answer: "C" a price system

Chapter 2 - The Market System and the Circular Flow



Reading Assignments:

Brief Outline


Before we begin, please log on to Blackboard and post your answer to the following question on the Weekly Assignments Survey for Week 2/Chapter 2. There is no need to study. What I want is your initial thoughts or opinion.


Should We Have Free Trade With Other Countries?
A. Yes

B. No

C. Other. Please explain on the Discussion Board

By "free trade" I mean that our government doesn't try to restrict trade through taxes or other means.

Structural Adjustment Programs / Globalization


Entrepreneurs Emerge As Cuba Loosens Control
National Public Radio (NPR), Morning Edition, September 20, 2011

"Since Cuba's communist government loosened its grip on the economy, thousands of small private businesses have sprung up. It's a new frontier for budding capitalists, but competition is fierce and advertising is still tightly restricted."

Major economic changes have been occurring in the last few decades. Countries all around the world, including the United States are currently engaged in a process of globalization, or structural adjustment. This includes, among other things, moving toward free trade. Globalization and the removal of trade barriers is occurring now and it will continue to occur. In the previous lecture it was mentioned that much of what we hear in the popular press is contrary to what we are going to learn in this course. This is very true when discussing globalization. For example, read the following quotes from the CNN news article: Dobbs: New Congress must show courage [].

Lou Dobbs, CNN News commentator and best-selling author, says:

Then read the following quotes taken from our textbook:

Recently, a few countries in South America have begun to move away from capitalism and toward socialism. Listen to the following five minute radio news article:

A View of Venezuelan Nationalization

  • Go to:
  • Click on: "Listen"

    Weekend Edition Saturday, January 13, 2007 - In the global economy where more and more capital is held in private hands or by publicly-traded companies, the South American nation of Venezuela seems to be bucking the trend.

    This week, as he assumed power for a second six-year term, President Hugo Chavez announced that Venezuela will nationalize firms in two major sectors of the economy — telecommunications and electricity. [NOTE: "nationalize" means that the government is going to take over these businesses.]

    And some companies in those sectors have shareholders in the United States, including Verizon, which owns a large stake in the Venezuelan telecom giant, CANTV.

    Economist Moises Naim, a former minister of trade and industry in Venezuela (and now editor of Foreign Policy magazine, reviews the implications of Chavez's plan with Scott Simon.

    As you listen:

    • "Nationalization" means the government "takes over", or buys, private companies
    • Will nationalization improve services and efficiency?
    • Would it be better for a company to be locally or government owned, than owned by foreigners?


No wonder students are often confused. They hear one thing in the popular press and are told the opposite in their college economics courses. If that isn't confusing enough for students new to economics, the news media also carries reports of protests, sometimes violent, against many of the policies of globalization and structural adjustment that economists support. In chapter 20 we will learn that the inefficiencies of protectionism (restricting trade between countries) have encouraged countries to seek ways to promote free trade. In 1993 they established the World Trade Organization (WTO). In 2006, it had 149 member countries. The latest round of negotiations (called the Doha Round) started in Doha, Qatar, in late 2001 and ended in July, 2006 in Geneva, Switzerland without a new trade agreement . Meetings of the WTO have become a target for protests by groups who are against various aspects of globalization. The WTO became well known in November 1999, with the sometimes violent protests of the WTO meeting in Seattle and they have been at WTO meetings ever since.

(See: )

Protesters at those meetings included labor unions, environmental groups, socialists, anarchists, and a few other, more specialized interests. Protesters called for international trade rules to include collective bargaining rights, minimum wages, workplace safety standards, and prohibition of child labor. Supporters of the WTO would say that the objectives of the protesters to achieve better conditions for labor and the environment are noble, but will best be achieved by strong economic growth and improved living standards achieved by freer trade and other globalization policies.

Are you confused?

Let's begin with a little review. We have defined economics as the study of how people CHOOSE to use LIMITED RESOURCES to obtain the MAXIMUM SATISFACTION of UNLIMITED human WANTS

The GOAL of economics then is to reduce scarcity and to maximize society's satisfaction, i.e. achieve the 5Es. 

To deal with scarcity (and we all must because our wants are unlimited) we must make choices - personal choices, or collective choices in the form of government economic policies. This brings us to the global economy. Governments all over the world are choosing to reduce scarcity by undertaking structural adjustment programs or SAPs (sometime more broadly defined as "globalization".)

What is Structural Adjustment?

Definition: Structural adjustment is a series of economic policies designed to lessen the role of government in an economy and move it closer to a market economy.

The goal of SAPs is to reduce scarcity and increase society's satisfaction -- to satisfy more of their unlimited wants (achieve the 5Es)..

Economic Systems

Structural adjustment, or globalization, involves a change in the economic system. An economic system is the way a country deals with scarcity. Because of scarcity all economies (and individuals) must make choices. The authors of our textbook have identified five fundamental questions (choices) that scarcity forces a country to answer:
The 5 Fundamental Questions:
  1. What will be produced?
  2. How will goods and services be produced?
  3. Who will get the output?
  4. How will the system accommodate change?
  5. How will the system promote progress?

A Continuum

Even though we will list and describe the "types" of economic systems, we must understand that in reality every country's economic system is unique. So there are nearly 200 hundred different economic systems. It is best to think of a continuum of types of economic systems. Each one is slightly different from its neighbor on the continuum. Some are more like pure command economies (one extreme). Some are more like pure market or capitalist economies (the other extreme). ALL have varying characteristics of each and are therefore called MIXED economies.


So the economy of the United States would fall close to the "Pure Capitalism" end of the continuum and that of Cuba would be close to the "Command Economy" end, and most other countries would fall somewhere in between.


In order to place an economic system on our continuum we need to define the different types of economic systems. To do this we need to identify some criteria. Economist use two criteria to define an economic system:

  1. WHO OWNS? (Who owns the resources?)
  2. WHO DECIDES (Who makes the basic economic decisions or answers the five fundamental questions?)

Types of Economic Systems

Based on this criteria, economists have identified three types of economic systems

  1. Pure Capitalism
  2. Command Economy
  3. Mixed Systems


    Pure Capitalism:

    private ownership
    the market system

    Command Economy:

    government ownership
    centralized (or gov't) decision-making

    Mixed Economy

    some private and some government
    some private and some government

Pure capitalism (often called a "market economy") is an economic system where private individuals (not the government) own the resources (factories, mines, businesses, etc.) and the MARKET makes the decisions. When we say "the market decides" we really mean that CONSUMERS make the decisions. Who decided to produce more music downloads and fewer CDs? I would say that consumers "voted" for downloads with their purchases (sometimes these are called "dollar votes"). We wanted to buy more music downloads and were willing to pay more for them, therefore business simply responded to this decision. This is called "consumer sovereignty" - the consumer is sovereign, or the ruler, and makes the decisions. In a capitalist economy the market answers the five fundamental questions.

A command economy is one where the government owns the resources (industries, natural resources, stores, farms, factories, etc.) and the government makes the decisions. The government answers the five fundamental questions. Many people call command economies "socialism" or even "communism".

In reality, ALL ECONOMIC SYSTEMS ARE MIXED SYSTEMS. Pure market economies and pure command economies do not exist. They are the extremes. All systems are mixed - but some lean more toward command economies (like Cuba) and others are closer to capitalism (like the United States).

Structural adjustment then is moving the economy away from a command economy toward a capitalist economy. This involves less government ownership and less government decision-making and more private ownership and a greater reliance on market decision-making. We will discuss how the market makes decision later in this lecture and in the supply and demand chapter (chapter 3).


WHAT ARE THEY DOING? - Structural Adjustment Program policies

There are a great variety of policies that comprise Structural Adjustment. Here is a list of some of the most important ones:
  • Privatization - the selling of government owned industries to the private sector. This is a fundamental change that is occurring around the world - even in the United States.
  • Promotion of Competition - the word "competition" has a special meaning in economics, but here all we mean is that many firms compete with each other for your business.
  • Reduced Role of Government - but we are not saying no government. How much the government should get involved in the economy is currently an important political question, i.e. health care/insurance reform.
  • Removing Price Controls - As we will see, a fundamental part of structural adjustment is to allow markets to set prices rather than the government. If people are used to government controlled LOW prices they often oppose the removal of these price controls.
  • Freer Trade and Convertible Currency - another major change occurring worldwide is the removal of trade barriers. More on this later
  • Foreign Investment - along with free trade goes the free movement of capital.


We can assume that the governments that are undertaking structural adjustment programs want to improve the standard of living for their citizens. They hope to do this by achieving the 5Es of economics:
  • economic growth
  • productive efficiency
  • allocative efficiency
  • equity
  • full employment

They also want to achieve the macroeconomic issues of:

  • full employment
  • low inflation
  • economic growth

We will soon discuss whether they are achieving these goals.


Often, as countries begin to implement their structural adjustment policies, things get worse before they get better - or they get worse for some and better for others. Common problems associated, at least initially, with structural adjustment programs would include.
  • Inflation as the governments remove price controls
  • Rising unemployment as people are laid off from inefficient government owned enterprises resulting in falling output and lower living standards
  • Inequality and other social costs as some people gain but others lose


Although many people protest SAPs,


most economists, and governments, believe the benefits of greater efficiency achieved through globalization outweigh the costs.

Therefore all around the world governments are moving their economies from command economies towards capitalism. The goal of unit 1 is to learn some fundamental economic principles to help us better understand these changes.

Characteristics of a Capitalist Economy

To understand structural adjustment, we first must understand market economies (capitalism) and command economies (socialism).

A surprising number of students do not really understand the characteristics of the American market system. Many students have little idea how prices are set and even after the chapter on supply and demand (chapter 3) may still believe that most prices are determined by an external government agency or by producers arbitrarily.

So what are the characteristics of capitalism (or a market economy) towards which most countries are moving?

Basic Characteristics:

1. private property
2. freedom of enterprise and choice
3. role of self interest
4. competition
5. markets and prices
6. limited role for government

1. Private individuals and firms own most of the private property (land and capital).

Private property, coupled with the freedom to negotiate binding legal contracts, enables individuals and businesses to obtain, control, use, and dispose of this property. This encourages investment, innovation, exchange of assets, maintenance of property, and and therefore economic growth. Property rights extend to intellectual property through patents, copyrights, and trademarks.


China Considers Private Property Rights on National Public Radio

All Things Considered, December 22, 2003 · In Beijing, legislators propose an amendment to the Chinese constitution guaranteeing private property rights. The move has great symbolic importance in a country that is nominally communist, but whose people have been buying property and trading stocks for years as the result of economic reforms by Deng Xiaoping. NPR's Rob Gifford reports.

This is a very important characteristic. Would you rather have the government own and run business, or have them privately owned? Think about it. If the government owned all gasoline stations they might have the same operating hours as the Post Office does now - Monday through Friday 9:00 am to 5:00 p.m. and Saturday mornings. Would this be good for society?

2. Freedom of enterprise and choice exist.

Freedom of enterprise means that entrepreneurs and businesses have the freedom to be in business. which means that they can obtain and use resources, produce products of their choice, and sell these products in the markets of their choice.

Freedom of choice means:

  • Owners of property and money resources can use resources as they choose.
  • Workers can choose the training, occupations, and job of their choice.
  • Consumers are free to spend their income in such a way as to best satisfy their wants.

3. Self-interest

Self interest is one of the driving forces in a market system. Entrepreneurs try to maximize profits or minimize losses; resource suppliers try to maximize income; consumers maximize satisfaction. As each tries to maximize profits, income, satisfaction, the economy will benefit if competition is present.

This "self-interest" is very important. Although some people call it "greed", it is the driving force behind capitalism and fundamental in capitalism's success in achieving productive efficiency, allocative efficiency, and economic growth. "Greedy" business owners will produce at a minimum cost (achieve productive efficiciency) to increase their profits. Also, they will use the limited resources to produce what consumers want (achieve allocative efficiency) to also increase their profits.

Although it may seem odd that the selfish decisions of millions of people will result is a situation that is good for society as a whole, but that is what happens (see: Last Word: Shuffling the Deck: p. 41). Each individual business person and worker is out to do what is best for themselves. In chapter one this was called "purposeful behavior" (p. 4). everyone want to increase there own utility. So how does this help society as a whole?

How about an example? Let's say that you are driving to California and ahead of you is a 200 mile long stretch of desert. Let's assume that if you run out of gas along the way you could die (maybe a little too extreme, but play along with me). Would we want the government to be responsible for putting up a warning sign before you enter the desert telling you to fill up with gas now, or else? Would it be necessary for the government to take on this responsibility? Think about it. Wouldn't every gasoline station in the last town before the desert already have signs up? I think YES, because they are selfish and want your business. Let's say that the government and the gas station both have signs up warning you to buy gas now and a strong wind blows them down one night. Who would wake up early and get their sign up first - the gas station owner who is selfish and wants your business or the government employee?

Self interest is a powerful force and IF THERE IS COMPETITION IN AN ECONOMY it will result in improving the social good as if there is some "invisible hand" guiding their decisions.

4. Competition among buyers and sellers is a controlling mechanism.

In economics the term "competition" has a slightly different meaning than you may be used to. Many of you have already studied "competitive markets" in microeconomics. In economics, we are not talking about the competition that exists between Chevrolet and Ford. Here, competition means that there are:
1. Large numbers of sellers mean that no single producer or seller can control the price or market supply.

2. Large number of buyers means that no single consumer or employer can control the price or market demand.

3. Depending upon market conditions, producers can enter or leave industry easily.

This is a very important characteristic of a market economy. We will soon discuss how market economies achieve allocative and productive efficiency, thereby reducing scarcity and raising living standards. This is why governments are undertaking structural adjustment programs. BUT, if there is not competition, then market economies will be INefficient. For example, in the previous lecture we said that it is good for the people of Florida if the price of plywood increases from $10 to $30 after a hurricane. This is assuming that there is competition. If there were only one lumber company in Florida. After a hurricane it may be able to charge $50, $60, or maybe $70 for plywood. This would not be allocatively efficient. It would not maximize society's satisfaction. Market economies achieve efficiency only if there is competition. Adam Smith in a groundbreaking text which set the foundation for the field of modern economics in 1776 called The Wealth of Nations talked of the "invisible hand" which promotes public interest through a market system where the primary motivation is self interest. By attempting to maximize profits (self interest), firms will also be producing the goods and services most wanted by society.

5. Markets and prices

As we saw in the 5Es lecture getting the price right is necessary if we want to achieve allocative efficiency. We will discuss HOW prices are set in a market economy in chapter 3. Here we need to understand the important roles that prices play. Prices guide resources and ration goods and services. We have already discussed how the increase in the price of plywood after a hurricane in Florida causes people in other states to load up their trucks with plywood and drive to Florida (GUIDING RESOURCES). We also discussed how the high plywood prices would discourage consumers from using more than they need and hey probably would not fix up their doghouses (RATIONING GOODS).

Quick Quiz:


The answer at the top of this lecture.

6. limited role for government

As we will see, the market system promotes allocative efficiency, productive efficiency, and economic growth, but it does have certain shortcomings that we will discuss in chapter 4. These problems include:
  • at times even market economies achieve allocative inefficiency:
    • overproduction (too much produced) of goods with negative externalities
    • underproduction (too little produced) of goods with positive externalities
    • tendency for business to increase monopoly power and produce less to increase profits
  • macroeconomic instability (periods of high unemployment and periods of high inflation)
  • no mechanism to guarantee equity

So in Chapter 4 we will study just what ARE the economic functions of government in a market economy. As countries undertake structural adjustment programs and REDUCE the role that governments play in their economies, it is important to keep in mind JUST WHAT SHOULD THE GOVERNMENT DO? There are important functions that assist the market in achieving the 5Es and improving the living standards.

Our textbook discussed three more characteristics of market economies. They are outlined here.

7. Reliance on technology and capital goods

a. Competition, freedom of choice, self-interest, and the potential of profits provide the incentive for capital accumulation (investment).

b. Advanced technology and capital goods promote efficiency and greater output.

8. Specialization

a. Division of labor allows workers to specialize.
1) People can take advantage of differences in abilities and skills.

2) People with identical skills may still benefit from specialization and improving certain skills. (Learning by doing)

3) Specialization saves time involved in shifting from one task to another.

b. Geographic specialization: Regional and international specialization take advantage of localized resources.

9. Use of money as a medium of exchange

a. Money substitutes for barter, which requires a coincidence of wants. (I may want what you produce but you may not want to exchange for what I have.)

b. Willingness to accept money in place of goods permits 3-way trades (or multilateral trades). See Figure 2.1 and examples in text.

1) Floridians give money to Nebraskans for wheat, who give money to Idahoans for potatoes, who give money to Florida for oranges.

2) Foreign exchange markets permit Americans, Japanese, Germans, Britons, and Mexicans to complete international exchanges of goods and services.

3) Detroit autoworker produces crankshafts for cars. If the worker were paid in crankshafts, he would have to find grocers, clothing retailers, etc., who would be willing to exchange their products for a crankshaft. It is much more efficient to use money wages than to accept one's wages in crankshafts!


Capitalism and the Five Fundamental Questions

Although the focus of this chapter is on the market system, we should keep in mind that the five fundamental questions must be answered by all economic systems.

The five fundamental questions are:

1. What goods and services will to be produced?
2. How will the goods and services be produced?
3. Who will get the output?
4. How will the system accommodate change?
5. How will the system promote progress?

What will be produced? (Allocative Efficiency)

1. In order to be profitable, businesses must respond to consumers' (individuals, other businesses, and the government) wants and desires.

2. Consumer Sovereignty

a. Consumer sovereignty is the key to determining the types and quantities of the various products that will be produced. "Dollar votes" for a product when purchases are made and "dollar votes" against a product when products are ignored will determine which industries continue to exist and which individual products survive or fail.

b. Consider This … McHits and McMisses

In an effort to stimulate demand and respond to market trends and conditions, McDonald's has introduced a number of new menu items over the years. The success and failure of these new items illustrates the important role of the consumer in determining what will be produced.

c. Businesses are not really "free" to produce what they wish. They must match their production choices with consumer choices or face losses and eventual bankruptcy. Profit-seeking firms must consider the allocation of the "dollar votes" when they make their production decisions.

3. As with producers of consumer goods and services, decisions of resources suppliers are driven by the desires of consumers for the products produced by the resources they own.

How will the goods and services be produced? (Productive Efficiency)

1. The market system encourages and rewards those producers who are achieving least-cost production.

2. Least-cost production techniques include: locating firms in the optimum location considering resource prices, resource productivity, and transportation costs, available technology, and resource prices in general.

3. The most productively efficient technique will be the one that produces a given amount of output with the smallest input of limited resources.

Who will get the output? (Equity)

1. The answer to this question is directly related to how the income is distributed among the individuals and the households and the tastes and preferences of consumers.

2. Products go to those who are willing and able to pay for them.

3. The productivity of the resources, the relative supply of particular resources, and the ownership of the resources will determine the income of individuals and households.

4. The resource markets, which determine income, are linked to this decision.

5. The resulting distribution of income may not be the most equitable (fair).

How will the system accommodate change?

1. Markets are dynamic - what is efficient today may not be efficient tomorrow as tastes, technology, and resource supplies change. Prices help signal those changes and the market will respond.

2. An increase in demand for some products (fruit juice) will lead to higher prices in those markets; a decrease in demand for other products (milk) will lead to lower prices in those markets.

3. Increased demand leads to higher prices that induce greater quantities of output from suppliers. The opposite is true for a decrease in demand.

4. Higher prices lead to more profits and new firms entering the market; lower prices lead to losses and firms leaving the industry.

5. The guiding function of prices is essential to a well-functioning market system. In the absence of such signals, government or some similar institution would have to decide where resources are allocated, but without knowing what people in society want. the result would most likely be allocatively inefficient.

How will the system promote progress?

1. The market system promotes technological improvements and capital accumulation (economic growth).

2. An entrepreneur or firm that introduces a popular new product will be rewarded with increased revenue and profits.

3. New technologies that reduce production costs, and thus product price, will spread throughout the industry as a result of competition.

4. Creative destruction occurs when new products and production methods destroy the market positions of firms that are not able or willing to adjust. NOTE: this is good for society.

5. Technological advances often require additional capital. Entrepreneurs cast "dollar votes" for capital, drawing resources to the production of capital goods.

Capitalism and the 5Es (the "invisible hand" of capitalism)

Competition is the mechanism of control for the market system. It not only guarantees that industry responds to consumer wants, but it also forces firms to adopt the most efficient production techniques. Adam Smith talked of the "invisible hand" which promotes public interest through a market system where the primary motivation is self interest. By attempting to maximize profits, firms will also be producing the goods and services most wanted by society.

Economic Growth

a. Define
b. Economic Growth and the characteristics of Capitalism
(1) private property
(2) self interest
(3) freedom of enterprise and choice

c. market economies tend to have faster growth rates than do command economies

Allocative Efficiency: Producing what consumers want

a. Capitalism's role of Self Interest provides INCENTIVES to be allocatively efficient.
  • more profits = produce more
  • losses = produce less

b. Capitalism's use of the market (supply and demand - Ch. 3) provides a MEANS to achieve allocative efficiency

  • consumer sovereignty and "dollar votes"

c. Capitalism tends to achieves allocative efficiency

Productive Efficiency: Producing at a minimum cost

a. Capitalism's role of Self Interest provides INCENTIVES to be productively efficient.
(1) profits = total revenues - total cost
(2) minimizing costs means more profits
(3) minimizing costs is productive efficiency

b. Capitalism tends to achieve productive efficiency


  • Capitalism does not have a mechanism to assure EQUITY. This will be a role of government discussed in chapter 4).

Full Employment

  • Economists disagree over whether capitalism will guarantee FULL EMPLOYMENT.
  • Some economists say yes, and if there is unemployment it is usually caused by government interference
  • Some economists say no, and at times government involvement is needed to move the economy towards full employment


1. The move toward capitalism has resulted in high rates of ECONOMIC GROWTH in many countries. Profits, private property, and freedom of enterprise and choice promote growth

2. The price mechanism (supply and demand) and the role of self interest provides for an ALLOCATIVELY EFFICIENT use of resources

3. Capitalism provides the incentives (profit) for a PRODUCTIVELY EFFICIENT use of resources

4. Capitalism does not have a mechanism to assure EQUITY. This may be a role of government

5. Economists disagree over whether capitalism will guarantee FULL EMPLOYMENT.


Problems with Command Economies (The Demise of the Command Systems)

Two of the most profound events of the past two decades are the collapse of communism in the Soviet Union and the rapid emergence of the market system in China. Russia and China are perhaps the world’s most significant developing economies: Together they constitute 20 percent of the world’s surface area and 24 percent of the world’s population.

The chapter from the previous edition of our textbook uses Russia and China as examples of two countries that have taken different approaches to structural adjustment. Russia used "shock therapy" moving very quickly to privatize state-owned industries and introduce market incentives. Furthermore, Russia, at the same time, changed its political system from and authoritarian communist state to a democracy.

China on the other hand began its structural adjustment program earlier, but it is moving slowly toward capitalism. It has also retained its authoritarian communist political system

Students sometimes confuse Russia with the whole former Soviet Union. A map showing the size (stretching eleven time zones) of Russia and its location relative to the fifteen former republics, which are now independent countries, is a good lesson in economic geography.

 A. History

1. The Russian Revolution of 1917 produced a dictatorship under Vladimir Lenin and later Joseph Stalin.

2. China’s communist takeover took place in 1947 under Mao Zedong

3. Both nations viewed centrally planned socialism (command economies) as a solution to the instability of what they believed were chaotic market systems.

4. The Soviet Union ceased to exist by that name in November of 1991, and became 15 separate nations.

5. Market reform in China began in agriculture in 1978

6. In 1980 China created special economic zones (SEZs) open to foreign investment, private ownership, and international trade.

There were two major institutional characteristics of the previous economies of Russia and China.

1. There was state ownership of all property, transportation and communication facilities, banking institutions, virtually all industry including retail and wholesale enterprises, and most urban housing structures.

2. There was also central economic planning, which meant that the economy was directed by the government rather than by decentralized market mechanisms.



Command systems in the Soviet Union, Eastern Europe, China eventually gave way to market systems, because of some significant problems associated with command economies.

Planning goals and techniques.

1. Industrialization and military strength had the highest priority in terms of resource allocation in the Soviet Union. In China emphasis was placed on developing small-scale industries scattered throughout the rural areas. Both countries neglected consumer goods industries.

2. Resources were overcommitted, planners committed more resources than were available, so there were persistent shortages.

3. Resources were initially mobilized to achieve rapid economic growth and this was successful through the 1950s. Both China and the Soviet Union induced or coerced a larger proportion of the population into the labor force.

4. Allocation of inputs was done by directive.

5. Government fixed prices of virtually all inputs and outputs, but prices did not reflect the relative scarcity of the resource or product. (NOTES FROM YOUR INSTRUCTOR: the result was often prices that were too low and shortages occurred resulting in allocative inefficiency.)

6. The Soviet Union and China aimed at self-sufficiency and avoided trade with western countries if possible. (NOTES FROM YOUR INSTRUCTOR: resulting in productive inefficiency.)

7. Macroeconomic policies were passive, meaning that money and prices accommodated output plans but did not play a role in influencing their outcome.

Problems of central planning were serious. 

Coordination problem - it was difficult (if not impossible) for central planners to effectively coordinate the allocation of resources and satisfaction of wants of millions of consumers, resource suppliers, and businesses.
1. If an industry failed to meet production targets it could disrupt production and resource allocation throughout the system.

2. Larger planned economies faced even greater difficulties because the greater number and complexity of allocation decisions to be made.

The COORDINATION PROBLEM was massive; outputs of some industries are inputs in others, so problems in any single sector would immediately be felt in many. There was no price mechanism to provide incentives to eliminate bottlenecks, as is true in a market economy. Planners had to coordinate inputs and outputs for thousands of production enterprises. Bottlenecks were common and had historical roots dating to the early 1960s or before.

Market economies on the other hand coordinate economic activity and changes in the prices of products and resources signal that changes have occurred within particular markets. A simple example of product X and product Y can be used. Assume an increase in the demand for X. This change will lead to an increase in the price of X, an increase in the profitability of X, an increase in the quantity supplied of X, an increase in the demand for the resources used to produce X, and an increase in the prices of the those resources. Because of a limit in consumer income, the demand for Y is assumed to decrease followed by all of the changes that will occur in response to the decrease in the demand of Y. After all of these changes have occurred, the result is that resources moved from Y to X. People want more X and they got more X. This illustrates the concepts of the "invisible hand."

Without market signals (i.e. prices) it was difficult to measure success. Even if quantitative production targets were met, ambiguities in the targets led to perverse outcomes in terms of poor quality, excessive costs, and the wrong mix of goods.

Incentive Problem

In a market system, profits and losses signal success and failure and provide incentives to increase or decrease production. In central planning managers are rewarded for meeting assigned goals and have no incentive to respond to product shortages or surpluses. The centrally planned system also lacked entrepreneurship. Without profit there is no reward for innovation or enterprise.

In centrally planned systems business is essentially a government owned monopoly with no reward for improving product quality or developing more efficient production techniques. Workers lack motivation because there are few material incentives. So even though many command economies have full employment, little is actually produced.

The Collapse of the Soviet Economy: The Soviet Union ceased to exist by that name in November of 1991, and became 15 separate countries.

After rapid economic growth through the 1950s and 1960s (about 6 percent reported per year, compared to 3 percent in the U.S.), the rate fell to less than 3 percent in the 1970s, and by late 1980s the Soviet GDP was actually declining. The quality of goods was below international standards, the selection of consumer goods was extremely limited, and technology was primitive by world standards. Shortages of basic goods were common, leading to long lines, black markets, and corruption in product distribution. The lack of ability to fulfill consumer needs contributed to the fall of communism.

There was also a huge military burden: 15 to 20 percent of GDP was devoted to military as compared with 6 to 7 percent of a much larger GDP in the U.S.

The agricultural sector experienced great inefficiency and consumed 25 percent of annual investment. It employed 30 percent of the labor force while still not producing enough for the population to feed itself. Output per farm worker was 10-25% that of U.S. farm workers.

The Russian Transition to a Market System / Structural Adjustment Policies

Privatization - Since 1992 more than two-thirds of former state owned enterprises have been privatized, including 90% of small companies and 80% of service sector companies. Land reform has progressed more slowly. It will take many years to develop a functional market for farm land.

Price Reform - Prices in the former Soviet system bore no relationship to the economic value of either products or resources. Because input prices did not measure the relative scarcity of resources, it was impossible for a firm to minimize real production costs resulting in productive inefficiency. Also, prices of many consumer items were fixed at artificially low levels and shortages existed for many of these goods causing allocative inefficiency.

In January 1992, the government decontrolled about 90% of all prices including the Russian currency. Domestic prices surged and the international value of the Russian ruble sank. The decontrolled prices began to more closely reflect the marginal (additional) cost of producing goods, which helped reallocate resources to best suit consumer wants.

Promotion of competition. The former Soviet Union consisted of large state-owned enterprises (SOEs) - monopolies that produced 30 to 40 percent of total industrial output. Russian reformers realized an efficient market economy requires competition, but only limited change has occurred. Joint ventures between Russia and foreign companies are one possible way to increase competition and recent legislation has opened the door for firms to invest directly in Russia.

Joining the world economy by making the ruble convertible. - The Soviet economy was largely isolated from the world economy for over 75 years, joining required making the ruble a convertible currency. The plunging value of the ruble has been detrimental to Russia’s world trade. The international value of the ruble has been more stable since its crash in 1998. It traded at about 17 rubles to $1 in 2000.

Price level stabilization. - The transition to free markets brought hyperinflation as large government deficits were financed by increases in the money supply.

Privatization of state enterprises caused the government to lose profits. The uncertainty of transition led to general disorder and widespread tax evasion causing the government to extend massive subsidy credits to both industry and agriculture and pensions and welfare spending was increased by printing more money. (The result of this increase in the money supply is INFLATION. We will discuss this in unit 3.)

3. Russia’s economic reforms included the creation of an independent central bank that implemented anti-inflationary monetary policy, reducing inflation from 1,353 percent in 1992 to 14 percent in 1997.

Other major problems of the transition:

Real output began its fall in the 1980s but the decline accelerated during the reforms; the magnitude resembles that associated with the Great Depression in the United States. Causes of the declined include:
  • Rapid inflation, which caused an uncertain environment.
  • Unraveling trade relationships with former Soviet Bloc trading partners.
  • Bankruptcy and closing of many former state-owned enterprises.
  • Massive reallocation of resources including major cuts in military spending.

Because real output equals real income, the Russian living standard has declined dramatically; at least 30,000 scientists have left Russian to work elsewhere.

Economic inequality has increased during the transition. While some new wealth has been created through entrepreneurship, others have enriched themselves via corruption and illegal activities. This is a common result of structural adjustment. As a command economy everyone had a job, housing, education, and medical care. With the move to a market economy the AVERAGE standard of living rises, but some become more poor and the gap between the rich and the poor increases. Attempting to achieve equity may be a a function of government in market economies

The major disruptions, swift changes, and lack of regulatory oversight created major opportunities for organized crime.

Greater economic freedom has brought greater economic insecurity; medical and educational services have declined, alcohol abuse has increased.

A remaining concern about the transition to markets in Russia is the weakness of government in law enforcement, particularly the collection of taxes.

Recent Revival

  • Aided by rising oil prices and production, and greater political stability, Russia's real GDP has increased by at least 5 percent per year since 1999. The unemployment rate fell from 13 percent in 1999 to about 8 percent in 2002. Recent income growth and stronger enforcement of tax collection has increased tax revenues, helping to turn the government's 1998 budget deficit into a surplus in 2002. The most severe economic dislocations seem to have ended, but the transition to a fully functioning market economy will require additional time.
  • Market Reforms in China

    China has taken a different path to market reform than Russia. The reforms began earlier, were more gradual, and allowed the old systems to function along with the new. Market reform began in agriculture in 1978. The key elements were the leasing of land to individual farmers and the establishment of a two-track price system (lower prices for government orders and market prices for the surplus). Responding to the profit motive, individual farmers increased their productivity and agricultural output soared.

    The success of reforms in agriculture led the central government to extend the reforms to state-owned enterprises (SOEs) in urban areas. The two-track price system was again employed, gradually increasing the portion of inputs and outputs that could be sold at market prices. The government also encouraged the formation of urban collectives—enterprises owned jointly by managers and their workforces. The urban collectives experienced explosive growth, some at the expense of the SOEs. However, the competition spurred productivity advance and innovation in many of the SOEs.

    In 1980 China created special economic zones (SEZs) open to foreign investment, private ownership, and international trade.


    Reforms in China also included building institutions to facilitate the market system and its macroeconomic control. A central bank, a stock market and currency exchange facilities were established. China replaced the system of "profit transfers" from state enterprises to the central government with an enterprise tax system.

    Transformation of the State Owned Enterprises (SOEs).

    In the 1990s the market reforms continue as the Communist Party operatives running the SOEs are replaced with professional business managers. In a competitive environment many SOEs found that they were producing the wrong goods, in the wrong amounts, using the wrong combinations of inputs. In short they were inefficient, in both production techniques and in allocation of resources. Some will be allowed to fail, others will issue stock with the government holding a controlling interest.

    Outcomes and Prospects

    China has been experiencing a period of remarkable economic growth.

    1. China's real output has grown over the past 25 years at a rate of nearly 9 percent per year, quadrupling real output over that period.

    2. Rising income has led to more saving, greater capital investment, and more direct foreign investment, which has helped fuel growth.

    3. Per capita income has increased at an annual rate of 8 percent since 1980, despite China's population expanding by 14 million people per year.

    4. Increased use of capital, better technology, labor reallocation from agriculture, and increased privatization have all contributed to greater productivity.

    5. China's growth has been supported by a dramatic increase in exports ($5 billion in 1978 to $752 billion in 2005).

    Despite its success, China faces a number of important problems:

    1. Inflation rates have been high at times (15 to 25 percent per year) because of too much spending relative to capacity. Central banking reform has helped keep inflation low in recent years.

    2. State owned enterprises and banks operate unprofitably, likely necessitating a government bailout.

    3. China has a poor record of protecting intellectual property rights, and keeps its currency artificially undervalued. These issues have caused tension with the United States and threaten to disrupt trade if they are not resolved.

    4. China's growth and development has been uneven, meaning that there are many that have not benefited from the nation's rising incomes.


     When countries undertake structural adjustment programs they move FROM a command economy TO a market economy with the following results:




    ownership of resources:


    government ownership


    private ownership

    decision making:


    centrally planned


    by the market



    "the social good"


    self interest and profit

    prices and wages:


    set by the government
    often distorted


    set by the market
    change with market



    full employment
    low inflation
    low standard of living
    more equal distribution


    economic efficiency
    periods of unemployment.
    periods of inflation
    high standard of living
    wide range available
    less equal distribution.



    corruption=self interest

    lack of incentives (the incentive problem)

    distorted prices (the coordination problem)



    monopoly= inefficiency
    changing prices
    instability (UE, IN)




    and a lower standard of living



    and a higher standard of living