Fascinating economy

Since resources are not unlimited everyone has to make tough decisions about what to do with the resources available. One big question that needs to be addressed in any economy is this: What is to be produced?

Because of scarcity, deciding what is to be produced involves also deciding what not to produce.

Remember your bag of flour? You can allocate the flour for making bread for sandwiches. But what if it is your friend’s birthday? If you use the flour for bread, you cannot make a birthday cake. Before you start producing something, you have to decide what to produce.

Allocating resources often involves deciding to produce one thing instead of another.

Getting Organized

Once it is decided what will be produced, there are still more questions to answer. It takes organization to produce and distribute goods and services.

There are all kinds of ways to organize production. There could be factories, offices of varying sizes, or people working at home. There could be different people who specialize in different jobs, or everyone could take turns doing all the different jobs. Production might go on 24 hours a day, seven days a week, or it could be kept to certain working hours.

This is just a short list of the different options. There are many methods of organizing production. How do people decide on the best way to organize production? The economic goals people have will affect how this question is answered. This can again lead to conflict.

The goal of efficiency requires a form of organization that has as little waste as possible. One good way of eliminating waste is to have different workers specialize in different jobs. But if equity is the goal, specialization might not be the way to go. When you divide up production into different tasks, some of the tasks might be harder than others. Equity could mean giving each of these workers a chance to do the easier, cleaner job. But what if freedom is your main economic goal? In this case, production would have to be organized to give workers different choices, and workers would have the freedom to decide what jobs to take.

Who Gets What and Where?

The questions do not stop once decisions about production have been made. You saw that goods often need to be transported from where they are made to where they are used. This is distribution. There is more to distribution than just transportation, however.

Getting goods to the people who use them means making decisions about who gets what. Because of scarcity, some people will not always get what they want. So, the game of economics involves answering a third question: How are goods and services to be distributed?

In other words, how shall we decide who gets what?

If you want equity or security, producers probably need to be told what to produce. Their choices could end up being incompatible with those goals. The government can make sure that everyone is secure, or that goods and services are distributed fairly. But when the government decides how goods and services are distributed, that takes away free choice. Producers are told what to produce and where to send it. A different way to organize distribution is not to organize it at all, to leave it up to people’s free choices to decide what gets produced and how goods and services are distributed. This might result in an unfair distribution, or one that leaves some people insecure, but it would not involve the government telling people what to do.

A Variety of Resources

Organizing an economic system involves making decisions about what is going to be produced and how it should be distributed. That takes care of most of the game of economics.

Still, there is one final question to be answered: What is the most effective allocation of resources?

There are all kinds of resources that go into production and distribution. Remember all the resources needed to make a birthday cake? There are a lot of them: an oven, a timer, ingredients, utensils, time, knowledge, and effort.

Production and distribution usually involve a long list with very different types of resources. The flour needed for the batter is a different type of resource than the oven needed to bake the batter, or the time needed for the whole process.

Deciding how to allocate resources means you have to pay attention to where the different resources come from.

It takes many different resources to make a cake.

The Factors of Production

The types of resources needed for production are known as the factors of production. There are three different factors of production: land (in economics, the term land refers to any natural resource on, under, or over the land), labor, and capital.

Land is useful for making things. Fields are used to grow food, and water or wind can be used to produce energy. And land is not just what you see on the surface of the Earth. It also includes things that can be found underground. Things like coal and iron – even steam and water come from underground. These natural resources are all useful for producing things.

Some goods spring directly from the Earth, but it takes some work on the part of humans to make all goods. Even a wild blackberry has to be picked by someone before it can be eaten. All production requires a human touch. Labor is the work that humans do to take natural resources and turn them into useful products. Sometimes the labor is physical. Sometimes the labor involves coming up with ideas. Whatever form labor takes, these human resources are just as necessary as natural resources.

Capital is the final type of resource needed for production. Capital resources are goods that have been produced by humans to make more goods. Capital includes machines like bulldozers and cement trucks. It also includes buildings like factories and other structures such as dams and oil wells.

The term capital also refers to the money used to pay for other resources. Like other forms of capital, money has been created by humans to help with the process of production.

You can see that playing the game of economics involves answering a lot of different questions. There are four fundamental questions faced by people in all economic systems.

The way these four questions are answered tells you a lot about the way decisions are made in different economic systems. When these questions are answered in different ways, you end up playing different games.

Another major element in economics is the concept of supply and demand. The fundamentals of supply and demand change depending on what type of economic system you are dealing with, however, so this concept cannot be included in the fundamental questions of economics, in general.

The Four Fundamental Questions

1. What is to be produced?

2. How is production to be organized?

3. How are goods and services to be distributed?

4. What is the most effective allocation of resources?

You have seen that there are different economic goals that can be pursued: efficiency, growth, security, equity, and freedom. It can be difficult to decide among them.

Individual people are not the only ones who choose economic goals. Entire societies also make the same choices. If it is hard enough to choose for yourself, imagine how hard it is for a whole society to agree on its economic goals! To make this decision, it helps to understand the different results that occur from pursuing different goals.

For example, what would the game look like if everyone agreed that freedom was the most important goal? To answer this, you can look at how a society that values freedom would answer the four fundamental questions of economics. This tells you what a free-market system looks like.

The free-market system, sometimes referred to as capitalism, is one of the most common economic systems on Earth. Examine how it works.

Free Choice

The first question raised by scarcity: What will be produced?

When you are alone, you can answer the question based simply on your personal needs or wants. When an entire society decides what will be produced, however, it raises a different question first: Who within society gets to make the decision? This question needs to be asked and answered before the first fundamental question.

It might seem obvious that the producers themselves should get to decide what to produce. Their role is to produce goods and services, so it makes sense to let them choose. This is exactly what happens in a free-market system: Producers are free to choose what to produce.

Producers also get to choose how to organize production, which addresses the second question. In fact, producers are free to answer all four of the fundamental questions without anyone telling them what they have to do. A capitalist society is one where allocation, production, and distribution are organized by the free choices of the producers.

The Customer Is Always Right

Capitalism leaves production decisions up to the producers, but the choices made by consumers also play an important role. Producers must eventually sell their goods and services to consumers. In a free-market system, consumers have the freedom to choose what to buy. This gives them a lot of power over producers.

Producers want the goods and services they make to be purchased and used. That means producers must pay attention to what consumers need and want. If consumers choose not to buy the goods and services they produce, the producers have to make different decisions.

Because of this, the needs and wants of consumers influence the decisions of producers. In a free-market economy, the free choices of both producers and consumers determine how the fundamental questions are answered.

Go with the Flow

A free-market system is based on the free choices of producers and consumers. The choices one group makes affect the other group. Consumers can only consume what producers produce. At the same time, producers want to make only what consumers need and want.

Because of this back-and-forth influence, capitalism has a circular flow. Influences and inputs move between producers and consumers. Economists call this a circular-flow model.

View the Circular-Flow Model below to see the circular-flow model of the free-market system.

The Circular Flow Model

The main players in the free-market game are producers and consumers. There is a circular flow of influences and inputs between them. A circle has no beginning and no end, so there is no first influence or input – but we need to begin somewhere, so let us start with the producers. Producers make goods and provide services. These go to the consumers to be used. The consumers purchase these goods and services. Consumers also provide the factors of production by working and investing. Producers pay for the work with wages, and they repay and reward the investments with profits. These things flow back and forth, continuing the cycle as producers and consumers interact and influence each other’s decisions.

Defending Freedom

The free-market system is based on producers and consumers making free choices. But often, consumers and producers have desires that conflict.

Conflict results naturally from people’s desires, and some people try to resolve conflict by using threats to force people to choose in a certain way. This is called coercion. When your desires conflict with someone else, the other person might try to make up your mind for you by using coercion.

Because the free-market system relies on free choices, coercion is usually forbidden in capitalist societies. It is illegal to take away people’s right to choose through coercion. Laws in capitalist societies are designed to defend the freedom of producers and consumers.

The Rules of the Game

There are many ways to take away someone’s freedom. Thus, rules are needed to make sure producers and consumers can make free choices. You already know some of these rules. For instance: No stealing.

«No coercion» is another important rule. Coercion can include lying, so «no lying» is also part of the rules of a free-market system.

In economics, the rules are laws. That is why the government passes laws against theft, coercion, and fraud. In a free-market system, the government has to make and enforce whatever laws are needed to guarantee free choice.

Private Property

Maybe you currently have some amount of financial freedom. Maybe you get an allowance, or you have a part-time job that provides a bit of spending money. But what if your allowance was taken away or you lost your job? Then you might have to ask someone else for money. Since the people you ask are free to choose, they can say yes or no.

To be free, you need more than protection against coercion. You need to have resources, too. If you do not have your own resources, then your ability to make free choices is limited.

In a free-market system, individuals get to make free choices about what to do with the resources they have. Therefore, rules protecting private property are among the most important rules of a capitalist society. These rules are referred to as property rights.

Land is one of the resources that helps people be free.

The Resource of Work

Land, money, and capital are resources, but they are not the only resources that allow one to make free choices. Healthy adults who own no property still possess one important resource – their own labor. The ability to work is an important resource in a capitalist system.

The rules of the free-market system protect you against coercion. It is illegal for anyone to force you to do something. This means that the rules guarantee that you can make free choices about how you sell your labor to others.

Labor is an important resource. Almost all production requires some labor. So, everyone who can work has an important resource, the resource of work. Having this resource gives people the ability to make free choices.

Competition

The free-market system relies on free choice and private property, but that is not all. Competition is another important part of capitalism.

Competition is needed to guarantee freedom. Without competition, people do not have a lot of choices. In fact, they might have only a single choice.

Free-market systems have to guarantee that there will be competition. It is one of the rules. Without competition, you would have to take the «free» out of free-market system.

Stock exchange

On the floor of the New York Stock Exchange, traders compete with each other to buy and sell shares.

The Importance of Competition

Imagine that you are hungry, and you want a sandwich. If there are a lot of different sandwich shops in competition with each other, then you will have a lot of choices. In fact, you will probably have fairly good choices. Because you can go to someone else, each shop is competing to get your business. This kind of competition gives the consumer a lot of good choices. They have got a lot of things to freely choose among.

But what if there were only one sandwich vendor? As a consumer, you would have to go to this one sandwich vendor and take what they had. Maybe they only have tuna fish sandwiches that cost $20. You do not even like tuna fish sandwiches, and you definitely do not want to pay $20 for one. But what other choice do you have? You have to buy the $20 tuna-fish sandwich or go hungry. You can always choose no sandwich and starve, but that is not much of a choice, is it? If your freedom consists solely of choosing between something you do not want – an expensive sandwich you won’t like – and something else you do not want – starvation – then it is hardly worth calling it freedom. Without competition, consumers do not have the freedom they are supposed to have.

The Profit Motive

Free choice, private property, and competition are at the heart of the free-market system. They are so important that there are rules protecting them.

We saw before that games often have properties in addition to the rules. Such properties are not enforced like rules, but they affect how a game is played. Properties of the free-market system are often called market forces.

One important market force in a capitalist system is the profit motive. Producers make a profit by selling a good or service for more than it costs to produce. The difference between the total cost of production and the selling price is the producer’s profit. If the cost is greater, the producer suffers a loss and will struggle to stay in business.

There is no rule that says you have to follow the profit motive because there does not need to be such a rule. It is obvious to any producer that a profit is better than a loss. In the free-market system, the profit motive exists without any kind of coercion.

Profit and Competition

The profit motive is extremely important for the free-market system. Because of competition, efficiency and innovation often result from this drive to make a profit. If you are competing with others, you cannot afford waste. Waste increases costs, which cuts into profit. So producers work hard to be as efficient as possible.

Competition keeps prices low, which means that producers cannot just make up for inefficiency by raising prices. The incentive to be efficient and innovative is an example of market forces.

The profit motive can also work against competition. If you really want to make a lot of money, it would be better not to have any competition. That way, you could sell your goods and services for a much higher price and make more profit. Profit seekers have an incentive to get rid of competitors, if they can, to make more profit. This is another reason it is necessary for the government to make laws protecting competition.

What is So Free About a Free Market?

You have seen that the free-market system is based on free choice, private property, competition, and the profit motive. These rules and properties create one particular version of the game of economics. It is just one version, but it is the game that most societies play.

Advocates of the free-market system might argue that the most important goal is freedom. Freedom is so desirable, they might say, that it makes it worthwhile to sacrifice other goals. Some advocates of the free-market system, however, think that we might not need to make these sacrifices. They believe that pursuing freedom allows us to reach the other goals as well.

Adam Smith was an early advocate of the free-market system. In the same year that the Declaration of Independence was written, he published a book called An Inquiry into the Nature and Causes of the Wealth of Nations. It is often simply called The Wealth of Nations.

Modern free-market advocates often cite Adam Smith to support their claim that freedom is the most important economic goal. Read some of what Smith said so you can judge the claims of the free-market supporters who agree with his reasoning.

Adam Smith is sometimes called the founder of capitalism.

Read the following excerpt from The Wealth of Nations and think about the things that Adam Smith said about the free-market system.

As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest, he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. It is an affectation, indeed, not very common among merchants, and very few words need be employed in dissuading them from it.

What is the species of domestic industry which his capital can employ, and of which the produce is likely to be of the greatest value, every individual, it is evident, can, in his local situation, judge much better than any statesman or lawgiver can do for him. The statesman who should attempt to direct private people in what manner they ought to employ their capitals would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it ….

The property which every man has in his own labour, as it is the original foundation of all other property, so it is the most sacred and inviolable. The patrimony of a poor man lies in the strength and dexterity of his hands; and to hinder him from employing this strength and dexterity in what manner he thinks proper without injury to his neighbour, is a plain violation of this most sacred property. It is a manifest encroachment upon the just liberty both of the workman, and of those who might be disposed to employ him. As it hinders the one from working at what he thinks proper, so it hinders the others from employing whom they think proper. To judge whether he is fit to be employed, may surely be trusted to the discretion of the employers whose interest it so much concerns. The affected anxiety of the law-giver lest they should employ an improper person, is evidently as impertinent as it is oppressive…

People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. It is impossible indeed to prevent such meetings, by any law which either could be executed, or would be consistent with liberty and justice. But though the law cannot hinder people of the same trade from sometimes assembling together, it ought to do nothing to facilitate such assemblies; much less to render them necessary.

The Invisible Hand

An important part of Smith’s theory is the «invisible hand.» He did not believe that a literal hand guides economic outcome. The invisible hand is a metaphor or symbol of market forces in the free-market system that lead to good outcomes without any planning. Because of this invisible hand, pursuing freedom helps realize other economic goals such as efficiency, growth, and security.

Smith clearly did not trust governments to direct economic affairs. Individuals pursuing their interests can «judge much better than any statesman or lawgiver can» what is best for the economy. Smith was very suspicious of government intervention in the economy.

Smith was also wary of producers since their pursuit of profit might persuade them to work against competition. That is what he meant by «some contrivance to raise prices.» He recognized that the government has a role to play in the game of economics. He believed that the government’s role should be limited to protecting such things as competition, free choice, and private property. The government should not have «folly and presumption enough» to believe it can run the economy directly. According to

Smith The invisible hand is not actually a hand.