Fascinating economy

It is better for everyone if the economy is left in the hands of private individuals pursuing their own interests. That is the invisible hand at work.

A different ball and different methods of pitching make softball and baseball two different games.

Playing the game of economics involves answering four fundamental questions. When they are answered differently, different games result.

Think about softball and baseball. They are similar games with a few important differences. This is also true for economics. There is more than one way to set up the rules. This means there are different versions of the game of economics.

The four all-important questions are

• What will be produced?

• How should production be organized?

• How will goods and services be distributed?

• What is the most effective allocation of resources?

Do What I Say and What I Do

A command economy has less freedom than a free-market system. Producers have to do what the government says. They do not get to decide what to make or how to make it. Also, people do not get to decide where they will work. The government decides that. This is why it is called a command economy: The government issues a lot of commands.

In a command economy, the government controls everything related to the allocation of resources and the production and distribution of goods and services. In order to do this, the government owns most of the property. Private property is an important feature of the free-market system, but it gets in the way of a command economy.

The following is a long list of government functions in a planned economy. The list goes on and on, but these are the fundamental commands issued in a command economy.

Government Commands

In a command economy, the government

1. Assigns production to producers.

2. Allocates resources to producers.

3. Sets prices for consumers.

4. Decides where people work.

5. Sets wages for workers.

6. Sells goods and services.

7. Decides who gets what and how much.

Your Wish Is the Government’s Command

Why would a government do all of this commanding?

There are other economic goals besides freedom and efficiency, and capitalism does not always serve these other goals. The free choices of producers and consumers often result in inequality and insecurity. Growth is sometimes strong and sometimes weak. People may be free to make choices, but they are often not free from struggle and need.

Command economies exist to serve other economic goals, usually equity, security, and freedom from need. These are the main concerns of both socialism and communism. Most nations have some elements of socialism as you will see later, but some countries have attempted complete socialism. Communism combines extreme socialism with political ideology. The former Soviet Union was a communist country. Today, China, North Korea, Vietnam, Laos, and Cuba still have communist governments though most have incorporated elements of capitalism. The philosophical goal of a command economy is to ensure equity and security. But under communism, the reality has been quite different. While some communist economies improved from what they were under previous authoritarian governments, none has achieved true equity or efficiency, and none has reached its economic potential. Some, such as North Korea, have had disastrous economic consequences. Additionally, these governments remain politically repressive.

Making a Plan

Free-market systems and command economies have different goals. But the differences do not end there. For one thing, a command economy has an extra set of players. There are producers and consumers, as in any economic system. There are also government planners. The planners are the ones who issue the commands.

In a free-market system, outcomes are not planned by anybody. They happen because of market forces. The law of supply and demand sets prices. Demand for different types of labor decides where people will work and how much they will make. Voluntary exchanges determine how resources are allocated.

In a command economy, these things are decided by the government instead of by market forces. Planners decide how to allocate resources for the production and distribution of goods and services. This means they decide what gets produced, they organize production, and they also decide which consumers will receive what and how much. In a command economy, planners, not producers, answer the four fundamental questions.

Diverting the Flow

The free-market system operates with a circular flow between producers and consumers. In a command economy, the flow is different because of the important role played by government planners. Their decisions affect almost everything that goes on in the economy.

A game with three sets of players is obviously very different from a game with two sets of players. A command economy has a flow that involves the planners at almost every step.

Remember how the circular flow model of the free-market system works? Inputs and influences go back and forth between producers and consumers. In a command economy, government planners get involved. What they do changes the flow. Goods and services are purchased from the government, and the money paid returns in the form of wages. Profit is eliminated. Diverting the flow of the free market this way tends to slow things down.

In a command economy, planners have to figure out what resources are needed to reach their society’s goals, and they have to figure out how to organize production. Collecting information and coordinating decisions use up a lot of labor, so there are fewer workers to contribute to production. This limits growth. The command economy also cuts down on efficiency and innovation. Planners are focused on organizing resources to meet society’s goals. They do not have much time or incentive to come up with the new products or different ways of doing things.

The Land of the (Mostly) Free Market

You have examined two different economic systems: the free-market system and the command economy. Both of these systems are based on a theory about how the economy should be organized. In reality, most economies are a mixture of both.

The United States has a free-market system – mostly. Almost all decisions are made by the free choices of producers and consumers. Still, there are parts of the U.S. economy that are planned. The government sometimes issues commands that limit the freedom of producers and consumers. These commands serve economic goals other than freedom and efficiency.

For example, minimum wage laws limit the freedom of producers by telling them the lowest wage they can pay their workers. The goal of a minimum wage is to promote economic security and equity by protecting workers from exploitation. Not everyone agrees that a minimum wage accomplishes this goal, and the value of minimum wage laws is frequently debated.

To many people, the free-market system is an important part of what the American flag represents.

It is in the Mix

When you mix two things, you can often get the best of both.

Freedom matters in the United States, but it is not the only thing that counts. Efficiency is important too, as are equity, security, and growth. This is why the U.S. government issues some commands, which means that the United States has a mixed economy. A mixed economy uses both free-market and command principles.

In freedom-oriented societies such as the United States, the commands are the exception rather than the rule – but the exceptions are usually quite important. The government limits freedom to serve other economic goals in areas that matter most.

The minimum wage has the goal of promoting security and equity by not allowing employers to exploit their workers. Experts disagree on its effectiveness.

Retirement is another important feature of a mixed economy. Social Security is a government program designed to ensure that retired workers age 66 or older receive a continuing income after retirement. Social Security was not intended to be a person’s only retirement income and the system faces difficulties.

People are free to, and should, save for retirement in other ways in the private sector to ensure a better quality of retired life.

Stay in School

One familiar example of government command in the United States is the public-school system. This system provides a useful service: education. This service is so important for all people that the government does not leave it up to producers to organize. The states provide this service themselves. While producers may provide education through a variety of private schools, government guarantees free education to all. In fact, all parents have to provide their children with either public or private education up to at least age 16.

This is an example of the operation of a command economy within the United States. But free-market principles also operate. Even though the government guarantees that an education will be provided to all, a system of private schools exists to give parents a choice of where to send their children. This is not true in a pure command economy. There were no private schools in the Soviet Union.

Take Advantage

Free-market systems and command economies both have advantages and disadvantages. The free-market system serves the goals of freedom and efficiency very well.

Command economies do a better job of providing security and equity. There are ups and downs to both systems, and no one would try to argue that either system is perfect. But is one a clear favorite over the other?

The Pros and Cons of the Two Systems

Free-market systems usually provide a much greater variety of goods and services. Competition among producers leads to innovation as the producers try to figure out what consumers need and want. This innovation inspires a diversity of goods and services that is not likely to exist in a command economy. Planners do not have much incentive to innovate. On the other hand, a command economy can make sure that everyone has their basic needs met. Planners can direct the production and distribution of goods and services such as food, medical care, and education to guarantee that everyone gets these important things.

Inequality of wealth is one of the disadvantages of the free-market system. When people are given the freedom to make different choices, they each get a different outcome. Inequality is bound to result when wealth is distributed by free choices instead of an overall plan. This can lead to insecurity, too. A command economy can provide greater equality and security but at the cost of efficiency. Planners may be able to implement an overall plan that assures that basic needs are met, and wealth is distributed more equally, but the planning required uses up a lot of resources. When market forces do the work, resources are not wasted paying, housing, and feeding government planners.

What is Big Brother Doing?

There are important differences between a free-market system and a command economy. In capitalist societies, the government does very little to interfere with the economy. Market forces, or the «invisible hand» is expected to allow the economy to function properly.

In a planned economy, the government takes on the job of the market forces. This uses up a lot of resources.

There are advantages and disadvantages to both approaches. That is probably why most countries have a mixed economy, so they can get some of the advantages of each system and pursue several economic goals at once.

Life is full of decisions. So is the game of economics.

Players decide on economic goals. They decide on the rules of the game. They make allocation and production decisions. They decide what to exchange and for how much to exchange it.

Making decisions never really ends in the game of economics. In fact, the economy is primarily just a constant stream of decisions and their outcomes.

So how are economic decisions made? Let us take a look.

Yogi Berra, one of the greatest baseball players ever, once said about the game, «It ain’t over til it is over.» This is not just true in the game of baseball. It is also true in the game of economics. No economic decision is over until it is over. In other words, you are not done with the decision-making process until you have carried out your decision. Even when you have already decided on a plan, you still have to decide whether to stick to it.

Life is all about personal choices. Sometimes decisions are easy; at other times they are difficult and require a lot of thought and maybe even sacrifice. Sometimes our decisions affect other people. This is true in baseball as well as in economics.

Weighing Pros and Cons

Compare going to see a movie with a trip to the dentist. Which sounds better: relaxing with a bucket of popcorn and a soda, or having someone poke around in your mouth with a metal instrument? If you are like most people, you would probably rather go to a movie than visit the dentist.

Think about it, however. There are pros, or positive aspects, to going to the dentist. And there are cons, or negative features, of going to the movies. Not even this decision is completely one-sided.

Cost-Benefit Analysis

Making decisions requires weighing the pros and cons. Good decisions can only be made after considering the different choices and picking the one that looks best. That is what players in the game of economics do.

Economists call this cost-benefit analysis. When you do a cost-benefit analysis, you look for the decision that has the maximum benefit with the minimum cost. In other words, the choice with the most pros and the fewest cons is usually the best option.

Be Rational

There is no rule that says you have to use cost-benefit analysis, but players who want to maximize benefits and minimize costs use it all the time. It is one of the properties of the game of economics.

You do not always have to list the pros and cons to do cost-benefit analyses. In fact, such an analysis happens frequently, and almost automatically. Any time you accept a cost, you are looking for a benefit. You have probably done a cost-benefit analysis of your own, even if you did not sit down to make a list of pros and cons.

Money Is not Everything

Money is one common way of calculating cost. You see price tags all over the place. It is normal to think of cost and price as the same thing, but the cost of a decision cannot be measured in money alone.

When you buy something with money, there are always additional costs. For instance, the time and effort involved in shopping are costs. And whatever you must give up by buying one thing instead of another is also a cost.

Imagine that you received $200 in birthday money. That is quite a benefit, but spending it involves costs. Maybe you decide to buy a new game console with the money. The price of the console is only one factor. There are hidden costs, too, such as gas for the car or bus fare to get to the store. The time you spend is another cost. So, while it may seem that you are getting something for free – a console bought with someone else’s money – buying it brings certain costs. And maybe you wanted a new backpack and a pair of shoes, too. You are sacrificing those purchases for the game console.

That is Your Opinion

Cost goes beyond money. No price tag reveals the full cost of something. Everyone’s feelings about cost are very personal. The way you calculate the cost of a decision depends very much on your tastes and your situation.

Whenever you buy something, there is a cost in time and effort beyond the price of the purchase. The time and effort spent on a task may be a high cost for one person and a low cost for another. An hour spent shopping probably seems like a low cost for someone who loves to shop – it may even seem like a benefit. But an hour spent shopping may be a very high cost for someone who does not like to shop. Time and effort are non-monetary costs of shopping.

Even monetary costs can vary depending on a person’s situation. If you are a millionaire, paying $10 for a movie is not a big deal. If your job pays $7 an hour, however, that $10 may seem like a lot of money.

Everyone calculates costs and benefits differently. That makes these calculations subjective. In other words, they depend on a lot of factors that vary from one person to another. Because people’s opinions and tastes differ, it affects how they see the costs and benefits of decisions.

Something’s Missing

Unfortunately, not all rational decisions work out the way you might hope. Sometimes you ignore a cost, or overestimate the benefits. This does not mean you are irrational. You simply could not think of everything.

Often, it is impossible to predict what is going to happen. Unexpected costs arise. Benefits turn out to be less than you thought. That is normal, because no one can predict the future. That does not mean a cost-benefit analysis is useless, though.

Economic Reasoning

Cost-benefit analysis is sometimes called economic reasoning. In many ways, economic reasoning is just like any other kind of reasoning – it is a matter of weighing pros and cons.

Some might call this logic, others common sense. Whether you call it economic reasoning, logic, or common sense, it is all the same thing. It is how people play the game of economics. They make rational decisions hoping for benefits that outweigh costs.

There is no such thing as a free lunch, even when someone else is buying.

The economy is not just a collection of people. It is like a game, except that instead of playing on a board or a field, the players move within the greater economic system. They follow rules and make decisions, and these decisions result in outcomes.

Definition of the Economy

The economy is the total of all the outcomes that result from people participating in the economic system.

Economists measure and discuss the strength and performance of the economy. When they use words such as health, vitality, and even stamina, it sounds much like a doctor talking about a patient. This is not far from the truth.

Economic Indicators

Economists measure the health of the economy by comparing and analyzing economic outcomes that result from various activities. Economists use these instruments to measure economic activity. These instruments, called economic indicators, include

• Gross domestic product.

• Growth rates.

• Unemployment rates.

• Inflation rates.

Doctors use measurements to judge the condition of their patients. Economists measure the health of the economy.

Gross Domestic Product

Some indicators are used quite often to measure the health and vitality of the economy. For example, gross domestic product (GDP) is a very helpful, and widely used, tool.

The GDP measures the overall size of a country’s economy. It is the monetary value of all goods and services produced in a country during a given time, usually one year. The GDP provides a good overall picture of how much economic activity there is within a country.

Understanding GDP

Gross domestic product is the sum total of private consumption, government spending, investment, and the net value of exports. The net value of exports, sometimes called the trade balance, is the value of the goods exported minus the goods imported.

The equation can be put more concisely as follows:

GDP = private consumption + government spending + investment + exports – imports

A common mathematical formula for measuring GDP looks like this:

GDP = C + G + I + Ex – Im

Private consumption includes all the goods and service purchased or consumed by individuals. Government spending includes all the costs incurred by the government, such as salaries of government employees, military spending, funding for education, and so on. Investment is limited to business investments in capital, and it does not include financial investments such as savings accounts or bonds. Exports are those goods that are produced inside one country and sold in another country. Imports are the reverse – goods made outside the country and purchased within the country. Imports are subtracted from the GDP because they are purchased from other countries before they are sold within the United States. These funds contribute to another country’s GDP.

The GDP is a very weighty number for every country in the world.

World GDP

GDP is an important economic indicator. The bigger the GDP, the more activity there is in a country’s economy. For large countries, the GDP numbers are likewise usually very large. Sometimes a country’s GDP is so large that it is hard to comprehend. So what does a GDP number really tell us?

There are a couple of ways to make the GDP more meaningful. One is to make comparisons. For example, in 2011, the GDP for the entire world was just under $70 trillion. The same year, the GDP of the United States was about $15 trillion. That means that roughly one-fifth of all economic activity in the world took place in the United States. That is a lot of economic activity for one country.

The United States has the largest GDP in the world, as evidenced by our many shopping malls.

Annual GDP

You can also compare the GDP from one year to the next, which gives an indication of economic growth on an annual basis, or year by year. For instance, if a country’s GDP grows by 10 percent from one year to the next, the economy is growing rapidly. If its GDP goes down, the economy is weakening. If the GDP stays about the same, the economy is stagnating.

Another way of making the GDP useful is to look at per capita GDP. To do this, you divide a country’s GDP by its population. This tells you the average amount of economic activity contributed by each person in that country.

Growing Up

There are measurements for almost every type of economic activity. These measurements are usually reported as growth rates. Growth rates show how much economic activity there is in specific parts of the economy.

There are additional indicators that show how fast the economy is growing (or shrinking) in particular areas. There are also dozens of other government statistics that measure economic activity, all of which tell us how well businesses and consumers are doing.

Additional growth indicators include

• Corporate profits.

• Farm income.

• Industrial production.

• New housing construction.

• Personal income.

• Retail sales.

Growth is important for an economy.

Help Wanted

GDP and other growth indicators measure the amount of activity taking place in an economy. Another way to measure activity is to look at inactivity.

One important measure of inactivity is the unemployment rate. This indicator tells us the percentage of workers who are out of work. This is a good way to measure the health of an economy. When only 5 percent of people are out of work, the economy is much healthier than when the unemployment rate is 10 percent.

As with GDP, comparisons across time provide a more useful perspective. If the unemployment rate is declining, that means more people are working. The economy is getting stronger. If the unemployment rate is rising, then the opposite is true.

Did You Know?

A country’s unemployment rate might actually be higher than what is officially listed. This is because many people who are out of work do not report this fact to the government, so they do not get recorded as part of the total percentage of unemployed citizens.