Chapter 1 & 2 Notes: Economic Systems, Gini, Economic Freedom, and Budget Constraint
Course logistics and upcoming assignments
Today's macroeconomics class covers two main tasks: finish Chapter 1 (economic systems) and preview Chapter 2 (choice in a world of scarcity).
Homework/discussion for this week:
First discussion assignment: not available yet and due Sept 7 (nearly three months away).
Read the background information, watch the video if desired, and study the world income inequality map.
Post your own draft discussion before Sunday, Sept 7, 11:00 PM Eastern Time.
If you have questions, ask the instructor.
Central topic introduced for Chapter 1 discussion: the Gini index and income inequality globally and in the US.
The class will compare economic systems (market vs command) and discuss implications like equality vs efficiency and economic freedom.
A quick segue into Chapter 2: Choice in the world of scarcity (the microeconomics of how individuals make choices given limited resources).
Chapter 1: Economic systems
Core idea: scarcity vs unlimited wants.
The circular flow diagram (circular flow model)
Visualizes interaction between households and firms across resource markets and product markets.
Money flows between these groups through different markets; this model is one of the first economic models learned.
Economic systems summarize how decisions are made in an economy under different settings.
Two broad ways to organize economic decisions (emphasis-driven):
Market system (free-market emphasis): private ownership, voluntary exchange, competitive markets, and price signals coordinate decisions.
Command system (centralized government emphasis): government dictates major decisions, ownership of resources by the public sector, and planned allocation of resources.
Command system (also called socialism or communism in many contexts)
Government ownership of major resources and central planning determine what to produce, how to produce, and how social wealth is allocated.
Market system (capitalism-focused):
Private ownership of resources and freedom to use them; individuals act based on self-interest, entrepreneurship, and competition.
Market economies are common in the US, UK, Australia, South Korea, Japan, and many other major economies.
Debate between the two systems (two ends of a spectrum):
Market promoting capitalism: private ownership, self-interest, competition, economic freedom, entrepreneurship; efficiency is a key virtue, but trade-offs exist (no free lunch).
Command emphasizing equality and centralized control: aims for more equal distribution of wealth but may incur costs in efficiency and innovation.
Key tension: equality vs efficiency
Command systems emphasize equality via allocation decisions by the government; potential drawback: reduced efficiency due to lack of price signals and incentives.
Market systems emphasize efficiency and innovation via prices and incentives; potential drawback: greater income inequality.
Practical examples of the debate
Countries often cited as market-based: United States, United Kingdom, Australia, South Korea, Japan.
Countries cited as more command-oriented (or with socialist policies) in the discussion: China, Cuba, North Korea (and sometimes Korea in general discussions).
Core takeaway from the debate
Understanding that economic systems shape incentives, property rights, and the distribution of resources, with trade-offs between efficiency and equality.
“No free lunch” idea: efficiency gains can come with costs in equality, and vice versa.
Gini index and income inequality discussion
What is the Gini index?
A coefficient measuring income or wealth distribution within a country.
Range: typically defined from 0% to 100% (or 0 to 1 in some presentations).
Interpretation: higher values indicate greater inequality; lower values indicate more equal distributions.
A Gini index of 100 (or 1) would imply extreme inequality where the top 1% owns almost everything and the rest have very little.
Global map of the Gini index
Different economies are colored to reflect inequality levels.
Common takeaways from the map in class discussion: Brazil (and parts of Latin America) show high inequality; Western nations (e.g., Canada and Western Europe) show relatively lower inequality.
The relationship between ideology (market vs command) and reality is a central discussion point: inequality levels do not perfectly align with economic ideology.
Encouragement for independent research
Students can explore why large income gaps persist in some places and not in others, and discuss related social and economic consequences.
Economic freedom map (historical perspective)
Economic freedom index map (data from around 1995 onward)
Colors indicate levels of economic freedom: green = more free, red = less free.
Over the past two decades, observations suggest shifts toward more restricted freedom in several regions, with notable declines possibly associated with events like the COVID-19 pandemic.
Takeaways
Economic policy changes, global events, and policy responses can influence economic freedom ratings over time.
The map introduces the broader theme of how government policy and institutions shape economic activity and growth.
Chapter 2: Choice in a world of scarcity
From macro to micro perspective
Micro perspective asks: how do individuals/households make choices under scarcity?
Macro perspective will address broader economic questions later in the course.
Key economizing problem: the budget constraint (two-good model)
Setup: a consumer with limited income and two goods to consider.
Goal for the consumer: spend the budget to maximize happiness/utility; saving is not considered in this simple model.
The budget constraint shows all combinations of two goods that can be afforded given income and prices.
Attainable vs unattainable (affordable vs unaffordable) and attainable vs inefficient (on-line vs inside the line).
Essential ingredients to draw a budget constraint
Prices of the two goods: px and py
Budget (income): I
The two major information inputs: prices and budget are what determine what can be afforded.
Worked example: two goods – burgers and bus tickets
Given: budget I = $10, price of a burger px = $2, price of a bus ticket py = $0.50
Corner solutions (extreme allocations):
Only burgers: x = 10 / 2 = 5 burgers, y = 0 buses
Only bus tickets: x = 0 burgers, y = 10 / 0.50 = 20 buses
These corner solutions are the endpoints of the budget line.
Intermediate allocations show multiple combinations (e.g., 4 burgers and 4 bus tickets):
Cost = $4 (for 4 burgers) + $2 (for 4 buses) = $6, leaving $4 unspent in this illustration, which is feasible but not spending the entire budget.
The key intuition: moving along the budget line trades off between goods; to buy more of one good, you must give up some of the other.
Opportunity cost and relative price
The opportunity cost of one unit of burgers in terms of buses is the slope of the budget line: OCx = px / p_y.
In the example: OC of 1 burger = rac{px}{py} = rac{2}{0.5} = 4 bus tickets.
Conversely, the opportunity cost of 1 bus ticket in terms of burgers is OCy = py / p_x = 0.25 burgers.
These values illustrate the trade-offs inherent in scarcity and show how prices encode relative cost.
The budget constraint in equation form
General form: px x + py y = I
Feasible region: px x + py y \le I with x \ge 0, y \ge 0.
The budget line is the set of feasible (x, y) that spend the entire budget (equality holds).
The slope of the budget line: rac{dy}{dx} = - rac{px}{py} (negative slope, downward sloping).
Interpreting the graph
Points on the line are attainable and efficient (you’ve spent the entire budget).
Points inside the line are attainable but inefficient (budget not fully spent).
Points outside the line are unattainable (do not fit the budget).
Why the line is straight
If prices are constant, the budget line is a straight line connecting the two corner solutions.
Reason: the line captures all combinations with total expenditure exactly equal to the budget; since both goods have constant prices, the trade-off is constant along the line.
Dynamic shifts of the budget constraint (what can move the line)
Inflation (price increases): leftward shift (you can afford less of both goods with the same income).
Price changes (one good becomes cheaper): the constraint pivots outward for the cheaper good, increasing your affordable combinations.
Income changes (a raise/promotion): outward parallel shift (you can afford more of both goods with higher income).
Changes in preferences/tastes: do not shift the budget constraint itself; they affect which point on the constraint the consumer chooses, not how much can be afforded.
Recap of the budget constraint concepts
The constraint is determined by prices and income, not by preferences.
Opportunity cost is captured by the slope, reflecting the trade-off between goods.
Efficient allocations lie on the budget line; inefficient but feasible allocations lie inside; unattainable allocations lie outside.
Real-world factors (inflation, price changes, income changes) shift or pivot the budget constraint; preferences shift demand along the constraint, not the constraint itself.
Connections and practical implications
The budget constraint concept links to real-world questions about how households allocate limited resources to maximize welfare, given prices and income.
Understanding the trade-offs helps explain entrepreneurship, saving vs spending decisions, and how governments’ policy changes (inflation, taxation, subsidies) may influence consumer choices indirectly through prices and income.
The discussion of inequality and economic freedom provides context for how different institutional arrangements shape incentives, distribution, and the efficiency/equality trade-offs faced by societies.
Quick takeaways for exam preparation
Distinguish between scarcity, choice, and opportunity costs; the budget constraint is the central micro model for illustrating this.
Know the general budget constraint equation: px x + py y = I and the feasibility region: px x + py y \le I, \ x \ge 0, \ y \ge 0 .
Corner solutions represent extreme allocations; any interior point represents a mix of both goods.
The slope of the budget line equals the opportunity cost ratio: ext{OC}{x} = \frac{px}{py} and \text{OC}{y} = \frac{py}{px} .
Changes in prices or income shift the constraint; changes in preferences shift the chosen point along the constraint, not the constraint itself.
Be prepared to explain the trade-off between equality and efficiency and to discuss how different economic systems attempt to balance these goals.
Practice concepts to review
Write the budget constraint for a two-good model with different prices and income.
Identify corner solutions and an interior solution on a budget diagram.
Compute opportunity costs from given prices and interpret them in terms of the two goods.
Describe how inflation, price changes, and income changes shift the budget constraint.
Explain why preferences do not affect the position of the budget constraint.
Next class preview
In the next session, we will move from budget constraints (microeconomics) to a macroeconomic perspective on economizing problems and further explore Chapter 2 concepts.