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ECON 2002


ECON 3870

 

ECON 4807/5807

Scholarship in Comparative Economics

Articles


 

 


Department of Economics



 

 

 




 

 

Welcome to Comparative

Economic Systems, ECON
 

3870, in Summer Session

 II,
 

July-August, 2015.



 
NOTE: The FINAL EXAM will be on Thursday, the 20th of August at 7 p.m. in a location TBA.


A copy of the CLASS ASSIGNMENT is directly below.  The due date is Friday, Aug. 7th, but because I mistakenly put Aug. 8th on the course outline, I will accept papers handed in on Saturday, Aug. 8th as well.


The ANSWER KEY to the midterm is also below.  The graphs and table may not have made the trip, but we'll work on that next week.


Most readings for this course, other than the text, are available on Library Reserve.  Most of these in turn are available electronically through ARES.  To access ARES, please go to the Library Homepage and click on ARES under POPULAR LINKS at the bottom of the page on the right-hand side.  You will need your student computing account information.




July 2015

CLASS TAKE-HOME ASSIGNMENT

CARLETON UNIVERSITY
Department of Economics

Econ 3870V

Instructor: R. Carson


COVERAGE:  Chs. 4, 5, and pp. 188-200 of Ch. 6.

Directions:


Please do each question below.  The question weights are as indicated.  Use graphs where you find them useful, but be


sure to explain them.  In general, be sure to explain yourself well enough that the grader understands you and knows


that you know what you are doing.  Finally, please type your answers double spaced, with adequate margins.  Please draw


your graphs neatly and legibly.  Illegible answers will be considered incorrect.
 
Sok scerencset.



 

1a. (15%).  The Lange-Lerner model of market socialism, pp. 194-196 of the text, is a system in which central planners try

to arrive at competitive prices through trial and error.  When a surplus of a good exists, the planners are supposed to lower

its official price.  When a shortage exists, the planners are supposed to raise its official price.  The hope is to reach prices

that just balance supply and demand.  Industry and enterprise managers are told to set output where price equals marginal

cost.


One criticism of this system is that industry managers in collusion with the managers of firms will withhold supply in order


to drive up the official price, which becomes a monopoly rather than a competitive price.  When would managers do this? 


When would they try to keep the official price below the monopoly level?  Explain.  (Hint: Think in terms of taxation.)

 


1b. (15%).
  A worker-managed firm is a firm managed by elected representatives of its employees.  Such firms are


believed to maximize profits per worker rather than total profits, as described in the text, pp. 196-200.  If such a firm faces


a product price, P, which it cannot alter by changing its output, will it have an upward-sloping product supply curve in the


short run, when labour is the only variable input, or will its short-run supply curve be downward-sloping?  Will an increase


in demand cause P to rise by more, less, or the same as the demand increase?  You may assume diminishing returns to


labour and constant returns to scale in production.

 


(Hint:  Suppose this firm produces an output, Q, with labour, L, and capital, K.  In the short run, K is fixed, as are capital


costs, F.  If MPL is labour’s marginal physical product, the profit-per-worker maximum is where P(MPL) = (PQF)/L as


at A in Fig. 6.1, p. 197 of the text.  Now re-arrange this equality so that F/P is alone on one side of the equation.  It can be


shown that constant returns to scale implies Q = (MPL)L + (MPK)K, while diminishing returns to labour then implies that an increase in L raises MPK.)

 


2.
  (30%).  Suppose that a firm introduces a profitable innovation that reduces production costs.  As a result, rival firms


suffer wealth losses, and some will go out of business, although historically, the old production methods usually survive for


a time before disappearing completely. 


Show that society receives a net gain from this innovation, in the sense that the benefits to society of the innovation are


greater than its costs, even if we don't count the innovator's profits and even if the innovator is able to exercise market


power after innovating.  Then explain why a government might still want to suppress the innovation.



3.  (10%). What is meant by the "scattering of strips" in medieval agriculture?  Explain how this was a response to


conditions existing in Europe during the Middle Ages and what its advantages were under these conditions.  (Please give


two different advantages.)  What factors would cause this practice to disappear?

 


4.  (30%).
  In 1970, the economic historian, Evsey Domar, said that it would be impossible to have at one and the same time "free" land, "free" labour, and a land-owning aristocracy.  If "free" land means land that is in excess supply—and therefore has a zero price—and "free" labour means labour that is free of bondage, explain why this combination would be impossible.





ECON 3870



July 2015 Midterm Answer Key

 

 

Note: The answers below are more thorough than student answers are expected to be.


1a. Prices are irrational, in the specific sense that they do not give the value of any product to users.  In addition, they usually fail to measure the marginal costs of supplying goods, since supply is driven, not by considerations of profit and cost effectiveness, but rather by a system of output targets or quotas.

(Note: Students should get at least one of the ways in which prices are irrational.)

To see the irrational nature of prices, consider the following graph:


1.jpg (26451
 bytes)

 


PD = the demand price, giving the value of the good to users.
P0 = the official price of the good, which becomes a price ceiling.

1b.  Unless the official price of the product is kept below equilibrium, the market will go to those willing and able to pay the going price.  If the government (state) wants to prioritize the distribution of the good---i.e., to achieve a different distribution than that dictated by the market---it must set the price below equilibrium, creating a shortage of the good.  Then it can determine which part of the demand is satisfied and which part remains unsatisfied.  In this way, it prioritizes between would-be demanders.  Those with higher priority are more generously supplied with the good.

In these conditions, the official price, P0, contains no useful information about demand.  If we observe only that price, we don't know what goods are worth to users.  We therefore lack a good measure of demand.  As a consequence, we don't


know which products should be
increased in supply and which should be reduced. We cannot compare the return on


investment in one product or industry vs. the return on investing somewhere else.  The planners of this economy don't have


good information to guide investment and resource allocation, which is to say that they don't have a good information base


for managing the economy. A legacy of this is likely to be a myriad of inefficient production facilities--the results of poor


investment choices--that are threatened with bankruptcy when forced to face greater competition (as in transition


economies).

Black market prices, where they exist, contain more information than official prices, but they are not easily observable by top government officials with basic responsibility for resource allocation, especially when this market is illegal.

1c. Because of the informational deficiency noted under (b), a major problem arises in setting output quotas for producers. State authorities lack good information about demand.  Yet they need simple, objective criteria that will be perceived as fair to use in setting quotas.

Because demand criteria were unavailable, Soviet-type economies used each firm’s historical record for this purpose.  Output quotas were set “from the achieved level.”  Each year, a firm was expected to do a bit better than last year.  Typically, a firm’s quota would equal last year’s output plus a measure of growth, the latter depending on recent investment in enterprise production capacity.

One consequence of this was that firms were reluctant to produce beyond their quota levels, even when able to do so.  Instead they produced less than capacity rather than expand production and find next year’s quotas raised in consequence.  They often wasted resources, in other words, deliberately holding surplus labor and capital to ensure plan fulfilment.

Firms also maintained a rhythm of production that made it hard for the authorities to raise their quotas while they were in the process of fulfilling them.  This was called “storming.”  Firms would start out slowly, then pick up speed, and were finally going flat out by the end of the plan period.  In the next period, they would repeat the cycle.  (We sometimes see students in a similar rhythm with respect to their course work.)

There were other consequences of planning from the achieved level, including inelastic supply.

2a.  Under state capitalism, governments grant market power to firms in exchange for the right to share in the profits of these firms and to use them as agents to help achieve state goals.  The firms in question cannot fully exploit their opportunities for monopoly profit when state priorities dictate another course of action.  For example, such a firm might be required to use domestic resources in its production rather than imported resources, and thereby to incur higher costs.  Loyalty to the government is often a factor in selecting enterprise managers, which can result in a lower quality of management.

Under socialism, the profits of these firms would be used to achieve social goals, such as greater equality. The government would not be able to rely on a few insiders, but would need broad public support—in effect, the political system would have to be a liberal democracy, with effective institutions of restraint, as well as of representation.


2b. Consider the graph below--it's the same as the one in website article #13.




In the graph above, let DD be the demand for a product, with MR denoting its marginal revenue.  Let P0 be the official price of the good, and let Q0 be the quantity demanded at price P0. 

 

What price and quantity would the firm set if it is a profit maximizer and has to turn all its official profit over to


the state—this is its profit at price
P0—but can keep its unofficial profit?  In the above graph, A gives the intersection of MR with P0.  Let QB0 be the output at which MR = P0.  Then QB0 is the output that maximizes unofficial profit, and PB0 is the profit-maximizing price.  Note that QB0 is less than Q0—thus there is a shortage of the good at the official price—while PB0 is greater than P0.

 

In fact, P0 is the marginal cost to the firm of the product, rather than its marginal revenue.  If the seller supplies one more unit of output, P0 is what it must pay in additional costs of production and profit tax turned over to the state budget.  Thus output is determined by buyer preferences as well as the irrational official price of the good. 


The good’s real cost of production is not taken directly into account, and P0 is not likely to reflect this—the firm may have either an official profit or an official loss at price P0.  As a result, outputs are not “rational” in the sense of being efficient and total prices, including bribes and other side payments, are not likely to be rational either.

If the seller could sell every unit of output at PB0, its "unofficial" profit would be the area of rectangle PB0EAP0.  This is the part of its profit that it can keep.  Instead of actually selling the product at price PB0, it might sell at price P0, and collect a bribe or other payment or favour, equal in value to length EA in the graph—in effect charging for the right to buy the good now rather than wait or do without. 

2c. From the graph above, raising the official price, eg., from P0 to P1, cannot get rid of the shortage at the official price, which equals the horizontal distance from the marginal revenue to the demand curve opposite the official price.  Quantity supplied falls, from QB0 to QB1, so that in a limited sense, the firm has a backward-bending supply curve.  It should be noted that the shortage does fall when the official price rises, as long as MR slopes downward more steeply than demand.

 

3a. The table below indicates 3 kinds of political rights that are "basic" in the sense that they are necessary for democracy to exist and also in the sense that they are often hard to establish or change.  NOTE:  This is the same table as in website article #11.

 

BASIC POLITICAL RIGHTS

I

Right to Vote

II

Right to Participate in Electoral Competition
A.  Right to Run for Office
B.  Right to Organize a Political Party, Faction, or Coalition
C.  Right to Organize an Election Campaign

III

Basic Freedoms (Constitutional Bill of Rights)



The most fundamental political right, which gives voting a social value, is the right to participate in electoral competition.  This forces parties to compete for votes by fielding candidates and designing policies, programs, and laws that will be attractive to voters.  It also tends to be a necessary, but not a sufficient condition for insuring basic freedoms, because support of such liberties will often gain votes for parties or candidates. Rights-related grievances have a way of becoming campaign issues.  The right to electoral competition embraces a range of more narrowly defined rights, including the right to run for office; the right to organize a political party or coalition able to field election candidates, and the right to organize particular election campaigns. Without the right of diverse political parties to organize and to compete in elections, the right to vote has no value, and basic freedoms are apt to be precarious.

3b. We divide democracies into "liberal" democracies and "illiberal" democracies, with the latter in some ways more like autocracies.  According to Dani Rodrik, a "liberal" democracy has two types of institutions.  These are institutions of representation--whose task is to translate popular preferences into government policy--and institutions of restraint, whose job is to uphold basic rights and freedoms, including rights of minorities, and prevent government abuse of its power, including its power to regulate elections. 

    Institutions of representation include political parties, parliaments, and electoral systems, which are needed to elicit popular preferences and turn them into policy action, while institutions of restraint include an independent judiciary, police, and media, notably a free press and a constitution that cannot easily be changed by the government currently in power. 

    "Illiberal" democracies have institutions of representation, but not effective institutions of restraint.  In these countries, whose number has been growing, government is more powerful and can act with fewer restraints than governments of liberal democracies must face.  Elections are less likely to be free and fair when democracy is illiberal, and opposition parties face a variety of constraints in electoral competition with the government. 

    State capitalism usually goes hand-in-hand with either dictatorship or illiberal democracy.  Such a political system allows government to rely on a relatively small number of insiders for most of its support and to pay for this support by giving access to monopoly profits, as well as to bribes, subsidies, tax breaks, and other types of economic rent.  The remuneration of insiders would disappear or be lower in a competitive environment.  Thus State Capitalism involves an exchange of rents, including monopoly profits, for support.  The government receives support from insiders, including the managements of state capitalist enterprises, while insiders receive rents in return. 

3c. We can identify two underlying views of public sector expansion.  These are possible because separate measures of


supply prices and quantities
—of Q2 and P3 belowfor goods and services financed by government are usually


unavailable.
  All we observe is total expenditure (P3Q2).  The two views in question are as follows:

 

1.     To some, government has become leviathan, exercising monopoly power over its citizens.  For these observers,

     
the growth of government is mainly a price effect, in which citizens pay higher and higher tax prices for publicly

    
financed goods and services, plus a nationalization effect in which services such as health care come to be paid

    
for, and in some cases to be supplied by, government agencies.  Nationalization also leads to higher effective

    
prices because of the moral hazard effect.  According to this view, the expanded share of GDP accounted for by

    
goods and services that are now publicly financed results mainly from the fact that the average supply price

    
of these products has risen faster than the average price of privately-financed goods and services.
 

 

2.     To others, relative prices of goods and services that are now publicly financed may have risen, but quantity and

    
quality increases have also occurred. To these observers, democratically elected governments have reflected voter

    
preferences and carried out the wishes of their citizens faithfully.   According to this view, at least a significant

    
part of the increase in the share of GDP accounted for by publicly-financed goods and services is a relative

    
quantity and/or quality increase.


The leviathan view notes that expansion of social insurance substitutes tax and payroll fee financing for direct financing in


the form of prices charged of users, resulting in a reduced incentive to economize on insurance-financed services.  The


result is to increase both quantity demanded and the supply price (or the price that must be paid to suppliers).  This is the


“moral hazard” effect and is shown in the graph below.  The shift from direct to indirect financing raises quantity


demanded from Q1 to Q2 while the supply price also rises from P1 to P3.  NOTE:  This graph is also in website article #11.




4.gif (4486 bytes)






 

However, the extent to which a government can exploit its subjects and survive depends on the nature of the political 
system. Exploitation is lower
in a liberal democracy—with both effective institutions of representation and effective
institutions of restraint—where government is under more pressure to be sensitive to the wishes of its citizens than in
a dictatorship or an illiberal democracy.
 




Richard Carson, Instructor 
  B850 Loeb Building 
  (613)520-2600, x1751. 

E-mail: richard_carson@carleton.ca 

 



 

 




 


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