternative allocation mechanism?
Why aren’t organs for transplant sold to the highest bidder?

12. Modeling a Market Economy without Government: Circular Flow Diagram
Resources are owned by households, who sell them to business
firms for wages & salaries, rent, interest, and profits.

13. The Flow of Goods & Services
Businesses use these resources to produce goods and services
that they sell back to households.
Households use the income they received from selling their
resources.

14. The Circular Flow Model
The model has two flows: (1) a flow of money and (2) a flow of
resources, goods, and services.

15. Economic Role of Government
Government is
Federal
State
Local
Each level of government:
Collects taxes.
Provides services.
Make laws and regulations.
Government alters the outcome of the three questions:
What? How? and For Whom?

16. Economic Role of Government
A mixed market system needs government in order to function effectively.
The government should:
Protect property rights.
Without property rights, the rest will not matter much.
Provide the infrastructure for a market to function efficiently.
Ensure that competition flourishes.
See that information flows freely.
Minimize side effects of economic activity such as pollution.
The appropriate size and functions of government depends largely on how well private enterprise does the job of efficiently allocating resources.

17. Market Failure
Market failure is when our resources are not allocated efficiently by the private sector using the price mechanism.
The profit incentives in private markets may yield too many socially undesirable outcomes.
The profit incentives in private markets may yield too few socially desirable outcomes.
Types of market failure include:
Externalities and environmental pollution.
Lack of public goods and services
Another cause of market failure is when large firms crowd out competition.
Government intervenes when markets fail.

18. Negative Externalities
Negative externalities are external costs.
“External” means affecting a third party who is not the buyer or the seller.
For Example:
You may satisfy your individual want by driving an inefficient vehicle that pollutes.
The seller has a profit motive to sell you the car you want.
The price you pay for the vehicle and gas will cover the costs of production for the seller and a profit, but not the costs of pollution on other peoples’ health and well-being.
The market price is lower than the true social cost.
Government can discourage negative externalities by taxing them or limiting them.

19. Two Approaches to Environmental Regulations
Command-and-control regulations
Government limits market choices.
fuel economy standards for new cars
ban on leaded gasoline
Incentive-based regulations
Government influences market choices by making some options more costly.
taxes on gasoline
tradable emissions rights

20. Positive Externalities
Positive Externalities are external benefits.
Example:
If you pay someone to paint your house, your neighbors will benefit.
If you do not paint your house, it will lower your neighbors’ property values.
The social value of painting your house may be greater than what you are willing to pay.
Government can encourage positive externalities by subsidies or regulations.
The federal government subsidizes student loans because society benefits from more college graduates.
Local governments may have regulations requiring you to maintain your property.

21. Public Goods and Services
Public goods and services are supplied by government because entrepreneurs could not make a profit by selling them.
Characteristics of public goods and services:
Non-excludable: once it exists, everyone can freely benefit from it.
There is no way to exclude anyone from consuming the goods even if she/he did not pay for them.
Tend to be indivisible or come in large units that cannot be broken into pieces for purchase or sale in the private market.
No rivalries: one person’s benefiting does not reduce the amount of it available for others.
Private goods are consumed by an individual.
After I eat my ice cream cone, it cannot be eaten by anyone else!
rival

22. Examples of Public Goods and Services
national defense
court system
police and fire protection
construction and maintenance of infrastructure including streets, highways, bridges, and water and sewer mains
environmental protection
public parks
public schools
public libraries
A public bus is not a public good:
Individuals can be excluded if they do not pay.
Government provides public transportation because it has positive externalities.

23. Government Failure
Government can fail to allocate resources efficiently and to meet desirable social goals.
Sometimes government is slow and bureaucratic or its programs continue even when not meeting objectives.
Examples:
The complex and confusing income tax code that creates inefficient need for professional tax preparers and others to process forms.
The agriculture price support system that was intended to save family farms but most payments go to huge corporate farms.
Despite a “War on Poverty,” 39 million Americans, mostly children, are still in poverty.

24. Questions for Thought and Discussion
Give an example of when government might be involved in answering each of the three economic questions: 1. What to produce? 2. How to produce? 3. For whom?
If a factory is polluting and producing its product cheaply, who are the third parties affected by this externality and how are they affected? How might the government approach this problem?
If people are under-purchasing higher education, who are the third parties affected by this positive externality and how are they affected? How might the government approach this problem?
What kinds of regulations affect the market for cigarettes? Why does government regulate this market?

25. Capital
Capital is the CRUCIAL element in every economic system.
Remember: capital consist of plant, equipment, & software.
Capital is the key to economic development and raising a country’s standard of living.
Countries who invest in capital have higher rates of economic growth.
Capital increases productivity.
Example:
U.S. farmer produces 10 – 20 times as much output as a Nigerian farmer because of the use of tractors, harvesters, and reapers.

26. Where does capital come from?
Capital comes from:
cutting consumption
increasing production
Examples:
In industrializing Europe, the low wages and barbaric conditions for factory workers enabled factory owners to invest in better capital.
In Soviet Union, communist government invested in capital and there were few consumer goods available for purchase.
After World War II, Japan and Western Europe focused on capital investments rather than consumption.

27. The “Isms”
Capitalism
There is private ownership of most means of production.
The profit motive moves individuals to produce.
The price system guides production.
The government’s role is kept to a minimum.
Most capitalist countries are political democracies, but the two systems do not always co-exist.
“The vice of capitalism is that it stands for the unequal sharing of blessings; whereas the virtue of socialism is that it stands for the equal sharing of misery.”
—Winston Churchill

28. The “Isms” Communism There is no private property.
At first, the state owns everything. Government planning committees dictate:
What is produced.
How it is produced.
For whom it is produced.
Prices no longer send signals about what consumers want.
Eventually, the state would “wither” away and workers would make economic decisions collectively.
“The theory of the Communists may be summed up in the single sentence: Abolition of private property.”
 Karl Marx & Friedrich Engels

29. The “Isms” Fascism Fascists have been virulently anti-communist.
Also called corporatism because corporate and state power are merged.
There is private ownership of the means of production, but strong role for government planning.
Government power is centralized.
Fascism is characterized by a one-party state, militarism, suppression of economic freedom, and intolerance of political opposition.
Fascists have been virulently anti-communist.

30. The “Isms”
Socialism
There is government ownership of some means of production but most are privately owned.
There is a substantial degree of government planning and provision of public goods and services.
Con: High taxes.
Pro: Promises cradle to grave security to protect citizens from fluctuations of market economies.
Some European countries are democratic socialist systems.
Soviet Union was sometimes called state socialist instead of communist.

31. For Example… Socialism Communism Fascism Capitalism
You have two cows; the state takes one and gives it to someone else.
Communism
You have two cows; the state takes both of them and gives you milk.
Fascism
You have two cows; the state takes both of them and sells you milk.
Capitalism
You have two cows; you sell one and buy a bull.

32. Transformation in China
1949–1979
The Chinese economy was dominated by Soviet style central planning.
Late 1970s–early 1980s
Reform began in the industrial sector.
State firms were allowed to sell any surplus output.
Family-run enterprises were allowed.
The government shifted the responsibility of operating huge collective farms to the families who lived on the farms.
The families could lease the land for 15 years.
Output above the government quota could be sold.
Output jumped 60%.

33. Transformation in China
China has become a world-class industrial power.
In 2012, China had a $315 billion export surplus to the U.S.
Old communist credo
“From each according to his ability, to each according to his needs.”
New Credo
“More pay for more work; less pay for less work.”
China operates basically as a capitalist economy with a strong state, although it is still defined as Communistic.
Presently, over 2/3 of its population lives in rural areas and the standard of living is still poor.

34. Questions for Thought and Discussion
How does capital explain productivity differences between countries?
Contrast Marx’s view of the exploitative capitalist with the mainstream economic view of the economic role of the entrepreneur.
What does “the bridge to nowhere” project tell us about the efficient allocation of scarce resources? Is it an example of market failure or government failure?