The Market SystemPrinciples of Microeconomics

Boris Nikolaev

How many……of you consider yourself a capitalist?… a liberal?

“Any 20-year old who isn’t a liberal doesn’t have a heart, and any 40 year old who isn’t conservative doesn’t have a brain.”

W. Churchill

Some famous communists

Economic systemsEvery economic system tries to answer 3 fundamental questions:• What to be produced?• How to produced?• For whom to be produced?

Capitalism vs Communismhttp://www.youtube.com/watch?v=u6H63CD7uQA (1948 Propaganda)

Pure CapitalismFree MarketLaissez Faire

Pure CommunismCentral PlanningCommand Economy

Mixed Economy

USAChina

Von Mises and the challenge of calculation

• “Economic Calculation in the Socialist Commonwealth” (1920)

• Who will do the dirty job?

Human nature and the herd mentality

• Change human nature.• Material vs moral incentives.

• But even then who would do the social calculation? It seems impossible.

The Use of Knowledge in Society

• Main problem is how to use available knowledge.• Some knowledge is scientific; others is tacit (some

even wrong). • No way to know the second type • Market is a discovery procedure (trial and error)• Prices reveal relative scarcities.• Spontaneous order (cosmos)(result of human action; not planning)

The Circular Flow of Income

Characteristics of the Market Economy

1. Protection of Private Property.2. Freedom of Enterprise and Choice.3. Self-Interest.4. Competition.5. Markets & Prices.6. Technology & Innovation.7. Specialization (division of labor).8. Sound money.9. Active, but limited government.

Protection of Private Property

• The Tragedy of the Commons.

The Mystery of Capital

Why Capitalism Triumphs in the West and Fails Everywhere Else?

Freedom of enterprise and choice

Arnold Schwarzenegger on Freedom [watch here]

Self-Interest(recollect previous lecture)

•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.

Markets, Prices & Profits

• Market – institution that brings buyers and sellers together.

• Prices – convey information about products.• Those who respond to market signals are

rewarded with profits.

I, the pencil [watch here]

Competition

Assumptions:

1. Many buyers & sellers no single buyer or seller can set up the price.

2. Free entry and exit efficiency in the long-run.

Technology & Capital Goods

• All of the above (protection of private property, freedom of choice, etc…) provide incentive for capital accumulation (investment).

• Technology and capital goods efficiency, variety & greater output.

Sound Money• Zimbabwe’s Guinness Record• Dec, 2008 - 231,000,000% inflation.• Prices doubled everyday.• People abandoned their currency.

[watch here]

Active but limited government• T. Hobbes’: “The state of nature” and the

existence of social contract. “During the time men live without a common power to keep them all in awe, they are in

that condition which is called war; and such a war as is of every man against every man" (Leviathan, ch. XIII)

• We need a government to ensure that the above conditions (protection of private property, freedom of choice, sound money, etc…) are satisfied…so that capitalism can work.

• Also recollect from last lecture that markets fail (externalities, etc…), which is another reason for the existence of a government.

Capitalism: A Love Story

• Efficiency• Incentives • Freedom

Competition & The Invisible Hand

“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.”

Adam Smith

http://www.youtube.com/watch?v=okHGCz6xxiw&feature=related (Margaret Thatcher on Socialism)

Andy Warhol on Capitalism"What’s great about this country is that America

started the tradition where the richest consumers buy essentially the same things as the poorest. You can be watching TV and see Coca Cola, and you know that the President drinks Coca Cola, Liz Taylor drinks Coca Cola, and just think, you can drink Coca Cola, too. A coke is a coke and no amount of money can get you a better coke than the one the bum on the corner is drinking. All the cokes are the same and all the cokes are good. Liz Taylor knows it, the President knows it, the bum knows it, and you know it."

Andy Warhol

Problems with Capitalism

• People with no resources starve (promotes inequality).

• Concentration of power (monopolies, oligopolies).• Markets fail (recollect externalities, public goods).• Firms have no incentive to produce “social goods.”

[watch here]

Problems with Communism

• Resources are used inefficiently.• No incentive to improve land.• Central planners (the communistic party) serves their

own interest, not the interest of the people.• Less variety of products.• Less personal/ economic freedom.

Who grew faster?• China vs Taiwan

North Korea vs South Korea• 1948 Korea is divided into South and North.