2.3: Measuring Economic Performance

2.3.1: The Business Cycle

Learning Objective

Summarize the phases and turning points inherent in the business cycle

Key Points

• The business cycle reflects economy-wide shifts and therefore is measured with close consideration of trends in Gross Domestic Product.
• Business cycles consist of two phases and two turning points.
• Although termed a cycle, the business cycle does not follow a predictable pattern.
• More recently, economists describe this phenomenon as economic fluctuations, where the long-run expansionary trend of an economy experiences shocks to the system that create short-term departures.

Key Terms

gross domestic product

Gross Domestic Product (GDP) is the market value of all officially recognized final goods and services produced within a country in a given period.

fluctuation

A motion like that of waves; a moving in this and that direction.

recession

a period of reduced economic activity

business cycle

(economics) A long-term fluctuation in economic activity between growth and recession

Example

• The boom in economic activity from about 2002 until 2008 is an example of the expansion characteristic of the upswing portion of the business cycle. Just before 2008, the business cycle peaked, and the economy began to contract.

Business Cycle Defined

The term business cycle (or economic cycle) refers to economy-wide fluctuations in production or economic activity over several months or years. These fluctuations occur around a long-term growth trend, and they typically involve shifts over time between periods of relatively rapid economic growth (an expansion or boom) and periods of relative stagnation or decline (a contraction or recession).

The Phases and Turning Points of Business Cycles

Business cycles are composed of two phases and two turning points.

Phases

• Expansion: The period of time in which real GDP rises and unemployment declines. It is sometimes called recovery.
• Contraction: The period of time in which real GDP declines and unemployment rises. A recession is six consecutive months of decrease. A “severe recession” is called a depression. There is no official definition of severe (length and depth).

Turning Points

• Peak: A peak occurs when the real GDP reaches its maximum, stops rising, and begins to decline. It is determined after the fact.
• Trough: A trough occurs when the real GDP reaches its minimum, stops declining, and begins to rise. It is determined after the fact.

Business cycles are usually measured by considering the growth rate of real gross domestic product. Despite being termed cycles, these fluctuations in economic activity do not follow a mechanical or predictable periodic pattern.

The Development of the Theory

The first systematic exposition of periodic economic crises, in opposition to the existing theory of economic equilibrium, was the 1819 Nouveaux principes d’économie politique by Jean Charles Léonard de Sismondi. Prior to that point, classical economics had denied the existence of business cycles; blamed them on external factors, notably war; or only studied them in a long-term context.

Sismondi found vindication in the Panic of 1825, which was the first international economic crisis occurring in peacetime. Sismondi and his contemporary Robert Owen, who expressed similar but less systematic thoughts in the 1817 Report to the Committee of the Association for the Relief of the Manufacturing Poor, both identified the cause of economic cycles as overproduction and underconsumption. These believed these problems were caused in particular by wealth inequality, and they advocated government intervention and socialism, respectively, as the solution.

This work did not generate interest among classical economists, although underconsumption theory developed as a heterodox branch in economics until being systematized in Keynesian economics in the 1930s.

Sismondi’s theory of periodic crises was developed into a theory of alternating cycles by Charles Dunoyer, and similar theories, showing signs of influence by Sismondi, were developed by Johann Karl Rodbertus.

Periodic crises in capitalism formed the basis of the theory of Karl Marx, who further claimed that these crises were increasing in severity and would lead to a Communist revolution. Marx devoted hundreds of pages of Das Kapital to crises.

Cycles or Fluctuations?

In recent years, economic theory has moved towards the study of economic fluctuation rather than the study of business cycles. However, some economists use the phrase “business cycle” as a convenient shorthand.

For Milton Friedman, the term “business cycle” is a misnomer because of its noncyclical nature. Friedman believed that for the most part, excluding very large supply shocks, business declines are more of a monetary phenomenon.

Rational expectations theory leads to the efficient-market hypothesis, which states that no deterministic cycle can persist, because it would consistently create arbitrage opportunities.

Much economic theory also holds that the economy is usually at or close to equilibrium. These views have led to the formulation of the idea that observed economic fluctuations can be modeled as shocks to a system.

In the tradition of Slutsky, business cycles can be viewed as the result of stochastic shocks that on aggregate form a moving average series. However, the recent research employing spectral analysis has confirmed the presence of business (Juglar) cycles in the world GDP dynamics at an acceptable level of statistical significance.

Long Term Growth

Deviations from the long term growth trend, US 1955–2005

A purple line moving up and down show trends from 1955-2005.

2.3.2: Economic Indicators

Learning Objective

Identify the major economic indicators and what economic factors they measure

Key Points

• Many different economic indicators are tracked in order to evaluate the economy in different ways or from different perspectives.
• Government agencies, such as the Bureau of Labor Statistics, and private entities, such as the National Bureau of Economic Research, report and compile many useful economic indicators.
• Economic indicators are used to evaluate the past performance of the economy as well as predict future economic conditions.

Key Terms

economic indicator

An economic indicator (or business indicator) is a statistic about the economy. Economic indicators allow analysis of economic performance and predictions of future performance.

Lagging indicators

Lagging indicators are indicators that usually change after the economy as a whole does.

leading indicator

Leading indicators are indicators that usually change before the economy as a whole changes.

Example

• The National Bureau of Economic Research analyzes and interprets many different trends in economic indicators, including GDP (gross domestic product), to identify business cycle dates.

Economic Indicators

An economic indicator is a statistic that provides valuable information about the economy. One application of economic indicators is the study of business cycles.

There is no shortage of economic indicators, and trying to follow them all would be an overwhelming task. Thus, economists and businesspeople track only a select few, including those that we’ll now discuss including:

• Indices
• Earnings reports
• Economic summaries

Examples within these categories include:

• Unemployment rate “”
• Quits rate
• Housing starts
• Consumer price index (a measure for inflation)
• Consumer leverage ratio
• Industrial production
• Bankruptcies
• Gross domestic product
• Broadband Internet penetration
• Retail sales
• Stock market prices
• Money supply changes

The leading business cycle dating committee in the United States of America is the National Bureau of Economic Research (private). The Bureau of Labor Statistics is the principal fact-finding agency for the U.S. government in the field of labor economics and statistics. Other producers of economic indicators includes the United States Census Bureau and United States Bureau of Economic Analysis.

Lagging Indicators and Leading Indicators

Statistics that report the status of the economy a few months in the past are called lagging economic indicators. One such lagging indicator is the average length of unemployment. If unemployed workers have remained out of work for a long time, we may infer that the economy has been slow.

Indicators that predict the status of the economy three to twelve months into the future are called leading economic indicators. If such a leading indicator rises, the economy is likely to expand in the coming year. If it falls, the economy is likely to slow down.

To predict where the economy is headed, we obviously must examine several leading indicators. It’s also helpful to look at indicators from various sectors of the economy (which might include labor, manufacturing, and housing).

One useful indicator of the outlook for future jobs is the number of new claims for unemployment insurance. This measure tells us how many people recently lost their jobs. If the number of claims is rising, it signals trouble ahead because unemployed consumers can’t buy as many goods and services as they could if they were working and had paychecks coming in.

To gauge the level of goods to be produced in the future (which will translate into future sales) economists look at a statistic called average weekly manufacturing hours. This measure tells us the average number of hours worked per week by production workers in manufacturing industries. If the average numbers of hours is on the rise, the economy will probably improve.

The number of building permits issued is often a good way to assess the strength of the housing market. An increase in this statistic—which tells us how many new housing units are being built—indicates that the economy is improving because increased building brings money into the economy not only through new home sales but also through sales of furniture and appliances to furnish these homes.

Finally, if you want a measure that combines all these economic indicators, as well as others, a private research firm called the Conference Board publishes a U.S. leading index.

To get an idea of what leading economic indicators are telling us about the state of the economy today, go to the “Business” section of the CNN Money website (CNNMoney.com), and click first on “Economy” and then on “Leading Indicators.”

Consumer Confidence Index

The Conference Board also publishes a consumer confidence index based on results of a monthly survey of 5,000 U.S. households. The survey gathers consumers’ opinions on the health of the economy and their plans for future purchases. It’s often a good indicator of consumers’ future buying intent.

For information on current consumer confidence, go to the CNN Money website (CNNMoney.com), click on the “Business” section, and click on “Economy” and on “Consumer Confidence.”

2.3.3: Gross Domestic Product

Learning Objective

Differentiate the product, income, and expenditure approaches to calculating GDP

Key Points

• GDP per capita is often considered an indicator of a country’s standard of living.
• The product approach sums the outputs of every class of enterprise to arrive at total GDP.
• The expenditure approach works on the principle that all products must be bought by a consumer; therefore, the value of the total product must be equal to consumers’ total expenditures.
• The income approach measures GDP by adding the incomes that firms pay households for factors of production — i.e., wages for labor, interest for capital, rent for land and profits for entrepreneurship.

Key Terms

per capita

per person

GDP

Gross Domestic Product (Economics). A measure of the economic production of a particular territory in financial capital terms over a specific time period.

GDI

gross domestic income; the total income received by all sectors of an economy within a nation.

Example

• The value of all the goods and services produced in the United States in 2011 (GDP) was around $15 trillion.

What is Gross Domestic Product (GDP)?

GDP is the value of all the final goods and services produced in a country during a given time period. Intermediate goods are not counted because they would cause double-counting to occur. GDP only refers to goods produced within a particular country. For instance, if a firm is located in one country but manufactures goods in another, those goods are counted as part of the manufacturing country’s GDP, not the firm’s home country. BMW is a German company, but cars manufactured in the U.S. are counted as part of the U.S. GDP. GDP is a measure used by economists to determine how productive a country is on the whole.

GDP per capita is often considered an indicator of a country’s standard of living. Under economic theory, GDP per capita exactly equals the gross domestic income (GDI) per capita.

GDP Categories – United States

Components of U.S. GDP

Chart showing the categories of product and the amount of money for each in the years 2009 and 2010.

How Is GDP Determined?

GDP can be determined in three ways:

• the product (or output) approach;
• the income approach; and
• the expenditure approach.

The product approach is the most direct, summing the outputs of every class of enterprise to arrive at the total. The expenditure approach works on the principle that all products must be bought by a consumer; therefore, the value of the total product must be equal to consumers’ total expenditures. The income approach works on the principle that the incomes of the productive factors must be equal to the value of their products. This approach determines GDP by finding the sum of all producers’ incomes.

Example: the Expenditure Approach

The expenditure approach only measures products that are intended to be sold. If you knit yourself a sweater, it is production but does not get counted as GDP because it is never sold. Components of GDP by expenditure are:

consumption + gross investment + government spending + (exports − imports)

Note: In the expenditure-method equation given above, the exports-minus-imports term is necessary in order to null out expenditures on things not produced in the country (imports) and add in things produced but not sold in the country (exports).

Consumption is normally the largest GDP component in the economy. Consumables fall under one of the following categories: durable goods, non-durable goods and services. Examples include food, rent, jewelry, gasoline and medical expenses.

Examples of investment include the construction of a new mine, purchase of software, or purchase of equipment for a factory. Spending by households on items like new houses is also included in investment. Buying financial products is classed as saving, as opposed to investment.

Government spending is the sum of government expenditures on final goods and services. It includes salaries of public servants, purchase of weapons for the military, and any investment expenditure by a government. It does not include any transfer payments like social security or unemployment benefits.

Example: the Production Approach

The production approach is also known as the Net Product or Value Added method. This method consists of three stages:

1. Estimating the gross value of domestic output in various economic activities;
2. Determining the intermediate consumption — i.e., the cost of material, supplies and services used to produce final goods or services; and
3. Deducting intermediate consumption from Gross Value to obtain the Net Value of Domestic Output.

For measuring gross output of domestic product, economic activities (i.e. industries) are classified into various sectors. After classifying economic activities, the gross output of each sector is calculated by either of the following two methods:

1. By multiplying the output of each sector by their respective market price and adding them together, or
2. By collecting data on gross sales and inventories from the records of companies and adding them together.

Example: the Income Approach

Another way of measuring GDP is to measure total income. If GDP is calculated this way, it is sometimes called Gross Domestic Income (GDI). GDI should provide the same amount as the expenditure method. However, in practice, measurement errors will make the two figures slightly off when reported by national statistical agencies.

This method measures GDP by adding the incomes that firms pay households for factors of production — i.e., wages for labor, interest for capital, rent for land and profits for entrepreneurship. The U.S. “National Income and Expenditure Accounts” divide incomes into five categories:

• Wages, salaries and supplementary labor income
• Corporate profits
• Interest and miscellaneous investment income
• Farmers’ income
• Income from non-farm unincorporated businesses

These five income components sum to net domestic income at factor cost. Two adjustments must then be made to get GDP:

1. Indirect taxes minus subsidies are added to get from factor cost to market prices.
2. Depreciation (or capital consumption allowance) is added to get from net domestic product to gross domestic product.

Map of world showing GDP per capita, 2011

GDP per capita 2011 for the world economy; with the darkest reds being the highest, and the lighter yellows to white being the lowest.

2.3.4: Employment Levels

Learning Objective

Differentiate between cyclical, structural and frictional unemployment

Key Points

• Full employment is defined by the majority of mainstream economists as being an acceptable level of natural unemployment above 0%, the discrepancy from 0% being due to non-cyclical types of unemployment.
• The Phillips curve tells us that there is no single unemployment number that one can single out as the full employment rate. Instead, there is a trade-off between unemployment and inflation.
• Cyclical unemployment occurs when there is not enough aggregate demand in the economy to provide jobs for everyone who wants to work.
• Structural unemployment occurs when a labor market is unable to provide jobs for everyone who wants to work because there is a mismatch between the skills of the unemployed workers and the skills needed for the available jobs.
• Frictional unemployment is the time period between jobs when a worker is searching for or transitioning from one job to another.

Key Terms

structural unemployment

A type of unemployment explained by a mismatch between the requirements of the employers and the properties (such as skills, age, gender, or location) of the unemployed.

Macroeconomics

the study of the entire financial system in terms of the total amount of goods and services produced, total income earned, the level of employment of productive resources, and the general behavior of prices

cyclical unemployment

A type of unemployment explained by the demand for labor going up and down with the business cycle.

frictional unemployment

A type of unemployment explained by people being temporarily between jobs, searching for new ones. A labor market is regarded as being in the state of full employment if no frictional unemployment is present.

unemployment rate

the percent of the total labor force without a job

Example

• One kind of frictional unemployment is called wait unemployment: it refers to the effects of the existence of some sectors where employed workers are paid more than the market-clearing equilibrium wage. Not only does this restrict the amount of employment in the high-wage sector, but it attracts workers from other sectors who wait to try to get jobs there. The main problem with this theory is that such workers will likely wait while having jobs, so they are not counted as unemployed. In Hollywood, for example, those who are waiting for acting jobs also wait on tables in restaurants for pay (while acting in Equity Waiver plays at night for no pay). However, these workers might be seen as underemployed.

Employment Levels

Full Employment Defined

Employment levels are one of the most important economic indicators available. Full employment, in macroeconomics, is the level of employment rates when there is no cyclical unemployment. It is defined by the majority of mainstream economists as being an acceptable level of natural unemployment above 0%, the discrepancy from 0% being due to non-cyclical types of unemployment. Unemployment above 0% is advocated as necessary to control inflation, which has brought about the concept of the Non-Accelerating Inflation Rate of Unemployment (NAIRU). Governments that follow NAIRU are attempting to keep unemployment at certain levels (usually over 4%, and as high as 10% or more) by keeping interest rates high. The majority of mainstream economists mean NAIRU when speaking of full employment.

What most economists mean by full employment is a rate somewhat less than 100%, considering slightly lower levels desirable. For example, the 20^th century British economist, William Beveridge, stated that an unemployment rate of 3% was full employment. Other economists have provided estimates between 2% and 13%, depending on the country, time period, and the various economists’ political biases. However, rates of unemployment substantially above 0% have also been attacked by prominent economists, such as John Maynard Keynes:

“The Conservative belief that there is some law of nature which prevents men from being employed, that it is ‘rash’ to employ men, and that it is financially ‘sound’ to maintain a tenth of the population in idleness for an indefinite period, is crazily improbable – the sort of thing which no man could believe who had not had his head fuddled with nonsense for years and years. The objections which are raised are mostly not the objections of experience or of practical men. They are based on highly abstract theories – venerable, academic inventions, half misunderstood by those who are applying them today, and based on assumptions which are contrary to the facts… J.M. Keynes, in a pamphlet to support Lloyd George in the 1929 election.

Ideal Unemployment

An alternative, more normative, definition describes full employment as the attainment of the ideal unemployment rate, where the types of unemployment that reflect labor-market inefficiency (such as structural unemployment) do not exist. Only some frictional unemployment would exist, where workers are temporarily searching for new jobs. For example, Lord William Beveridge defined full employment as where the number of unemployed workers equaled the number of job vacancies available. He preferred that the economy be kept above that full employment level in order to allow maximum economic production.

The Phillips curve tells us that there is no single unemployment number that one can single out as the full employment rate. Instead, there is a trade-off between unemployment and inflation: a government might choose to attain a lower unemployment rate but would pay for it with higher inflation rates. Ideas associated with the Phillips curve questioned the possibility and value of full employment in a society: this theory suggests that full employment—especially as defined normatively—will be associated with positive inflation.

NAIRU-SR-and-LR

Short-run Phillips curve before and after Expansionary Policy, with long-run Phillips curve (NAIRU).

A chart where unemployment rate is the x-axis and inflation rate is the y-axis. A red vertical line represents NAIRU or Long-Run Phillips Curve, and two blue lines are curving down and across the red line: New Short-Run Phillips Curve and Initial Short-Run Phillips Curve.

There are three important categories of unemployment levels that should be understood in order to evaluate the effect of employment levels on overall economic performance: cyclical unemployment, structural unemployment, and frictional unemployment.

Cyclical Unemployment

Cyclical unemployment occurs when there is not enough aggregate demand in the economy to provide jobs for everyone who wants to work. When demand for most goods and services falls, less production is needed, consequently fewer workers are needed; wages are sticky and do not fall to meet the equilibrium level and mass unemployment results. With cyclical unemployment, the number of unemployed workers exceeds the number of job vacancies, so that even if full employment was attained and all open jobs were filled, some workers would still remain unemployed.

Structural Unemployment

Structural unemployment occurs when a labor market is unable to provide jobs for everyone who wants to work because there is a mismatch between the skills of the unemployed workers and the skills needed for the available jobs. Structural unemployment may be encouraged to rise by persistent cyclical unemployment: if an economy suffers from long-lasting low aggregate demand, many of the unemployed may become disheartened and their skills (including job-searching skills) become rusty and obsolete. The implication is that sustained high demand may lower structural unemployment. Seasonal unemployment may be seen as a kind of structural unemployment, since it is a type of unemployment that is linked to certain kinds of jobs (construction work or migratory farm work).

Frictional Unemployment

Frictional unemployment is the time period between jobs when a worker is searching for or transitioning from one job to another. It is sometimes called search unemployment and can be voluntary based on the circumstances of the unemployed individual. Frictional unemployment is always present in an economy, so the level of involuntary unemployment is properly the unemployment rate minus the rate of frictional unemployment. Frictional unemployment exists because both jobs and workers are heterogeneous, and a mismatch can result between the characteristics of supply and demand. Such a mismatch can be related to any of the following reasons:

• Skills
• Payment
• Work-time
• Location
• Seasonal industries
• Attitude
• Taste

There can be a multitude of other factors, too. New entrants (such as graduating students) and re-entrants (such as former homemakers) can also suffer a spell of frictional unemployment. Workers as well as employers accept a certain level of imperfection, risk, or compromise, but usually not right away; they will invest some time and effort to find a better match. This is in fact beneficial to the economy, since it results in a better allocation of resources.

2.3.5: Productivity

Learning Objective

Explain how productivity is modeled on the company and national level, and how productivity is driven

Key Points

• Productivity is considered a key source of economic growth and competitiveness and, as such, is basic statistical information for many international comparisons and country performance assessments.
• The performance of production measures production’s ability to generate income.
• Labour productivity is a revealing indicator of several economic factors, as it offers a dynamic measure of economic growth, competitiveness, and living standards within an economy.
• Factors driving productivity growth include: investment, innovation, skills, enterprise, and competition.
• Productivity growth means more value is added in production, and this means more income is available to be distributed.

Key Terms

productivity

Productivity is a measure of the efficiency of production and is defined as total output per one unit of a total input.

efficiency

The extent to which time is well used for the intended task.

Example

• When the moving assembly line when integrated into the production of automobiles, it became possible to produce many more autos with the same number of factory workers. Said another way, the productivity of labor in the auto manufacturing business increased dramatically.

Productivity Defined

Production is the act of creating output, which is a good or service that has value and contributes to the utility of individuals. Productivity is the ratio of what is produced to what is required to produce it. In other words, productivity is a measure of production efficiency, and its level has major results on overall economic performance. Productivity is considered a key source of economic growth and competitiveness and, as such, is basic statistical information for many international comparisons and country performance assessments.

Production Performance

The performance of production measures production’s ability to generate income. There are two components in income growth due to performance: the income growth caused by an increase in production volume and the income growth caused by an increase in productivity. The income growth caused by increased production volume is determined by moving along the production function graph. The income growth corresponding to a shift of the production function is generated by the increase in productivity. The change of real income signifies a move from Point 1 to Point 2 on the production function. When we want to maximize the production performance, we have to maximize the income generated by the production function.

The Production Function

Growth in income due to production are due to an increase in production volume or an increase in productivity.

Diagram showing how production performance works. Dotted lines labeled T1, T2, P1, and P2 cross over lines labeled 1 and 2.

Productivity Models

With the help of productivity models, it is possible to calculate the performance of the production process. The starting point is a profitability calculation, using surplus value as a criterion of profitability. The surplus value calculation is the only valid measure for understanding the connection between profitability and productivity. A valid measurement of total productivity necessitates considering all production inputs, and the surplus value calculation is the only calculation to conform to that requirement.

Surplus Value Calculation

This is an example of a model calculating surplus value, and thus measuring productivity.

This chart shows the quantity, price, and value for different production inputs over two periods.

The results of the above model are easily interpreted and understood. We see that the real income has increased by 58.12 units, of which 41.12 units came from the increase of productivity growth. The other 17.00 units came from the production volume growth. Based on these changes in productivity and production volume values, we can explicitly locate the production on the production.

There are two parts of the production function. The first is called “increasing returns” and occurs when productivity and production volume increase or when productivity and production volume decrease. The second, “diminishing returns”, occurs when productivity decreases and volume increases or when productivity increases and volume decreases.

In the above example, the combination of volume growth (+17.00) and productivity growth (+41.12) reports explicitly that the production is classified as “increasing returns” on the production function. This model demonstration reveals the fundamental character of total productivity. Total productivity is that part of real income change which is caused by the shift of the production function. Accordingly, any productivity measure is valid only when it indicates this kind of income change correctly.

National Productivity

In order to measure the productivity of a nation or an industry, it is necessary to operationalize the same concept of productivity as in a production unit or a company. However, the object of modelling is substantially wider and the information more aggregate. There are different measures of national productivity, and the choice between them depends on the purpose of the productivity measurement and/or data availability.

One of the most widely used measures of productivity is Gross Domestic Product (GDP) per hour worked. Another productivity measure is known as multi-factor productivity (MFP). It measures the residual growth that cannot be explained by the rate of change in the services of labour, capital and intermediate outputs, and is often interpreted as the contribution to economic growth made by factors such as technical and organizational innovation.

Labor productivity is a revealing indicator of several economic factors, as it offers a dynamic measure of economic growth, competitiveness, and living standards within an economy. Labor productivity is equal to the ratio between a volume measure of output (gross domestic product or gross value added) and a measure of input use (the total number of hours worked or total employment). The volume measure of output reflects the goods and services produced by the workforce. The measure of input use reflects the time, effort, and skills of the workforce.

Drivers Of Productivity Growth

Certain factors are critical for determining productivity growth. These include:

1. Investment: The more capital workers have at their disposal, generally the better they are able to do their jobs.
2. Innovation: For example, better equipment works faster and more efficiently, or better organization increases motivation at work.
3. Skills: These are needed to take advantage of investment in new technologies and organisational structures.
4. Enterprise: This is the seizing of new business opportunities by both start-ups and existing firms.
5. Competition: Improves productivity by creating incentives to innovate and ensures that resources are allocated to the most efficient firms.

Importance Of Productivity Growth

Productivity growth is a crucial source of growth in living standards. Productivity growth means more value is added in production, and this means more income is available to be distributed. At a firm or industry level, the benefits of productivity growth can be distributed in a number of different ways:

1. to the workforce through better wages and conditions;
2. to shareholders through increased profits and dividend distributions;
3. to customers through lower prices;
4. to the environment through more stringent environmental protection; and
5. to governments through increases in tax payments.

At the national level, productivity growth raises living standards because more real income improves people’s ability to purchase goods and services, enjoy leisure, improve housing and education and contribute to social and environmental programs. Over long periods of time, small differences in rates of productivity growth compound — like interest in a bank account — and can make an enormous difference to a society’s prosperity. Nothing contributes more to reduction of poverty, to increases in leisure, and to the country’s ability to finance education, public health, environment and the arts.

2.3.6: Stability Through Fiscal Policy

Learning Objective

Outline the economic objectives of fiscal policy

Key Points

• Governments use fiscal policy to influence the level of aggregate demand in an economy.
• The effectiveness of fiscal policy in general played an important role in recent discussions surrounding the appropriateness of various government responses to recessions.
• Different factions of economic thought offer different theoretical perspectives on fiscal policy.
• Tight fiscal policy, resulting from increasing taxes and reducing government spending, can keep inflation down at the expense of increasing unemployment.
• Loose fiscal policy, resulting from increasing government spending and reducing taxes, can decrease the unemployment level at the risk of increasing inflation.

Key Term

fiscal policy

Government policy that attempts to influence the direction of the economy through changes in government spending or taxes.

Example

• A recent fiscal policy initiative in the United Sates was the American Recovery and Reinvestment Act of 2009, which was aimed at stimulating economic activity through various channels, such as job creation and federal tax credits.

The Debate Around Fiscal Policy

Governments use fiscal policy to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of:

• Price stability
• Full employment
• Economic growth

Keynesian economics suggests that increasing government spending and decreasing tax rates are the best ways to stimulate aggregate demand, and decreasing spending and increasing taxes after the economic boom begins.

Keynesians argue that this method may be used in times of recession or low economic activity as an essential tool for building the framework for strong economic growth and working towards full employment.

In theory, the resulting deficits would be paid for by an expanded economy during the boom that would follow; this was the reasoning behind the New Deal.

Governments can use a budget surplus to do two things:

• To slow the pace of strong economic growth
• To stabilize prices when inflation is too high

Keynesian theory posits that removing spending from the economy will reduce levels of aggregate demand and contract the economy, thus stabilizing prices.

AS + AD graph

The “aggregate supply” and “aggregate demand” curves for the AS-AD model.

Economists debate the effectiveness of fiscal stimulus.

The argument mostly centers on crowding out, a phenomenon where government borrowing leads to higher interest rates that offset the stimulative impact of spending.

When the government runs a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing, or monetizing the debt. When governments fund a deficit with the issuing of government bonds, interest rates can increase across the market, because government borrowing creates higher demand for credit in the financial markets. This causes a lower aggregate demand for goods and services, contrary to the objective of a fiscal stimulus.

Neoclassical economists generally emphasize crowding out, while Keynesians argue that fiscal policy can still be effective especially in a liquidity trap where, they argue, crowding out is minimal, while Austrians argue against almost any government distortion in the market.

Some classical and neoclassical economists argue that crowding out completely negates any fiscal stimulus; this is known as the Treasury View, which Keynesian economics rejects.

The Treasury View refers to the theoretical positions of classical economists in the British Treasury, who opposed Keynes’ call in the 1930s for fiscal stimulus. The same general argument has been repeated by some neoclassical economists up to the present.

Austrians say that Fiscal Stimulus, such as investing in roads and bridges, does not create economic growth or recovery, pointing to the case that unemployment rates don’t decrease because of fiscal stimulus spending, and that it only puts more debt burden on the economy. Many times, they point to the American Recovery and Reinvestment Act of 2009 as an example.

In the classical view, the expansionary fiscal policy also decreases net exports, which has a mitigating effect on national output and income.

When government borrowing increases interest rates, it attracts foreign capital from foreign investors. This is because, all other things being equal, the bonds issued from a country executing expansionary fiscal policy now offer a higher rate of return.

In other words, companies wanting to finance projects must compete with their government for capital so they offer higher rates of return.

To purchase bonds originating from a certain country, foreign investors must obtain that country’s currency. Therefore, when foreign capital flows into the country undergoing fiscal expansion, demand for that country’s currency increases.

The increased demand causes that country’s currency to appreciate. Once the currency appreciates, goods originating from that country cost more to foreigners than they did before, and foreign goods cost less than they did before. Consequently, exports decrease, and imports increase.

Other possible problems with fiscal stimulus include the time lag between the implementation of the policy and detectable effects in the economy, and inflationary effects driven by increased demand.

In theory, fiscal stimulus does not cause inflation when it uses resources that would have otherwise been idle. For instance, if a fiscal stimulus employs a worker who otherwise would have been unemployed, there is no inflationary effect; however, if the stimulus employs a worker who otherwise would have had a job, the stimulus is increasing labor demand, while labor supply remains fixed, leading to wage inflation and, therefore, price inflation.

2.3.7: Growth Through Monetary Policy

Learning Objective

Explain how monetary policy theoretically promotes growth

Key Points

• Monetary policy refers to actions taken by a central bank, such as the Federal Reserve in the United States, which seek to influence the overall level of economic activity in an economy by targeting interest rates or the money supply.
• Expansionary monetary policy seeks to lower interest rates or increase the money supply, allowing money to be acquired more easily, increasing economic activity in an economy.
• Contractionary monetary policy will increase interest rates or reduce the money supply, making money (loans, etc.) more difficult to acquire and, thus, reducing (or at least reducing the growth rate of) economic activity in an economy.
• The Federal Reserve System (the Fed) can initiate monetary policy through open market operations, or by changing reserve requirements or the discount window lending interest rate.

Key Terms

Federal Reserve

the central banking system of the United States

monetary policy

The process by which the government, central bank, or monetary authority manages the supply of money, or trading in foreign exchange markets.

Example

• By adjusting monetary policy in favor of low interest rates and a large monetary base, the Fed is taking expansionary actions designed to help the United States recover from the recession.

Influencing Economic Activity Through Policy

In every country, the government takes steps to help the economy achieve the goals of growth, full employment, and price stability.

In the United States, the government influences economic activity through two approaches:

• Monetary policy
• Fiscal policy

Through monetary policy, the government exerts its power to regulate the money supply and level of interest rates. Through fiscal policy, it uses its power to tax and to spend.

Monetary Policy and the Fed

Monetary policy is exercised by the Federal Reserve System (“the Fed”), which is empowered to take various actions that decrease or increase the money supply and raise or lower short-term interest rates, making it harder or easier to borrow money.

When the Fed believes that inflation is a problem, it will use contractionary policy to decrease the money supply and raise interest rates. In theory, when rates are higher, borrowers have to pay more for the money they borrow, and banks are more selective in making loans. Because money is “tighter”more expensive to borrow–demand for goods and services will go down, and so will inflation.

To counter a recession, the Fed uses expansionary policy to increase the money supply and reduce interest rates. With lower interest rates, it’s cheaper to borrow money, and banks are more willing to lend it. We then say that money is “easy. ” Attractive interest rates encourage businesses to borrow money to expand production and encourage consumers to buy more goods and services.

The Tools of Monetary Policy

Since the 1970s, monetary policy has generally been formed separately from fiscal policy. Even prior to the 1970s, the Bretton Woods system still ensured that most nations would form the two policies separately.

Within almost all modern nations, special institutions (such as the Fed in the United States, the Bank of England, and the European Central Bank) exist which have the task of executing the monetary policy, often independently of the executive. In general, these institutions are called “central banks” and often have other responsibilities, such as supervising the smooth operation of the financial system. The beginning of monetary policy as such comes from the late nineteenth century, where it was used to maintain the gold standard.

Monetary policy rests on the relationship between the rates of interest in an economy (the price at which money can be borrowed) and the total money supply. Monetary policy uses a variety of tools to control one or both of these in order to influence economic growth, inflation, exchange rates, and unemployment.

Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and, thus, influence the interest rate (to achieve policy goals).

Monetary Policy Tools

There are several monetary policy tools available to achieve these ends:

• Increasing interest rates by fiat
• Reducing the monetary base
• Increasing reserve requirements

All have the effect of contracting the money supply and, if reversed, expand the money supply.

The primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various financial instruments, such as treasury bills, company bonds, or foreign currencies. All of these purchases or sales result in more or less base currency entering or leaving market circulation.

Usually, the short-term goal of open market operations is to achieve a specific short-term interest rate target. In other instances, monetary policy might instead entail the targeting of a specific exchange rate relative to some foreign currency or else relative to gold.

For example, in the case of the United States, the Fed targets the federal funds rate, the rate at which member banks lend to one another overnight; however, the monetary policy of China is to target the exchange rate between the Chinese renminbi and a basket of foreign currencies.

The other primary means of conducting monetary policy include:

• Discount window lending (lender of last resort)
• Fractional deposit lending (changes in the reserve requirement)
• Moral suasion (cajoling certain market players to achieve specified outcomes)
• “Open mouth operations” (talking monetary policy with the market)

Types of Monetary Policy

A policy is referred to as “contractionary,” if it reduces the size of the money supply or increases it only slowly or if it raises the interest rate. An expansionary policy increases the size of the money supply more rapidly or decreases the interest rate.

Furthermore, monetary policies are described as follows: accommodative, if the interest rate set by the central monetary authority is intended to create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or tight, if intended to reduce inflation.

MB, M1 and M2 aggregates from 1981 to 2012

These are the aggregates for MB, M1, and M2, as taken from the St. Louis Federal Reserve’s aggregate graph generator.

Years are on the x-axis and dollar amounts are on the y-axis. Three differently colored lines representing MB, M1, and M2 move up the graph.

2.4: Businesses Under Socialist Systems

2.4.1: Socialism and Planned Economies

Socialism is characterized by social ownership of the means of production.

Learning Objective

Distinguish between economic planning in socialist versus capitalist economic systems

Key Points

• A planned economy is a type of economy consisting of a mixture of public ownership of the means of production and the coordination of production and distribution through state planning.
• Socialism has many variations, depending on the level of planning versus market power, the organization of management, and the role of the state.
• In a socialist system, production is geared towards satisfying economic demands and human needs. Distribution of this output is based on individual contribution.
• Socialists distinguish between a planned economy, such as that of the fomer Soviet Union, and socialist economies. They often compare the former to a top-down bureaucratic capitalist firm.

Key Terms

planned economy

An economic system in which government directly manages supply and demand for goods and services by controlling production, prices, and distribution in accordance with a long-term design and schedule of objectives.

socialism

Any of various economic and political philosophies that support social equality, collective decision-making, distribution of income based on contribution and public ownership of productive capital and natural resources, as advocated by socialists.

Example

• There are few clear examples of purely socialist economies; nonetheless, many of the industrialized countries of Western Europe experimented with one form of social democratic mixed economies or another during the twentieth century, including Britain, France, Sweden, and Norway. They can be regarded as social democratic experiments, because they universally retained a wage-based economy and private ownership and control of the decisive means of production. Variations range from social democratic welfare states, such as in Sweden, to mixed economies where a major percentage of GDP comes from the state sector, such as in Norway, which ranks among the highest countries in quality of life and equality of opportunity for its citizens.

Planned Economy

A planned economy is a type of economy consisting of a mixture of public ownership of the means of production and the coordination of production and distribution through state planning.

Planned Socialist Economy

Economic planning in socialism takes a different form than economic planning in capitalist mixed economies. In socialism, planning refers to production of use-value directly (planning of production), while in capitalist mixed economies, planning refers to the design of capital accumulation in order to stabilize or increase the efficiency of its process. While many socialists advocate for economic planning as an eventual substitute for the market for factors of production, others define economic planning as being based on worker-self management, with production being carried out to directly satisfy human needs. Enrico Barone provided a comprehensive theoretical framework for a planned socialist economy. In his model, assuming perfect computation techniques, simultaneous equations relating inputs and outputs to ratios of equivalence would provide appropriate valuations in order to balance supply and demand.

Hierarchy of Needs

Worker self-management and production to satisfy human needs are key.

The command economy is distinguished from economic planning. Most notably, a command economy is associated with bureaucratic collectivism, state capitalism, or state socialism.

Socialism

Socialism is an economic system characterized by social ownership, control of the means of production, and cooperative management of the economy. A socialist economic system would consist of an organization of production to directly satisfy economic demands and human needs, so that goods and services would be produced directly for use instead of for private profit driven by the accumulation of capital. Accounting would be based on physical quantities, a common physical magnitude, or a direct measure of labor-time. Distribution of output would be based on the principle of individual contribution.

There are many variations of socialism and as such there is no single definition encapsulating all of socialism. They differ in:

• The type of social ownership they advocate;
• The degree to which they rely on markets versus planning;
• How management is to be organised within economic enterprises; and
• The role of the state in constructing socialism.

2.4.2: The Benefits of Socialism

Socialism has a number of theoretical benefits, based on the idea of social equality and justice.

Learning Objective

Demonstrate how the nationalization of key industries, redistribution of wealth, social security schemes and minimum wages are beneficial in socialist economies

Key Points

• Advantages of socialism relating to social equality include a focus on reducing wealth disparities, unemployment and inflation (through price controls).
• Advantages of socialism related to economic planning include an ability to make good use of land, labor and resources, as well as avoiding excess or insufficient production.
• Additional benefits of Socialism: Nationalization of key industries, redistribution of wealth, social security schemes, minimum wages, employment protection and trade union recognition rights.

Key Terms

Public Benefit

A payment made in accordance with an insurance policy or a public assistance scheme.

redistribution

The act of changing the distribution of resources

Example

• Socialist systems have a number of policy tools to help them achieve these goals. Nationalization of key industries such as mining, oil, and energy allows the state to invest directly, set prices and production levels, publicly fund research, and avoid exploitation. Wealth redistribution can occur through targeted, progressive taxation and welfare policies such as free/subsidized education and access to housing. Social security schemes also provide security in old age, while minimum wages, employment protection, and other labor rights ensure a fair wage and safety at work.

How Economies Can Benefit From Socialism

Socialist economics entails the following:

Socialism

A graphical illustration of socialism.

1. Nationalization of key industries, such as mining, oil, steel, energy and transportation. A common model includes a sector being taken over by the state, followed by one or more publicly owned corporations arranging its day-to-day running. Advantages of nationalization include: the ability of the state to direct investment in key industries, distribute state profits from nationalized industries for the overall national good, direct producers to social rather than market goals, and better control the industries both by and for the workers. Additionally, nationalization enables the benefits and burdens of publicly funded research and development to be extended to the wider populace.
2. Redistribution of wealth, through tax and spending policies that aim to reduce economic inequalities. Social democracies typically employ various forms of progressive taxation regarding wage and business income, wealth, inheritance, capital gains and property. On the spending side, a set of social policies typically provides free access to public services such as education, health care and child care. Additionally, subsidized access to housing, food, pharmaceutical goods, water supply, waste management and electricity is common.
3. Social security schemes in which workers contribute to a mandatory public insurance program. The insurance typically includes monetary provisions for retirement pensions and survivor benefits, permanent and temporary disabilities, unemployment and parental leave. Unlike private insurance, governmental schemes are based on public statutes rather than contracts; therefore, contributions and benefits may change in time, and are based on solidarity among participants. Its funding is done on an ongoing basis, without direct relationship to future liabilities.
4. Minimum wages, employment protection and trade union recognition rights for the benefit of workers. These policies aim to guarantee living wages and help produce full employment. While a number of different models of trade union protection have evolved throughout the world over time, they all guarantee the right of workers to form unions, negotiate benefits and participate in strikes. Germany, for instance, appointed union representatives at high levels in all corporations, and as a result, endured much less industrial strife than the UK, whose laws encouraged strikes rather than negotiation.

The benefits of socialism also include the following:

• In theory, based on public benefits, socialism has the greatest goal of common wealth;
• Since the government controls almost all of society’s functions, it can make better use of resources, labors and lands;
• Socialism reduces disparity in wealth, not only in different areas, but also in all societal ranks and classes. Those who suffer from illnesses or are too old to work are still provided for and valued in by the government, assuming that the government is more compassionate that the individual’s family;
• Excess or insufficient production can be avoided;
• Prices can be controlled in a proper extent;
• Socialism can tackle unemployment to a great extent.

2.4.3: The Disadvantages of Socialism

Despite the theoretical benefits of socialist economic systems, there are also disadvantages that may arise in application.

Learning Objective

Evaluate how key components of socialism, such as state ownership of the means of production and the centralization of capital, can be disadvantageous to an economy

Key Points

• Disadvantages of socialism include slow economic growth, less entrepreneurial opportunity and competition, and a potential lack of motivation by individuals due to lesser rewards.
• Critics of socialism claims that it creates distorted or absent price signals, results in reduced incentives, causes reduced prosperity, has low feasibility, and that it has negative social and political effects.
• Economic liberals and pro-capitalist libertarians see private ownership of the means of production and the market exchange as natural entities or moral rights, which are central to their conceptions of freedom and liberty.

Key Terms

socialism

Any of various economic and political philosophies that support social equality, collective decision-making, distribution of income based on contribution and public ownership of productive capital and natural resources, as advocated by socialists.

economy

The system of production and distribution and consumption. The overall measure of a currency system.

Example

• Austrian school economists, such as Friedrich Hayek and Ludwig Von Mises, have argued that the elimination of private ownership of the means of production would inevitably create worse economic conditions for the general populace than those that would be found in market economies. Without the price signals of the market, they state that it is impossible to calculate rationally how to allocate resources.

The Disadvantages of Socialism

Economic liberals and pro-capitalist libertarians see private ownership of the means of production and the market exchange as natural entities or moral rights which are central to their conceptions of freedom and liberty. They, therefore, perceive public ownership of the means of production, cooperatives and economic planning as infringements upon liberty. Some of the primary criticisms of socialism are claims that it creates distorted or absent price signals, results in reduced incentives, causes reduced prosperity, has low feasibility, and that it has negative social and political effects.

Critics from the neoclassical school of economics criticize state-ownership and centralization of capital on the grounds that there is a lack of incentive in state institutions to act on information as efficiently as capitalist firms because they lack hard budget constraints, resulting in reduced overall economic welfare for society. Economists of the Austrian school argue that socialist systems based on economic planning are unfeasible because they lack the information to perform economic calculations in the first place, due to a lack of price signals and a free-price system, which they argue are required for rational economic calculation.

Thus, Socialism can have several disadvantages:

Socialism

Some of the primary criticisms of socialism are claims that it creates distorted or absent price signals, results in reduced incentives, causes reduced prosperity, has low feasibility, and that it has negative social and political effects.

• The national economy develops relatively slowly;
• There is an inability to obtain the upmost profit from the use of resources, labors and land;
• Places that have a geographical advantage lose chances to develop better and people who have intelligence and wealth lose chances to make their businesses become bigger and more powerful; and
• People lose initiative to work and enthusiasm to study as doing more isn’t rewarded.

2.5: Businesses Under Communist Systems

2.5.1: The Communist Economic System

The communist economic system is one where class distinctions are eliminated and the community as a whole owns the means to production.

Learning Objective

Explain how a communist economic system is representative of a command planned economy

Key Points

• Karl Marx and Freidrich Engels wrote the Communist Manifesto in 1848, in response to poor working conditions for workers across Europe. The goal was to establish a system where class distinctions were eliminated and the means of production were owned by the masses.
• Recent attempts at creating political economic systems have led to state-driven authoritarian economies with unaccountable political elites, further driving power away from the hands of the masses.
• A Command Economy is characterized by collective ownership of capital: property is owned by the State, production levels are determined by the State via advanced planning mechanisms rather than supply and demand, and prices are regulated and controlled.

Key Terms

proletariat

The proletariat (from Latin proletarius, a citizen of the lowest class) is a term used to identify a lower social class, usually the working class; a member of such a class is proletarian. Originally it was identified as those people who had no wealth other than their children.

Command Economy

Most of the economy is planned by a central government authority and organized along a top-down administration where decisions regarding production output requirements and investments are decided by planners from the top, or near the top, of the chain of command.

bourgeoisie

In sociology and political science, bourgeoisie (Fr.: [buʁ.ʒwa’zi] | Eng.: /bʊrʒwɑziː/) and the adjective bourgeois are terms that describe a historical range of socio-economic classes. Since the late 18th century in the Western world, the bourgeoisie describes a social class that is characterized by their ownership of capital and their related culture. In contemporary academic theories, the term bourgeoisie usually refers to the ruling class in capitalist societies. In Marxist theory, the abiding characteristics of this class are their ownership of the means of production.

Examples

• The former USSR (or Soviet Union) is the typical example of a communistic, command economy. It was formed in 1922 by the Bolshevik party of the former Russian Empire. In 1928, Joseph Stalin achieved party leadership and introduced the first Five Year Plan, ending the limited level of capitalism that still existed. In 1991, under Mikhael Gorbachev, the Soviet Union was dissolved.
• A modern day example is China, particularly in the 70s, 80s and 90s. Today, China is seen to be more of an authoritarian capitalist rather than communistic command economy.

The Communist Economic System

A communist economic system is an economic system where, in theory, economic decisions are made by the community as a whole. In reality, however, attempts to establish communism have ended up creating state-driven authoritarian economies and regimes which benefit single party political élite who are not accountable to the people or community.

Communist theory was developed by a German philosopher in the 1800s named Karl Marx . He thought that the only way to have a harmonious society was to put workers in control. This idea was established during the Industrial Revolution when many workers were treated unfairly in France, Germany, and England.

Communist Ideology

The Hammer and Sickle represents the communion of the peasant and the worker.

Marx did not want there to be a difference in economic classes and he wanted class struggle to be eliminated. His main goal was to abolish capitalism (an economic system ruled by private ownership). Marx abhorred capitalism because the proletariat was exploited and unfairly represented in politics, and because capitalism allows the bourgeoisie to control a disproportionate amount of power. Therefore, he thought that if everything was shared and owned by everyone, a worker’s paradise or Utopia could be achieved.

Together with Friedrich Engel, a German economist, Marx wrote a pamphlet called the Communist Manifesto. This was published in 1848 and it expressed Marx’s ideas on communism. However, it was later realized that communism did not work. Most interpretations or attempts to establish communism have ended up creating state-driven authoritarian economies and regimes which benefit single party political élite who are not accountable to the people at all.

Command Planned Economy

An economy characterized by Command Planning is notable for several distinguishing features:

1. Collective or state ownership of capital: capital resources such as money, property and other physical assets are owned by the State. There is no (or very little) private ownership.
2. Inputs and outputs are determined by the State: the State has an elaborate planning mechanism in place that determines the level and proportions of inputs to be devoted to producing goods and services. Local planning authorities are handed 1 year, 5 year, 10 year or, in the case of China, up to 25-year plans. The local authorities then implement these plans by meeting with State Owned Enterprises, whereby further plans are developed specific to the business. Inputs are allocated according to the plans and output targets are set.
3. Labor is allocated according to state plans: in a command planning economy, there is no choice of profession; when a child is in school (from a very early age), a streaming system allocates people into designated industries.
4. Private ownership is not possible: under a command planning system an individual cannot own shares, real estate, or any other form of physical or non-physical asset. People are allocated residences by the State.
5. Prices and paying for goods and services: prices are regulated entirely by the State with little regard for the actual costs of production. Often a currency does not exist in a command planning economy and when it does, its main purpose is for accounting. Instead of paying for goods and services when you need to buy them, you are allocated goods and services. This is often also called rationing.

In western democratic and capitalist societies, the price mechanism is a fundamental operator in allocating resources. The laws of demand and supply interact, the price of goods (and services) send signals to producers and consumers alike to determine what goods and quantities are produced, and helps determine what the future demands and quantities will be.

The law of demand states that the higher the price of a good or service, the less the amount of that good or service will be consumed. In other words, the quantity of a good or service demanded, rises when the price falls and falls when the price increases.

2.5.2: The Benefits of Communism

Communism ideology supports widespread universal social welfare, including improvements in public health and education.

Learning Objective

Explain how the theoretical benefits of communism may lead to a more equitable society

Key Points

• The theoretical advantages of communism are built around equality and strong social communities.
• Communist ideology advocates universal education with a focus on developing the proletariat with knowledge, class consciousness, and historical understanding.
• Communism supports the emancipation of women and the ending of their exploitation.
• Communist ideology emphasizes the development of a “New Man”—a class-conscious, knowledgeable, heroic, proletarian person devoted to work and social cohesion, as opposed to the antithetic “bourgeois individualist” associated with cultural backwardness and social atomisation.

Key Terms

Communism

a political philosophy or ideology advocating holding the production of resources collectively

bourgeois

Of or relating to capitalist exploitation of the proletariat.

antithetic

Diametrically opposed.

proletariat

The working class or lower class.

Examples

• In theory, Communism seems to have some very desirable characteristics. In practice, however, it has many drawbacks, and historically it seems that only the most corrupt members of Communist governments have gained advancement within systems. When a system depends on an entire community but is controlled by a few corrupt bureaucrats, it cannot be successful.
• However, this is not to say that state run enterprises in certain areas are a bad idea. Publically owned utilities such as water, electricity, and postal services have proven to be beneficial in countries, even when no communist system exists.

The Benefits of Communism

Theoretically, there are many benefits that can be achieved through a communist society. Communist ideology supports widespread universal social welfare. Improvements in public health and education, provision of child care, provision of state-directed social services, and provision of social benefits will, theoretically, help to raise labor productivity and advance a society in its development. Communist ideology advocates universal education with a focus on developing the proletariat with knowledge, class consciousness, and historical understanding. Communism supports the emancipation of women and the ending of their exploitation. Both cultural and educational policy in communist states have emphasized the development of a “New Man”—a class-conscious, knowledgeable, heroic, proletarian person devoted to work and social cohesion, as opposed to the antithetic “bourgeois individualist” associated with cultural backwardness and social atomization.

Other theoretically beneficial ideas characteristic of communist societies include:

1. People are equal. In a communist regime, people are treated equally in the eyes of the government regardless of education, financial standing, et cetera. Economic boundaries don’t separate or categorize people, which can help mitigate crime and violence.
2. Every citizen can keep a job. In a communist system, people are entitled to jobs. Because the government owns all means of production, the government can provide jobs for at least a majority of the people. Everyone in a communist country is given enough work opportunities to live and survive. Every citizen, however, must do his or her part for the economy to receive pay and other work benefits.
3. There is an internally stable economic system. In communism, the government dictates economic structure; therefore, economic instability is out of the question. Every citizen is required to work in order to receive benefits, and those who don’t have corresponding sanctions. This creates an incentive to participate and to encourage economic growth.
4. Strong social communities are established. In communism, there are certain laws and goals which determine resource and responsibility allocation. If the citizens abide by these laws, this leads to a harmonious spirit of sharing one goal. Consequently, this builds stronger social communities and an even stronger economy.
5. Competition doesn’t exist. In communist societies, everyone can work harmoniously without stepping on each other’s toes. Work, responsibility, and rewards are shared equally among the citizens. If people have no sense of envy, jealousy or ambitions that counter the goals of the state, then a harmonious economic development can be maintained .
6. Efficient distribution of resources. In a communist society, the sense of cooperation allows for efficiency in resource distribution. This is very important, especially in times of need and in emergency situations.

2.5.3: The Disadvantages of Communism

Businesses under Communist system have very strict limitations as to what they can and cannot do, which can hamper productivity and innovation.

Learning Objective

Summarize how the strict rules placed on businesses in a communist economic system can lead to social unrest

Key Points

• In a Communist system, the central authority dictates the means and quantity of production, and places strict rules on businesses.
• Since there is no competition amongst firms, each is given the same amount of money and each worker is paid the same, with the same expectations of each.
• All businesses are ultimately owned by the government.
• Populations tend to be treated homogeneously, meaning that common goals or sets of rules will not apply to different segments of the population and community.
• Without a price mechanism, supply and demand are difficult to balance perfectly over time.

Key Term

Price mechanism

An economic term that refers to the buyers and sellers who negotiate prices of goods or services depending on demand and supply. A price mechanism or market-based mechanism refers to a wide variety of ways to match up buyers and sellers through price rationing.

Example

• Ho Chi Minh raised a guerrilla army in Vietnam, promising them a Utopian communist future of rule by the people and a communal country. However, what transpired was a nation ruled by corrupt Party officials, with no rights or civil liberty. The theory peddled by Ho Chi Minh was far removed from the practice of Communism once he was successfully elected. There are many other examples of how Communism has failed the people of a country. Whether this is down simply to corrupt leaders, or to a deeper flaw in the nature of Communism is a subject debated by many scholars.

Disadvantages of Communism

The economic and political system of Communism effectively dictates what can and cannot be done in the realm of business. There are defined limitations for the amount a business can produce and how much money it can earn.

In addition to directly controlling the means of production, Communism places strict rules as to how businesses operate in such a way that a classless society is born. No matter what field a business specializes in, the same amount of funds will be allocated to each, and each worker will receive the same amount of money. This can cause emotional unrest between workers who wish to be specially recognized for their work. It can serve to create uncomfortable conditions for workers in a society without rank or varying specialty. Finally, it can be stifling to entrepreneurial spirit, which is key to a country’s economic growth and development. The U.S., a capitalistic nation, has greatly benefited from that small business and entrepreneurial atmosphere, a backdrop for the American dream.

More specifically, in Communism:

• The government owns all the businesses and properties (the means of production).
• There is no freedom of speech.
• Large or geographically-broad populations tend to be diverse, making it difficult to maintain a common goal or set of rules for shared effort and resources.
• Central planning is difficult to achieve.
• Consumers’ needs are not taken into consideration.
• Productivity and efficiency are difficult to achieve without profit motive for the workers.
• It is difficult to achieve internal balances between supply and demand without a price mechanism.

The Kremlin

Only the government has a say in production planning under a Communist system.

2.6: Businesses under Mixed Economic Systems

2.6.1: Mixed Economies

A Mixed Economy exhibits characteristics of both market and planned economies, with private and state sectors providing direction.

Learning Objective

Outline the plan behind and what governments provide in a mixed economy

Key Points

• The term Mixed Economy is very broadly defined and has been used to describe economies as diverse as the United States and Cuba.
• The means of production are privately owned, and markets remain the dominant form of economic coordination. However, governments wield significant influence over the economy through monetary and fiscal policy and regulation.
• Characteristics of mixed economies include welfare systems, employment standards, environmental protection, publicly owned enterprises, and antitrust policies.
• Keynesian economics advocates the presence of a mixed economy. This line of thought subsided between 1970 and 2000, but has regained considerable popularity after the financial crisis of 2008.

Key Terms

mixed economies

a system in which both the state and private sector direct the way goods and services are bought and sold

mixed economy

An economic system in which both the state and private sector direct the economy, reflecting characteristics of both market economies and planned economies.

welfare state

A social system in which the state takes overall responsibility for the welfare of its citizens, providing health care, education, unemployment compensation and social security.

Keynesian Economics

The group of macroeconomic schools of thought based on the ideas of 20th-century economist John Maynard Keynes. Advocates of Keynesian economics argue that private sector decisions sometimes lead to inefficient macroeconomic outcomes that require active policy responses by the public sector, particularly monetary policy actions by the central bank and fiscal policy actions by the government to stabilize output over the business cycle.

Examples

• The American School (also known as the National System) is the economic philosophy that dominated United States national policies from the time of the American Civil War until the mid-twentieth century, and is an example of a mixed economy. It consisted of a three core policy initiative: protecting industry through high tariffs (1861–1932), government investment in infrastructure through internal improvements, and a national bank to promote the growth of productive enterprises. During this period the United States grew into the largest economy in the world, surpassing the UK (though not the British Empire) by 1880.
• Dirigisme is an economic policy initiated under Charles de Gaulle of France designating an economy where the government exerts strong directive influence. It involved state control of a minority of the industry, such as transportation, energy and telecommunication infrastructures, as well as various incentives for private corporations to merge or engage in certain projects. Under its influence, France experienced what is called Thirty Glorious Years of profound economic growth.
• Social market economy is the economic policy of modern Germany that steers a middle path between the goals of socialism and capitalism within the framework of a private market economy and aims at maintaining a balance between a high rate of economic growth, low inflation, low levels of unemployment, good working conditions, public welfare and public services by using state intervention.

Mixed Economies

What is a Mixed Economy?

A mixed economy is an economic system in which both the state and private sector direct the economy, reflecting characteristics of both market economies and planned economies. Most mixed economies can be described as market economies with strong regulatory oversight, in addition to having a variety of government-sponsored aspects.

A mail truck

Restrictions are sometimes placed on private mail systems by mixed economy governments. For example, in the United States, the USPS enjoys a government monopoly on nonurgent letter mail as described in the Private Express Statutes.

While there is not one single definition for a mixed economy, the definitions always involve a degree of private economic freedom mixed with a degree of government regulation of markets.

The Plan Behind a Mixed Economy

The basic plan of the mixed economy is that:

• The means of production are mainly under private ownership;
• Markets remain the dominant form of economic coordination; and
• Profit-seeking enterprises and the accumulation of capital would remain the fundamental driving force behind economic activity. However, the government would wield considerable indirect influence over the economy through fiscal and monetary policies designed to counteract economic downturns and capitalism’s tendency toward financial crises and unemployment, along with playing a role in interventions that promote social welfare. Subsequently, some mixed economies have expanded in scope to include a role for indicative economic planning and/or large public enterprise sectors.

The relative strength or weakness of each component in the national economy can vary greatly between countries. Economies ranging from the United States to Cuba have been termed mixed economies. The term is also used to describe the economies of countries which are referred to as welfare states, such as Norway and Sweden.

What do Governments Provide?

Governments in mixed economies often provide:

• Environmental protection,
• Maintenance of employment standards,
• A standardized welfare system,
• Maintenance of competition.

Who Supports the Ideal of Mixed Economies?

As an economic ideal, mixed economies are supported by people of various political persuasions, typically center-left and center-right, such as social democrats or Christian democrats. Supporters view mixed economies as a compromise between state socialism and laissez-faire capitalism that is superior in net effect to either of those.

Keynesian economics advocates a mixed economy — predominantly private sector, but with a significant role of government and public sector. It also served as the economic model during the later part of the Great Depression, World War II, and the post-war economic expansion (1945–1973), though it lost some influence following the tax surcharge in 1968 and the stagflation of the 1970s. The advent of the global financial crisis in 2008 has caused a resurgence in Keynesian thought.

2.6.2: The Benefits of Mixed Economies

A mixed economy allows private participation in production while ensuring that society is protected from the full swings of the market.

Learning Objective

Outline the characteristics of a mixed economy that help to maintain a stable economy

Key Points

• Mixed economies allow many more freedoms than command economies, such as the freedom to possess the means of production; to participate in managerial decisions; to buy, sell, fire, and hire as needed; and for employees to organize and protest peacefully.
• Mixed economies have a high level of state participation and spending, leading to tax-funded libraries, schools, hospitals, roads, utilities, legal assistance, welfare, and social security.
• Various restrictions on business are made for the greater good, such as environmental regulation, labor regulation, antitrust and intellectual property laws.
• The ideal combination of these freedoms and restrictions is meant to ensure the maximum standard of living for the population as a whole.

Key Terms

Social Security

A system whereby the state either through general or specific taxation provides various benefits to help ensure the wellbeing of its citizens.

protectionism

A policy of protecting the domestic producers of a product by imposing tariffs, quotas or other barriers on imports.

monopoly

An exclusive control over the trade or production of a commodity or service through exclusive possession.

Example

• The US economy is best described as a mixed economy, because even though it strongly advocates free market principles, it relies on the government to deal with matters that the private sector overlooks, ranging from education to the environment. The government has also helped nurture new industries and has played a role in protecting American companies from competition abroad. An example of this is the heavily subsidized agriculture industry in the US. Overall, the US has benefited from this combination.

Overview: The Advantages of a Mixed Economy

A mixed economy permits private participation in production, which in return allows healthy competition that can result in profit. It also contributes to public ownership in manufacturing, which can address social welfare needs.

Marketplace

Private investment, freedom to buy, sell, and profit, combined with economic planning by the state, including significant regulations (e.g., wage or price controls), taxes, tariffs, and state-directed investment.

The advantage of this type of market is that it allows competition between producers with regulations in place to protect society as a whole. With the government being present in the economy it brings a sense of security to sellers and buyers. This security helps maintain a stable economy.

Overall, businesses, as well as consumers, in mixed economies have freedoms that are important to both. And while government is actively involved and provides support, its control is limited, which is good for structure.

The Details: The Advantages of a Mixed Economy

• In a mixed economy, private businesses can decide how to run their businesses (e.g. what to produce, at what price, who to employ, etc.).
• Consumers also have a choice in what they want to buy.
• In this system, there is also less income inequality.
• Monopolies, market structures that are the only producer of a certain product, are allowed under government watch so they do not make it impossible for entrepreneurs in the same industry to succeed.

More specifically:

The elements of a mixed economy have been demonstrated to include a variety of freedoms:

• to possess means of production (farms, factories, stores, etc.)
• to participate in managerial decisions (cooperative and participatory economics)
• to travel (needed to transport all the items in commerce, to make deals in person, for workers and owners to go to where needed)
• to buy (items for personal use, for resale; buy whole enterprises to make the organization that creates wealth a form of wealth itself)
• to sell (same as buy)
• to hire (to create organizations that create wealth)
• to fire (to maintain organizations that create wealth)
• to organize (private enterprise for profit, labor unions, workers’ and professional associations, non-profit groups, religions, etc.)
• to communicate (free speech, newspapers, books, advertisements, make deals, create business partners, create markets)
• to protest peacefully (marches, petitions, sue the government, make laws friendly to profit making and workers alike, remove pointless inefficiencies to maximize wealth creation).

They provide tax-funded, subsidized, or state-owned factors of production, infrastructure, and services:

• libraries and other information services
• roads and other transportation services
• schools and other education services
• hospitals and other health services
• banks and other financial services
• telephone, mail, and other communication services
• electricity and other energy services (e.g. oil, gas)
• water systems for drinking, agriculture, and waste disposal
• subsidies to agriculture and other businesses
• government-granted monopoly to otherwise private businesses
• legal assistance
• government-funded or state-run research and development agencies

Such governments also provide some autonomy over personal finances, but include involuntary spending and investments, such as transfer payments and other cash benefits, including:

• welfare for the poor
• social security for the aged and infirm
• government subsidies to business
• mandatory insurance (e.g. automobile)

They also impose regulation laws and restrictions that help society as a whole, such as:

• environmental regulation (e.g. toxins in land, water, air)
• labor regulation, including minimum wage laws
• consumer regulation (e.g. product safety)
• antitrust laws
• intellectual property laws
• incorporation laws
• protectionism
• import and export controls, such as tariffs and quotas
• taxes and fees written or enforced with manipulation of the economy in mind

2.6.3: The Disadvantages of Mixed Economies

The disadvantages of mixed economies can be understood through examining criticisms of social democracy.

Learning Objective

Examine the criticisms of social democracy as a vessel to understanding the disadvantages of mixed economies.

Key Points

• One disadvantage of mixed economies is that they tend to lean more toward government control and less toward individual freedoms.
• While most modern forms of government are consistent with some form of mixed economy, the mixed economy is most commonly associated with social democratic parties or nations run by social democratic governments.
• Some critics of contemporary social democracy argue that when social democracy abandoned Marxism it also abandoned socialism and has become, in effect, a liberal capitalist movement.
• Marxian socialists argue that because social democratic programs retain the capitalist mode of production they also retain the fundamental issues of capitalism, including cyclical fluctuations, exploitation and alienation.
• The democratic socialist critique of social democracy states that capitalism could never be sufficiently “humanized” and any attempt to suppress the economic contradictions of capitalism would only cause them to emerge elsewhere.
• Market socialists criticize social democracy for maintaining a property-owning capitalist class, which has an active interest in reversing social democratic policies and a disproportionate amount of power over society to influence governmental policy as a class.

Key Terms

regulation

A law or administrative rule, issued by an organization, used to guide or prescribe the conduct of members of that organization.

social democracy

a moderate political philosophy or ideology that aims to achieve socialistic goals within capitalist society such as by means of a strong welfare state and regulation of private industry

mixed economy

Mixed economy is an economic system in which both the state and private sector direct the economy, reflecting characteristics of both market economies and planned economies.

Example

• Many pubs in Britain are suffering due to drinking and smoking regulations imposed by the government for the good of society. As a result, many question whether pubs have a future.

One disadvantage of mixed economies is that they tend to lean more toward government control and less toward individual freedoms. Sometimes, government regulation requirements may cost a company so much that it puts it out of business. In addition, unsuccessful regulations may paralyze features of production. This, in return, can cause the economic balance to shift.

Another negative is that the government decides the amount of tax on products, which leads to people complaining about high taxes and their unwillingness to pay them. Moreover, lack of price control management can cause shortages in goods and can result in a recession.

Disadvantages of Social Democratic Policy In a Mixed Economy

While most modern forms of government are consistent with some form of mixed economy, given the broad range of economic systems that can be described by the term, the mixed economy is most commonly associated with social democratic parties or nations run by social democratic governments. In contemporary terms, “social democracy” usually refers to a social corporatist arrangement and a welfare state in developed capitalist economies.

Critics of contemporary social democracy argue that when social democracy abandoned Marxism it also abandoned socialism and has become, in effect, a liberal capitalist movement. They argue that this has made social democrats similar to center-left, but pro-capitalist groups, such as the U.S. Democratic Party .

The Democratic Party Logo

The Democratic party in the United States is seen by some critics of contemporary social democracy (and mixed economies) as a watered-down, pro-capitalist movement.

Marxian socialists argue that because social democratic programs retain the capitalist mode of production they also retain the fundamental issues of capitalism, including cyclical fluctuations, exploitation and alienation. Social democratic programs intended to ameliorate capitalism, such as unemployment benefits or taxation on profits and the wealthy, create contradictions of their own through limiting the efficiency of the capitalist system by reducing incentives for capitalists to invest in production.

Others contrast social democracy with democratic socialism by defining the former as an attempt to strengthen the welfare state and the latter as an alternative socialist economic system to capitalism. The democratic socialist critique of social democracy states that capitalism could never be sufficiently “humanized” and any attempt to suppress the economic contradictions of capitalism would only cause them to emerge elsewhere. For example, attempts to reduce unemployment too much would result in inflation, and too much job security would erode labor discipline. In contrast to social democracy, democratic socialists advocate a post-capitalist economic system based either on market socialism combined with workers self-management, or on some form of participatory-economic planning.

Social democracy can also be contrasted with market socialism. While a common goal of both systems is to achieve greater social and economic equality, market socialism does so by changes in enterprise ownership and management, whereas social democracy attempts to do so by government-imposed taxes and subsidies on privately owned enterprises. Market socialists criticize social democracy for maintaining a property-owning capitalist class, which has an active interest in reversing social democratic policies and a disproportionate amount of power over society to influence governmental policy as a class.

3: Business Ethics and Social Responsibility