Under what circumstances will a nation achieve efficiency in the use of its factors of production? The discussion above suggested that Christie Ryder would have an incentive to allocate her plants efficiently because by doing so she could achieve greater output of skis and snowboards than would be possible from inefficient production. But why would she want to produce more of these two goods—or of any goods? Why would decision makers throughout the economy want to achieve such efficiency?
Economists assume that privately owned firms seek to maximize their profits. The drive to maximize profits will lead firms such as Alpine Sports to allocate resources efficiently to gain as much production as possible from their factors of production. But whether firms will seek to maximize profits depends on the nature of the economic system within which they operate.
Each of the world’s economies can be viewed as operating somewhere on a spectrum between market capitalism and command socialism. In a market capitalist economyEconomy in which resources are generally owned by private individuals who have the power to make decisions about their use., resources are generally owned by private individuals who have the power to make decisions about their use. A market capitalist system is often referred to as a free enterprise economic system. In a command socialist economyEconomy in which government is the primary owner of capital and natural resources and has broad power to allocate the use of factors of production., the government is the primary owner of capital and natural resources and has broad power to allocate the use of factors of production. Between these two categories lie mixed economiesEconomy that combine elements of market capitalist and of command socialist economic systems. that combine elements of market capitalist and of command socialist economic systems.
No economy represents a pure case of either market capitalism or command socialism. To determine where an economy lies between these two types of systems, we evaluate the extent of government ownership of capital and natural resources and the degree to which government is involved in decisions about the use of factors of production.
Figure 2.11 "Economic Systems" suggests the spectrum of economic systems. Market capitalist economies lie toward the left end of this spectrum; command socialist economies appear toward the right. Mixed economies lie in between. The market capitalist end of the spectrum includes countries such as the United States, the United Kingdom, and Chile. Hong Kong, though now part of China, has a long history as a market capitalist economy and is generally regarded as operating at the market capitalist end of the spectrum. Countries at the command socialist end of the spectrum include North Korea and Cuba.
Figure 2.11 Economic Systems
Some European economies, such as France, Germany, and Sweden, have a sufficiently high degree of regulation that we consider them as operating more toward the center of the spectrum. Russia and China, which long operated at the command socialist end of the spectrum, can now be considered mixed economies. Most economies in Latin America once operated toward the right end of the spectrum. While their governments did not exercise the extensive ownership of capital and natural resources that are one characteristic of command socialist systems, their governments did impose extensive regulations. Many of these nations are in the process of carrying out economic reforms that will move them further in the direction of market capitalism.
The global shift toward market capitalist economic systems that occurred in the 1980s and 1990s was in large part the result of three important features of such economies. First, the emphasis on individual ownership and decision-making power has generally yielded greater individual freedom than has been available under command socialist or some more heavily regulated mixed economic systems that lie toward the command socialist end of the spectrum. People seeking political, religious, and economic freedom have thus gravitated toward market capitalism. Second, market economies are more likely than other systems to allocate resources on the basis of comparative advantage. They thus tend to generate higher levels of production and income than do other economic systems. Third, market capitalist-type systems appear to be the most conducive to entrepreneurial activity.
Suppose Christie Ryder had the same three plants we considered earlier in this chapter but was operating in a mixed economic system with extensive government regulation. In such a system, she might be prohibited from transferring resources from one use to another to achieve the gains possible from comparative advantage. If she were operating under a command socialist system, she would not be the owner of the plants and thus would be unlikely to profit from their efficient use. If that were the case, there is no reason to believe she would make any effort to assure the efficient use of the three plants. Generally speaking, it is economies toward the market capitalist end of the spectrum that offer the greatest inducement to allocate resources on the basis of comparative advantage. They tend to be more productive and to deliver higher material standards of living than do economies that operate at or near the command socialist end of the spectrum.
Figure 2.12 Economic Freedom and Income
The graph shows the relationship between economic freedom and per capita income by region. Countries with higher degrees of economic freedom tended to have higher per capita incomes.
Market capitalist economies rely on economic freedom. Indeed, one way we can assess the degree to which a country can be considered market capitalist is by the degree of economic freedom it permits. Several organizations have attempted to compare economic freedom in various countries. One of the most extensive comparisons is a joint annual effort by the Heritage Foundation and the Wall Street Journal. The 2011 rating was based on policies in effect in 183 nations early that year. The report ranks these nations on the basis of such things as the degree of regulation of firms, tax levels, and restrictions on international trade. Hong Kong ranked as the freest economy in the world. North Korea received the dubious distinction of being the least free.
It seems reasonable to expect that the greater the degree of economic freedom a country permits, the greater the amount of income per person it will generate. This proposition is illustrated in Figure 2.12 "Economic Freedom and Income". The study also found a positive association between the degree of economic freedom and overall well-being using a measure that takes into account such variables as health, education, security, and personal freedom. We must be wary of slipping into the fallacy of false cause by concluding from this evidence that economic freedom generates higher incomes. It could be that higher incomes lead nations to opt for greater economic freedom. But in this case, it seems reasonable to conclude that, in general, economic freedom does lead to higher incomes.
Have you been to a frontier lately? Whether you realize it or not, the economy has a frontier—it has an outer limit of economic production. In this episode of the Economic Lowdown Video Series, economic education specialist Scott Wolla explains how the production possibilities frontier (PPF) illustrates some very important economic concepts.
Segment 2 of The Production Possibilities Frontier uses the production possibilities frontier to explain key economic ideas such as why an economy might have underemployed resources but later expand, and how changes in productivity can lead to economic growth.
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Transcript:
Below is the full transcript of this video presentation. It has not been edited for readability, and there may be slight differences between the text and the video.
In the previous segment we learned that scarcity forces people to make a choice, and when people choose, there is an opportunity cost.
Opportunity cost is the value of the next-best alternative when a decision is made; it's what is given up. The opportunity cost of producing 1 more widget is the lost opportunity to produce 2 gadgets.
So, the PPF can be used to illustrate two very important economic concepts—scarcity and opportunity cost.
Now, let's move beyond the basics and see how the PPF graph illustrates some bigger economic ideas.
This space right here, on the inside of the frontier, helps illustrate our next lesson.
Lesson 3: A point inside the frontier represents underemployment; movement back toward the frontier reflects economic expansion.
The frontier represents maximum production with the available resources, but it isn't just the points along the line that are production possibilities. Econ Isle could alternatively produce at any point inside the frontier. So, while it could produce 4 gadgets and 4 widgets, it might produce only 2 gadgets and 2 widgets. In this case, Econ Isle would not be fully employed, or put differently, resources in Econ Isle would be underemployed. In fact, any point inside the frontier represents underemployment, which is a failure to reach full employment. Why would an economy produce below its potential? Well, it could be in a recession, which is a significant decline in general economic activity extending over a period of time.
During a recession, Econ Isle's production will likely decline, resulting in workers losing jobs and leaving other resources—machines and factories—underutilized as well. When economic activity picks up again, production levels would likely move back toward the frontier. That is, the economy would move toward full employment. The shift from a recession toward the frontier is sometimes called an economic expansion.
So far, we've talked about Econ Isle's possibilities up to its frontier, but the frontier line itself can shift. Two primary changes can cause the frontier to shift: a change in productive resources and technological change.
Remember that the frontier reflects the available resources. The frontier will shift as the economy acquires or loses productive resources. For example, if the labor force grows and other resources levels stay the same, the frontier will shift outward. Or, if an economy diverts resources to produce more capital goods, which means they are using economic resources to make other resources, the frontier will shift outward.
Technological change is an advance in overall knowledge in a specific area. The gains achieved through technological change tend to be gains through increased productivity—or an increase in economic output per input. In fact, productivity is measured as the ratio of output per worker per unit of time. Take Fred, for example.
Imagine Fred can produce 2 widgets per hour, but then his productivity improves and he can produce 3 widgets per hour. Notice that there is still only 1 Fred, and we are still measuring his production per hour, but his output has increased.
Two factors can increase worker productivity over time: investment in physical capital, things such as computer software and tools, and human capital. Human capital is the knowledge and skills that people obtain through education, experience, and training.
Imagine Fred's hand tools were replaced with new power tools. All of a sudden Fred would be able to produce more output in the same amount of time. His increase in productivity would be due to investment in physical capital.
And then when Fred learns to use the new power tools more effectively, he'll likely increase his productivity even more! This increase in productivity would be due to investment in human capital.
Increasing the productivity of workers allows for more production without an increase in resources.
And improvements in productivity will shift the frontier outward, which illustrates our fourth lesson.
Lesson 4: An outward shift of the frontier reflects economic growth.
Fred increased his productivity by learning how to use new tools. Increasing the productivity of workers allows for more production without an increase in resources. And improvements in productivity will shift the frontier outward, which reflects economic growth.
For Econ Isle, an outward shift can mean that it can produce both more gadgets and more widgets. Notice that I said the economy could produce more of both goods. Remember that when the PPF is static, producing more gadgets means producing fewer widgets—there is an opportunity cost. But when the frontier shifts outward, it is possible to produce more of both goods. Economists call this economic growth—a sustained rise over time in a nation's production of goods and services. Economic growth is important because it allows more people to have more of what they want over time.
Be sure to watch Part 3 of this series to learn our final lesson, and wrap up this episode.
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