Module 3

But first, answers to worksheets from the last module….

1.A student has 8 hours per week to study and is taking two classes: Art and Math.
a. Draw the grade production possibilities frontier.

Art Math art

Grade grade A
A F
A F
A D
A D+ B
A C
B C+
C B
C
D B+
F A

F
math
F D C B A

b. In terms of grades, what is the opportunity cost of improving his Math grade from a D to a C?

In terms of grades there is no opportunity cost to improving the Math grade from a D to a C (because
the Art grade remains an A). (Of course there is an opportunity cost in terms of time).

c. What is the opportunity cost of improving his Math grade from a B to an A?

The opportunity cost of improving the Math grade from a B to an A is a fall in the Art grade from a C
to an F. If you said the opportunity cost “is an F” then you got the answer wrong. Opportunity cost is
what you sacrifice… going from an A to an F is quite different than going from a D to an F.
 Production Possibilities Curves

Farmer Bill has a 2-acre farm. He can divide this land in any way he wants
between cows and corn (that is, he could use ½ acre to grow corn and 1
½ acres to raise cows… or any other such division). If he grows grass on
the land then each acre could support 10 cows each year. If he grows
corn on the land then one acre – near the river – would yield 5 thousand
bushels of corn. The other acre would yield 2 thousand bushels of corn.

a. Plot the production possibilities curve

20
Cows

10

5 7 Corn (th bushels)

b. If he initially uses all of his land to raise cows, what is the opportunity cost of 1 thousand
bushels of corn?

He will use the good corn land first… each (th bushels of) corn results in a loss of 2 cows. (The
slope of the top line is -2)

c. If he is initially growing 6 thousand bushels of corn, what is the opportunity cost of another 1
thousand bushels of corn?

Now he is on the “bad” corn land… and the opp cost of more corn is 5 cows. (Slope = -5)

d. If he is initially growing 6 thousand bushels of corn, what is the opportunity cost of raising one
more cow?

We are still starting on the “bad” corn land… and the opp cost of one more cow is going to be
1/slope corn. Or 1/5 of a corn. (Since we are measuring corn in thousands of bushels this is the
same as (1/5)1000 = 200 corn)

e. What happens (if anything) to the opportunity cost of corn if fertilizer allows him to support
twice as many cows as before?

It will double… the PPC rotates up and becomes twice as steep. Since you are better at cow
production now you must sacrifice twice as many cows to get a given amount of corn.
 Now… onto Module 3
Classifying economic systems

The fundamental differences between pure capitalism and command socialism (aka communism):
Pure capitalism Command socialism
Private ownership of resources – private State ownership of resources
property of land, labor, and capital
prices free to adjust prices controlled by state planners
resources free to flow resource allocation by state planners
firms produce to make a profit firms produce to meet a quota
decentralized decision making centralized decision making

The primary attractiveness of communism is the goal of a “classless society.” Paris Hilton has lived in
luxury from the moment she was born… while I had to walk 5 miles uphill to school …both ways.
How fair is that? Why not create a system that treats us all equally?

Karl Marx – the father of communism - saw it as the ultimate and inevitable economic system. His
definition, however, is quite different from the list above: Under communism,
according to Marx, the government disappears and there is economic
cooperation as well. The principle of distribution becomes "from each according
to his/her ability, to each according to his/her need." (Quote from the Maoist
International Movement webpage). So in this system everything is owned
communally – from housing to beaches – and shared as needed. No persons or
organizations impose any restrictions on use or charge any fees. No economy has
ever come anywhere near this. In fact, countries commonly called communist
were the opposite – the government owned and controlled everything. The link is
that the single party state of the first definition was thought to be a necessary precursor to Marx’
communist society of the second definition.

Unfortunately countries that have tried command socialism have done poorly. The pie might have
been more evenly distributed but it also turned out to be a really small pie. The sad reality is perhaps
best illustrated by the fact that these countries had to guard their borders with machine guns to prevent
people from escaping. The US capitalist system has the opposite problem. The USSR finally gave up
its 70 year experiment in 1990. China remained one of the poorest countries in the world until they
began to introduce market forces in 1978. The system is not “evil”… it just doesn`t work very well.
Let’s consider two fundamental problems that are hard to overcome:

1. Incentives. You can see the problem directly in Marx’ famous line, “From
each according to ability, to each according to need.” Think about that. There
is no connection between how much you produce (your ability) and how
much you get (your needs). If we are all going to live equally then why
would I work hard? This would be like me giving all of you the average
grade of the class on the next quiz rather than the individual grade you will
get. Under which grading scheme would you study more? Of course some of
you would study hard either way – but those that only care about their grade
would study a lot less – since the benefits of their hard work would be diluted
between all the members of this class. You would only get 1/nth of the
benefits (where n is the number of students in the class). (I use this example
again at the end of the quarter I think to illustrate free-riding.) More than anything it is this
 assumption that we are not self-interested that ensures the failure of command socialism. Thus, in
order to get people to work the government had to resort to abundant propaganda and ultimately
force.

2. Lack of knowledge. It is absurd to think that a group of planners will be able to correctly calculate
the needs of society. Without a system of working prices the relative values of resources are
unknowable. If the plan calls for 1,000,000 desks…what are the odds this will be the
correct number? What are the odds they will be the correct size and quality? The
knowledge of what is needed in society – and how to produce it – is dispersed.
Markets allow for decentralized decisions – each farmer chooses how much corn and
how many cows – rather than have it dictated by someone 2000 miles away. Friedrich
A. Hayek famously called the assumption that policy-makers have sufficient
knowledge to solve societies’ problems “the fatal conceit.” A famous quote - The
curious task of economics is to demonstrate to men how little they really know about what they
imagine they can design. - F.A Hayek. Ponder that for a bit. Good stuff.

Virtually all command economies have begun moving toward market-oriented systems. China began a
gradual move toward a market-based economy in 1978. Vietnam began in the 1980s. Russia, Poland,
Hungary, Mongolia and many other former “Soviet bloc” countries began the transition in 1990. India
also in the early 1990s (though they were not as extremely communist as the others). Together, these
countries are referred to as transition economies.

On Socialism

The tragically perverse incentive effects of central-planning led to decades miserable living standards.
That argument is over… markets won and central-planning lost. Only North Korea and, to a lesser
extent, Cuba, still claim to be focused on central-planning. A different argument that will never end
concerns free-market capitalism vs socialism…

As with Communism, there are two incompatible definitions for Socialism:

1. Socialism - government ownership of all resources and production (as above… Command
Socialism).
2. Socialism - market economies that put strong emphasis on income equality (Sweden and
France… Social Capitalism).

Sweden and France are not socialist by the first definition. They are socialist because the government
intervenes extensively in the economy to “soften the hard edges of capitalism.” This intervention alters
what is produced (the allocation of resources) in the economy – free health care, free college education,
free day care, lots of mandatory paid vacation, and relatively high welfare payments are typical things
you will see. Together the provision of goods and services like this is often called a Welfare State. But
the economy is fundamentally based on markets and private property… so it is very different than
command socialism. We can call it a Social Capitalism … or a mixed economy. Clearly the extent to
which countries are socialist from this perspective is a matter of degree. Even the US, often held up as
a dog-eat-dog capitalist economy, has substantial government intervention intended to even out the
income distribution: social security, welfare, unemployment benefits, food stamps, progressive income
taxes… we have plenty of socialist policies. Enough? I don’t know... it is a normative decision in the
end. What we can do in this class is to illustrate trade-offs. Things given to us by the government are
not actually free. Ignoring costs leads to poor decisions.
There is a natural human desire to help out those in need – and thus there is always a lot of support for
socialist policies. Unfortunately there is a trade-off … the same one we examined earlier. These
policies threaten to affect incentives in a way that makes the economy less productive (meaning a
slower growing pie). Take, for example, unemployment benefits. As you make unemployment benefits
nicer you have created two incentive problems:

1. You make it nicer to be unemployed. People

might not take a job that they otherwise would because
it may be more attractive to get free money from the
government. In Spain, where unemployment benefits
are attractive, it is common for young people to work
until they qualify for benefits – then stop working and
receive benefits until they run out. This can clearly
harm the economy.

2. You need to raise more tax revenues (to pay for

unemployment benefits). Raising taxes means the
return to work is lowered… so you are making work
less attractive.

This is not to say that we should not have unemployment

benefits (or any given policy) – just that we want to be honest about the trade-offs.

The fatal conceit is at work too. I read recently that the US government is subsidizing textbook rental
programs as a strategy to bring down the cost of textbooks for students (note
that in the picture provided there is a person asking Congress to solve this
problem). Now, this is something I happen to know a little about… and
textbook rental programs are probably not the best way to approach the
problem. There are huge logistical problems, the inventory of books is very
expensive – and they must be replaced about every three years. In fact, the
article was about all the problems these companies were having … which
did not surprise me. Two superior strategies from my perspective are online
books OR the adoption of old editions (I am trying both!). Textbook rental
programs are simply not the way to go in my mind. But, hey, what do I
know? This is a free market economy. If you want to go for it… great!! Rent
out a warehouse, hire some workers and start buying books!! If you succeed you will make lots of
money. If you fail you will release those resources back into the economy so they can be more
effectively employed elsewhere. No problem.

Why would the government have the knowledge required to what is best here? My answer is they do
not – just like me! So when I read the government was subsidizing textbook rental companies I was
saddened. Not because I am in favor of expensive textbooks … but because this is probably a waste
of our scarce resources (or taxpayer dollars depending on how you want to think about it) – but once
the government is involved the feedback mechanism is lost.

Politicians are not betting their own money – they bet taxpayers money - so they have less concern
about risks and costs. By subsidizing rental programs some politician was able to a) claim they were
fighting the high price of textbooks, and b) reward their supporters in that industry (who might just so
happen to make a nice contribution to their re-election campaign). The fact that it is not the most
efficient way to solve the problem is lost… and results in an inefficient allocation of resources. All the
people, buildings, advertisers, etc. that get sucked into the subsidized industry would have done
something else … something actually worth the money being paid for their services if we let market
have a say.

Capitalism is a profit and loss system

In a free market the way businesses acquire dollars is by selling something people are willing to buy.
If I want to sell broccoli-flavored ice-cream I am free to do so. If I make money … great! I have
created something of greater value to society than the cost of the resources I have
employed – which allows me to make a profit. This is good! I am doing something for
society by providing a good people want.

I stress this because there is something of an anti-profit movement out there. The belief
that if a firm makes a profit they must be exploiting somebody… and the profits must be stopped! I
think the reverse is true… if a company is making profits it reveals that they have produced something
we want. Thank you!

Competition will not be far behind to try to

grab some of those profits. Competition
means the price remains low and the product
improves. The clear winners of all this are
not firms… the clear winners are consumers.
Sure Apple makes bucket loads of money…
but look at how quickly the iPods, iPhones
and iPads improve. Apple pours most of its
profits right back into its business in order to
stay a step ahead of competitors. Google –
even more extreme. I have never directly
paid Google one penny… yet they have
given me all sorts of awesome stuff. Suckers.

Now back to broccoli ice-cream. What happens if I lose money? I go out of business and the resources
I would have employed flow somewhere else. Capitalism is a profit and loss system. The losses are
important as that is how we ensure that resources are not
wasted. It is a very clear feedback mechanism… success
leads to more resources entering the industry while failure
leads to resources flowing out.

Unfortunately the feedback mechanism is broken when it

comes to government spending money (consuming scarce
resources). If the government spends money foolishly (e.g.
textbook rental programs) are they going to go out of
business? Is the politician going to lose money or his job for
his bad decision? Of course not. They are probably more likely to raise taxes and expand the program
once entrenched interests are created that benefit from the program. Government bureaucrats and
politicians are self-interested just like you and me – and, unfortunately what is best for them is
frequently not what is best for society.
Now, that said, markets are not perfect either. Market failures provide a potential justification for
government intervention… one we will take up toward the end of our journey. In addition, many
people acknowledge the problems with government interference but still feel that a less efficient
economy is worth the benefit of a stronger social safety net. Much of the debate between Democrats,
Republicans, Libertarians and Tea Partiers boils down to the appropriate role of government. Tea
Partiers tend to take the stance that government incentives are so poor that the best strategy is to
greatly minimize their activity. Democrats are much more willing to have the government continue to
try to solve social issues – while trying to minimize the negative impacts.

What do you think?

Here is a nice essay that relates Hayek’s ideas to the recent housing crisis:

Socialism’s “Fatal Conceit”

by Ralph R. Reiland, February 25, 2009

The appeal of socialism, wrote Nobel-winning economist F. A. Hayek, “depends on the instinctual
appeal of promised consequences.”

The problem, argued Hayek, is that “socialism cannot possibly do what it promises.”

Socialism fails, unavoidably, because it is based on the flawed concept, the “fatal conceit,” that one
man or one group, one cabinet of commanding officials or one central committee, or one team of
planners from Harvard and Yale, can gather and understand enough information in order to reshape
the world around them according to their wishes, reshape human nature, and design an economic
system that can outstrip the overall and long run performance of the decentralized and basically self-
ordering and spontaneous processes of the marketplace.

Prior to the “economic failure of Eastern European socialism, it was widely thought” that “a centrally
planned economy would deliver not only ‘social justice’ but also a more efficient use of economic
resources,” explains Hayek. “This notion appears eminently sensible at first glance. But it proves to
overlook the fact that the totality of resources that one could employ in such a plan is simply not
knowable to anyone, and therefore can hardly be centrally controlled.”

That’s why the results of the “plan” seldom work out as its intellectual and political leaders intended.
It’s why what starts out as idealism often ends up as disillusion, and then tyranny. As evidence, Hayek
points to “a seemingly endless string of ‘utopias,’” i.e., failed systems with unintended consequences
on a massive scale, “the Soviet Union, then Cuba, China, Yugoslavia, Vietnam, Tanzania, Nicaragua.”
Here in the United States, it’s exactly the same two flaws that Hayek warned of, i.e., lack of
knowledge and conceit, that are simultaneously present in our political leadership and got the ball
rolling to produce our current economic crisis.

“Congress and regulators pushed Fannie Mae and Freddie Mac to become a vast duopoly in the
mortgage finance industry,” writes David Boaz, executive vice president of the Cato Institute and
author of Libertarianism: A Primer. “Their debt was implicitly backed by the Treasury Department,
and they were able to expand their debt and engage in risky transactions.”
With big bonuses to be made at Fannie Mae and Freddie Mac for increased volume and the
government, i..e., the taxpayers, standing by to pick up any losses, the stage was set for some top level
central planning and high-priced social engineering.

As Larry Summers, Obama’s chief economic advisor, explained, “Little wonder with gains privatized
and losses socialized that the enterprises have gambled their way into financial catastrophe.”
The central plan for housing? No money down, more homeowners, more happy voters, all by way of
cheap mortgages and rising house prices.

“There was substantial agreement in Washington that homeownership was a good thing and that more
homeownership would be even better,” writes Boaz. “Thus Congress and regulators encouraged
Fannie, Freddie, and mortgage lenders to extend credit to under-qualified borrowers. To generate more
mortgage lending to low- and moderate-income people, the federal government loosened down-
payment standards, pressured lenders to increase their percentages of ‘affordable’ loans, and implicitly
guaranteed Fannie and Freddie’s dramatic expansion.”

The result was a flood of non-prime mortgages, a corresponding surge of bad loans, the development
of convoluted financial products to finance and redistribute the substandard paper, rising home prices
and an inevitably bursting bubble.

“In 1996, the department of Housing and Urban Development gave Fannie and Freddie an explicit
target: 12 percent of their mortgage financing had to go to borrowers with incomes less than 60
percent of their area’s median income,” reports Anna J. Schwartz at the National Bureau of Economic
Research. “That number was increased to 20 percent in 2000 and 22 percent in 2005. The 2008 goal
was to be 28 percent. Between 2000 and 2005, Freddie and Fannie met those goals every year.”
Everything went according to plan, in other words, except that our collective nest eggs in the market
dropped by $10 trillion over the past 17 months and the politicians are handing out trillions that
they’re borrowing from China or pilfering from our kids and grandchildren.

As Hayek explained, central plans go haywire with unforeseen and unintended consequences because
everything isn’t knowable to the central planners. In other words, they don’t know what they’re doing.

Ralph R. Reiland is an associate professor of economics at Robert Morris University in Pittsburgh.