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Chapter 2
An Introduction to Economic Systems and
The Workings of the Price System
What's in This Chapter and Why
Chapter 2 compares a market system to a planned system in the context of the collapse of the
centrally-planned economies and their efforts to build a new economic system. Market economies
are recognized as being superior in terms of production, distribution, and coordination.
The chapter introduces the market system as a coordinating mechanism for the economy. Two
fundamental questions are discussed: What are the essential characteristics of a market economy,
and why do they perform better than command systems? Specialization and the division of labor
are examined, and it is shown, that together with comparative advantage, productivity and output
can increase. Allowing for specialization increases the importance of coordinating the activities of
thousands of firms and millions of people. Demand and supply analysis is introduced and shows
how markets solve the coordination problem.
The importance of price is developed showing how the price system coordinates by providing
information, motivation, and rationing. The coordination that naturally occurs in a market economy
is compared to coordination in a command economy and in a market with price ceilings.
The chapter concludes with a discussion of some experiences of the transition economies. The
idea is to convince students that choice of economic systems is important and relevant.
Instructional Objectives
1. The questions that an economic system must answer, the essential elements of a market
economy, and the importance of coordination.
2. The meaning and importance of the division and specialization of labor and how specialization
makes coordination more important.
3. The benefits of trade and comparative advantage.
4. The laws of demand and supply, the meaning of demand and supply prices, and how the laws
of demand and supply interact to lead to market equilibrium.
4. The attributes of a price system--informing, motivating, and rationing--that allow it to
coordinate.
5. The relative success of a market economy's price system, a command economy's planning
system, and a price-controlled economy in achieving coordination.
6. The experiences of transition economies in attaining the five important elements of a market
economy.
12
Key Terms
This chapter introduces the idea of economic systems and how they coordinate the activities of
specialized economic agents. To cover it thoroughly will require three or four class sections.
To begin, it is important to develop students’ understanding of property rights; they are the key
to efficient market exchange and incentives. Discuss with students how they treat things they own
versus rent and the incentives of each.
Students are accustomed to thinking about markets in terms of the price paid for goods and
services. Introduce them to the economists’ ideas about price. Understanding relative prices will
help students grasp the concept of opportunity cost. Also discuss the idea that price is a signal to
producers and consumers, hence it helps coordinate markets.
Notice that the book does not provide a separate chapter or appendix on graphing. Instead, the
first couple of chapters develop arithmetic examples and show how to graph the relevant schedules.
Next, the demand and supply curves are presented with assumed numerical prices and quantities
without the underlying tables. Finally, more abstract demand and supply curves are used alone.
This allows students to move naturally to graphical analysis and to appreciate the simplification
that it allows.
The collapse of the centrally-planned economies and the varying success that transition
economies have experienced are defining events. Their importance cannot be overemphasized.
Students quickly grasp this and are intrigued by it. Current examples about events in transition
economies can make the analysis more concrete.
Additional References
In addition to the references in the text, instructors may wish to read or assign one or more of the
following:
1. Olivier J. Blanchard, Kenneth A. Froot, and Jeffrey D. Sachs, eds., The Transition in Eastern
Europe, National Bureau of Economic Research (Chicago: The University of Chicago Press,
1994).
2. Morris Bornstein, Comparative Economic Systems: Models and Cases, 7th ed. (Irwin: Boston,
1994).
3. Business Week, "21st Century Capitalism," Special Issue, 1994.
4. Paul R. Gregory and Robert C. Stuart, Soviet and Post-Soviet Economic Structure and
Performance, 5th ed., (Harper Collins: New York, 1994).
14 Chapter 2/An Introduction to Economic Systems and the Workings of the Price System
Outline
The Republicans had named May 16th, 1860, as the date and
Chicago as the place for holding their second National Convention.
They had been greatly encouraged by the vote for Fremont and
Dayton, and, what had now become apparent as an irreconcilable
division of the Democracy, encouraged them in the belief that they
could elect their candidates. Those of the great West were especially
enthusiastic, and had contributed freely to the erection of an
immense “Wigwam,” capable of holding ten thousand people, at
Chicago. All the Northern States were fully represented, and there
were besides partial delegations from Delaware, Maryland,
Kentucky, Missouri and Virginia, with occasional delegates from
other Slave States, there being none, however, from the Gulf States.
David Wilmot, of Penna., author of the Wilmot proviso, was made
temporary chairman, and George Ashmun, of Mass., permanent
President. No differences were excited by the report of the committee
on platform, and the proceedings throughout were characterized by
great harmony, though there was a somewhat sharp contest for the
Presidential nomination. The prominent candidates were Wm. H.
Seward, of New York; Abraham Lincoln, of Illinois; Salmon P. Chase,
of Ohio; Simon Cameron, of Pennsylvania, and Edward Bates, of
Missouri. There were three ballots, Mr. Lincoln receiving in the last
354 out of 446 votes. Mr. Seward led the vote at the beginning, but
he was strongly opposed by gentlemen in his own State as prominent
as Horace Greeley and Thurlow Weed, and his nomination was
thought to be inexpedient. Lincoln’s successful debate with Douglas
was still fresh in the minds of the delegates, and every addition to his
vote so heightened the enthusiasm that the convention was finally
carried “off its feet,” the delegations rapidly changing on the last
ballot. Lincoln had been a known candidate but a month or two
before, while Seward’s name had been everywhere canvassed, and
where opposed in the Eastern and Middle States, it was mainly
because of the belief that his views on slavery were too radical. He
was more strongly favored by the Abolition branch of the party than
any other candidate. When the news of his success was first conveyed
to Mr. Lincoln he was siting in the office of the State Journal, at
Springfield, which was connected by a telegraph wire with the
Wigwam. On the close of the third ballot a despatch was handed Mr.
Lincoln. He read it in silence, and then announcing the result said:
“There is a little woman down at our house would like to hear this—
I’ll go down and tell her,” and he started amid the shouts of personal
admirers. Hannibal Hamlin, of Maine, was nominated for Vice-
President with much unanimity, and the Chicago Convention closed
its work in a single day.
The American Convention.
Lincoln received large majorities in nearly all of the free States, his
popular vote being 1,866,452; electoral vote, 180. Douglas was next
in the popular estimate, receiving 1,375,157 votes, with but 12
electors. Breckinridge had 847,953 votes, with 76 electors; Bell, with
570,631 votes, had 39 electors.
The principles involved in the controversy are given at length in
the Book of Platforms, and were briefly these: The Republican party
asserted that slavery should not be extended to the territories; that it
could exist only by virtue of local and positive law; that freedom was
national; that slavery was morally wrong, and the nation should at
least anticipate its gradual extinction. The Douglas wing of the
Democratic party adhered to the doctrine of popular sovereignty, and
claimed that in its exercise in the territories they were indifferent
whether slavery was voted up or down. The Breckinridge wing of the
Democratic party asserted both the moral and legal right to hold
slaves, and to carry them to the territories, and that no power save
the national constitution could prohibit or interfere with it outside of
State lines. The Americans supporting Bell, adhered to their peculiar
doctrines touching emigration and naturalization, but had
abandoned, in most of the States, the secrecy and oaths of the Know-
Nothing order. They were evasive and non-committal on the slavery
question.
Preparing for Secession.
SOUTH CAROLINA.
GEORGIA.
MISSISSIPPI.
FLORIDA.
LOUISIANA.
ALABAMA.
ARKANSAS.
TEXAS.
NORTH CAROLINA.
VIRGINIA.
KENTUCKY.