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ECON 2002

ECON 3870


ECON 4807/5807

Scholarship in Comparative Economics




Department of Economics






Welcome to Comparative

Economic Systems, ECON

3870, in Summer Session


July-August, 2015.

NOTE: The FINAL EXAM will be on Thursday, the 20th of August at 7 p.m. in AT 102.

  The graded CLASS ASSIGNMENTS are now in the CUOL Student Centre, D299 Loeb, for pick-up.  The ANSWER KEY is below.

The ANSWER KEY to the midterm is also below. 

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


Department of Economics

Econ 3870V

Instructor: R. Carson

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


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


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.)


  (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:



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


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.




Right to Vote


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


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

  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.

Social Insureance


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.

ECON 3870

  August 2015 CLASS ASSIGNMENT Answer Key

1a. If industry managers receive pay based on the profitability of the industry, they have an incentive to try to collude with managers of firms in their industries to turn the industry into a cartel that maximizes industry-wide profits.  To do this, they have to get monopoly rather than competitive prices for products supplied by the industry.  They don’t set their own prices, but they do set their own outputs, and they know the criteria used by the central planning board to set prices.  Thus they are in a position to keep outputs at monopoly levels and wait for the central planning board to set monopoly prices.  However, they would also have to be able to conceal their true marginal costs from the central authorities.

In order to make this work, the cartel has to be stable.  Historically, cartels have broken down because of disagreements about how its profits should be divided between member firms and over how the quotas of individual firms should be set.  Individual enterprises always have an incentive to expand production since prices exceed true marginal costs.  In order to do this, however, they have to be able to offer price cuts kept secret from industry managers and other firms in the industry.

A key question then arises as to whether the central authorities would encourage cartel-destructive behaviour. They could, for example, allow firms to set prices below the official prices set by the planning board, but not above.  The authorities are supposed to be anti-cartel, but in practice, their tolerance of cartel behaviour depends on how close the political system is to liberal democracy.  If the economic system is allowed to turn into state capitalism, monopolistic behaviour by firms will be tolerated in return for support in achieving state goals.

The behaviour of industry managers toward the central planning board also depends on taxation.  If taxes on profits at official prices are low enough, maximization of official profits makes sense.  But this is at least a nominally socialist government, making it possible that official profits will be mostly taxed away and that most losses at official prices will be subsidized.  Then industry managers would want to keep official prices below monopoly levels, so that sellers can charge bribes and other side payments which they are able to keep.

1b. The firm’s short-run supply curve will slope downward, and as a result, an increase in demand will cause quantity supplied to fall and P to rise by more than the increase in demand.  To see that the supply curve is downward-sloping, consider the necessary condition for maximizing profit per worker, P(MPL) = (PQF)/L.  This can be rewritten as (MPL)L = QF/P.  This in turn can be rewritten as F/P = Q – (MPL)L = (MPK)K, since Q = (MPL)L + (MPK)K under constant returns to scale.

Suppose that P rises.  Then F/P will fall, and therefore (MPK)K must fall in order to restore the necessary condition for maximizing profit per worker.  K is fixed in the short run, and therefore MPK must fall, which can only happen if L falls.  Thus L falls in response to an increase in P.  This in turn causes Q to fall.  The higher is P, the lower is Q—which is too say that the firm’s short-run supply curve is downward-sloping.  In the long run, a vigorous industry supply increase in response to an upward shift of demand depends entirely on new investment in the industry, whether by existing firms, by new entrants, or by both.  Protectionist measures are more damaging, both to employment and to output, than when firms maximize profit.

Note:  The assumption of constant returns to scale is not necessary here, although it does make the problem easier to solve.  Let us go back to F/P = Q – (MPL)L and assume diminishing returns to labour.  A unit increase in L causes the right-hand side of this equality to change by MPLMPL – (MPLL)L = –(MPLL)L, where MPLL is the change in MPL when L increases by a unit.  Because of diminishing returns to labour, MPLL is negative, and thus –(MPLL)L is positive.  An increase in L raises Q – (MPL)L.  Thus when P rises, L and therefore Q must fall.

2. Consider the graph on p.165 of Market and State in Economic Systems. Suppose that Firm M develops a tire capable of significantly reducing automobile fuel consumption.  When marketed, the new Brand X tires will hurt producers of older types, while making consumers better off. This is "creative destruction", which creates consumer surplus, but destroys producer surplus associated with the old technology.  However, the value of the increase in consumer surplus will exceed the value of the indicated fall in producer surplus, as the graph shows. Suppose the industry is perfectly competitive before Brand X tires come along, with price, PB, and quantity, QB, given by the intersection of supply, SB , with demand, D. (For simplicity here, Q measures consumption of tire services, rather than of tires per se.)

As a result of the innovation, Firm M and companies licenced by it can supply tire services more cheaply than the rest of the industry. Thus, the industry supply curve shifts out to SA. If the industry remained competitive, price would fall to PA, and quantity rise to QA, of which Q'B would come from the older type of tire and (QA - Q'B) from the new Brand X tires.

However, the innovation will also give Firm M market power, so that it is able to set price, PE, higher than PA, which reduces quantity demanded to QE. Even so, the innovation creates additional consumer surplus of approximately area PBBEPE, while destroying producer surplus equal to area PBBCPE, for a net gain of BEC, over and above the gain to the innovating firm.

There is also a "deadweight loss" equal to area EAT, because Firm M is setting its price above marginal cost. Nevertheless, it is area BEC that is important here because it is the net gain to society from the innovation over and above the gain to the innovating firm.  A static efficiency analysis would find the industry efficient before the innovation and inefficient afterwards, but in the interim, a net gain has occurred.  This is why Schumpeter called the standard economic analysis of capitalism in his day “like Hamlet, without the Danish prince…”  It focused too much on static outcomes, whereas Schumpeter believed that capitalism could only be understood as a dynamic entity, in which firms grow on the backs of their innovations.

However, the political weight of producer and consumer surplus is not necessarily the same.  A government might still want to suppress the innovation because of the losses to firms supplying the older type of tire. Production of the older tire will also use specialized physical and human capital, whose value will fall as a result of the innovation. If the political support of those who lose because of the “destruction” part of Creative Destruction is sufficiently valuable to government, the innovation will be suppressed.  Worse, such a government might adopt policies that lower innovation generally in order to protect the producer surplus or rent on past investments in both physical and human capital. Innovation does destroy area PBBCPE, representing a wealth loss to producers using the old technology and possibly to workers whose human capital has been made less valuable.

3. In medieval Western Europe, a farmer who owned land would rarely have his land holdings consolidated into a single parcel

of land in one place.  Instead, his holdings would consist of several long, thin strips that were separated from one another and

scattered through the open fields surrounding his village. To hold 40 different strips of land would not be unusual.


This seems inefficient because more land was required for boundaries and roads, and more time was lost going to, from, and between strips than would have been required had land holdings been consolidated. There were more boundary disputes, and whatever a peasant did on one strip—sowing, weeding, irrigation, drainage, fertilization,etc.—would affect his neighbours. Therefore why did it occur?  We can give three reasons, only two of which are required.


A.   The first cause was the decentralization of government authority down to the regional level of government—central authority was weak—plus the low level of trade between regions and the low value of land.  In absence of central authority, trade routes were blocked or too dangerous to use, and land was plentiful.


This meant regional self-sufficiency, which increased the number of different crops that every village and every peasant had to grow.  Each manor grew several different kinds of crops and divided its land according to crop.  It could take several days to plant or harvest a given crop, and seasonal patterns varied from crop to crop.


          The scattering of strips allowed a peasant to own at least one strip of

          land within the area devoted to each crop.  With scattering of strips,

         each peasant could work for himself throughout the planting and

         harvesting seasons for each crop, rather than having to hire out his

         labour to other peasants. 


         Many serfs owned little or no land and largely worked for other

         peasants who did. The scattering of strips enabled each landless

          peasant to work for just one or two peasant employers throughout the

         planting and harvesting season. The scattering of strips thus

         minimized the costs of the transactions that peasants would have to

         make with one another to carry out planting, caring for, and

         harvesting of crops.


B.   While a typical peasant would grow several different crops, he would likely not grow as many as 40.  There were often local markets and local trade. Thus a second reason for the medieval scattering of strips is that it was also a way of insuring against the risk of crop failure, as well as from theft or destruction of crops.  A local lord had the right to trample crops down in pursuit of game, for example, and his animals might eat part of a crop—crop land was usually not enclosed.  Crop blight, pestilence or drought would typically cause greater losses in some areas than in others.  A poor crop in one part of the manor did not necessarily imply the same degree of failure elsewhere.  Thus the scattering of strips was a form of risk management or of insurance.


C.   The scattering of strips also appears to have been a way to give each peasant some good and some bad land, thereby treating peasants more fairly than if some had only good land and some had only bad.


The practice came to an end with the rise of the nation state and the expansion of trade at the end of the Middle Ages. The rise of the nation state meant that stronger central governments could promote trade within their jurisdictions, reducing the need for local or regional self sufficiency. Peasants could now specialize, growing fewer crops. Growing trade between nations reduced self sufficiency at the national level.  The growing scarcity of land also made it costlier to waste land.

4.  Let us first graph the two “frees” mentioned by Domar.  Abundant land means that diminishing returns to labour on land in agriculture have not yet appeared. The marginal product (MPL) of labour is horizontal and equal to the average product (APL) or output per unit of labour, say Q/L. We get the following:


With “free” labour, the equilibrium is at C, where the demand for labour (or MPL) equals the supply. There MPL equals the real wage, regardless of whether this is paid in money or in kind.


Thus MPL = W/P = Q/L = APL at C.  But then WL = PQ = national income. National income is entirely paid out as wages or earnings of labour.  Nothing is left for the poor aristocracy!  Thus if labour and land are both free, there can be no land-owning aristocracy, unless the nobility is also able to claim some of the income of labour. This could be done through monopsony buying power over labour, but if there are thousands or even hundreds of aristocrats, it may be hard to keep them from competing for labour.  The alternative way of claiming some of labour’s income is through bondage.


Note that in the above circumstances—abundant land and scarce labour, there is a labour theory of value.


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






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