CHAPTER 1 
ECONOMIC SYSTEMS:
CLASSIFICATION AND PERFORMANCE

I.    The Economic System, the Environment, and Policies

A.   Economic System - Set of institutions that constrain, facilitate and coordinate economic behaviors.

B.   Institution - Organization, practice, convention or custom that is persistent and material in society.
 Alternatively, according to Douglass North, "Institutions are the humanly devised constraints that structure political, economic, and social interaction. . . . Throughout history, institutions have been devised by human beings to create order and to reduce uncertainty in exchange."

C.   Environment - Factors that cannot be manipulated by policy makers. 

D.   Policies - Factors that can be manipulated in the medium term to influence economic performance.

Auto Analogy

Applications - Explanations of Performance

Yugoslav failure - System, Environment, Policies

Asian Crisis - Systems & Policies 

Applications - Choice of System

Why did Eastern Europe reform before Soviet Union?

Why does Sweden have preference for Welfare State?

II.   Forms of Business Enterprise (update)

Transitions:

• Incorporation - Proprietorship or partnership to corporation
• Initial Public Offering (IPO); "Going Public" - Private corporation to public Corporation
• Leveraged Buyout (LBO) - Use of debt (often by a Private Equity Company) to purchase a controlling share of a public corporation, often converting it back to a private corporation.
• Nationalization - conversion of a firm in the private sector into a government-owned enterprise.
• Expropriation - Nationalization without compensation.
• Privatization - Conversion of government-owned enterprise into a form of private enterprise

III.   Modes of Classification

A.   Ownership - Rights to control an asset, keep income generated, or transfer ownership.

1.    Feudalism - Rights ultimately held by the king, delegated in exchange for loyalty, tribute, and military support.  Labor tied to the land.

2.    Capitalism - Means of production held by private individuals.  Laborers free to change employers.

3.    Socialism - Means of production owned socially, by the government, cooperatives, communes, or workers' councils.

Caution - Formal ownership may be separated from effective control.  Corporate capitalism and Soviet-style socialism.

World Bank, Beyond Economic Growth, 2004

B.   Coordinating Mechanism - An institution that coordinates decisions concerning production, sale, and purchases of commodities.

1.    Tradition - Preservation of the status quo.  Dominant only in static economies.

2.    Market - Operation of supply and demand, and free movement of market prices.  Provides for consumer sovereignty.

3.    Plan - Central plan directs the economy toward specified goals.

a.    Directive Planning - A central agency issues instructions to subordinates. 

b.    Indicative Planning - Market coordinates short run while plan directs long run.  The plans are very general, span long time periods.  Compliance is mostly voluntary.

c.    Industrial Policy - Support provided to favored sectors; low-priority sectors are phased out. 

C.   Incentive Systems - Reward desired behavior and discourage inappropriate action.

1.    Coercive Incentives - Actual or threatened force.

2.    Material Incentives - Material reward for desired behavior, usually in monetary payments. Automatic in market economies. Must be designed in directively planned economy.

3.    Moral Incentives - Appeal to emotions such as compassion or nationalism.

D.   Objectives - Involved both in classification and evaluation of economic systems. Include individual freedom, output growth, military power, equitable income distribution, full employment, dynamic efficiency, protection of natural environment, and price stability.

1.    Free enterprise economy - Individual freedom. 

2.    Welfare State - Equitable distribution of income and full employment.

3.    Mercantilism - Military and economic power.  Governments supported monopolies, subsidized exports, and limited imports.  Fascism and Nazism are exaggerated forms of mercantilism.

IV. An Operational Classification System

IV. Comparisons of System Performance—In order to be fair, comparisons of the performance of economic systems should take the following into account:

A.   Isolation of the economic system - Performance is influenced by policy and environment as well as by the economic system.

B.   Actual and ideal economic systems - For most purposes, an idealized theoretical system should not be compared to an actual system.

C.   Measurement problems - Statistical problems arise from differences in monetary systems, accounting standards, and data collection methods.

D.   Assigning Priorities - Broad performance comparisons depend on individual value judgments.