THREE BASIC ECONOMIC QUESTIONS -THE QUESTIONS FACING …

AS Economics

Lecture Notes

THREE BASIC ECONOMIC QUESTIONS - THE QUESTIONS FACING ALL ECONOMIES

All societies face three fundamental questions and how these are answered will depend on the type of economic system being operated. These questions are as follows. WHAT TO PRODUCE - WHICH GOODS AND SERVICES SHALL BE PRODUCED AND IN WHAT QUANTITIES? This problem concerns the composition of total output. The community must decide which goods and services it is going to produce and hence which goods and services it is not going to produce. Having decided the range of goods and services to be produced, the society must then decide how much of each good and service should be produced. In reality the choices open to a society are rarely of the 'all or nothing" variety. They usually take the form of more of one thing and less of another The first and major function of any economic system is to determine in some way the actual quantities and varieties of goods and services that will best meet the wants of its citizens. HOW TO PRODUCE - HOW SHOULD THE VARIOUS GOODS AND SERVICES BE PRODUCED? Most goods and services can be produced by a variety of methods. Wheat can be grown by making use of much labour and little capital, or by using large amounts of capital and very little labour Electrical appliances can be made by using large and complex machines operated by relatively few semi- or unskilled workers. Alternatively they might be produced in hosts of small workshops by highly skilled technicians using relatively little machinery. Different methods of production can be distinguished from one another by the differences in the quantities of resources used in producing them. Economists use the terms capital-intensive and labour-intensive to describe the alternative methods just outlined. The total output of the society depends not only on the total supply of resources available but also on the ways in which these resources are combined. A society must make decisions on the methods of production to be adopted. FOR WHOM TO PRODUCE - HOW SHOULD THE GOODS AND SERVICES BE DISTRIBUTED? This is the third question which an economic system has to answer. The total output has to be shared out among the members of the society. The economic system has to determine the relative sizes of the shares going to each household. Should everyone be given an equal share? Should the division depend upon the individual's contribution to production? Should the output be shared out in accordance with people's ability to pay for the price, or should the shares be decided according to tradition and custom?

ECONOMIC SYSTEMS ? DIFFERENT ALLOCATIVE MECHANISMS

A system which will give answer to the following questions is called economic system. a. What to produce? b. How to produce? c. For whom to produce?

Economic systems can be categorized into planned economies, market economies and a combination of the two, mixed economies. Two key features distinguish economic systems; who owns the land and capital, and who decides what is produced. PLANNED ECONOMIES An economic system characterized by govt. ownership of prices, no price mechanism and no profit objectives is called command or planned economy. A planned economy is one in which the government makes the decisions on what to produce, how to produce it, and who gets it. The communist regimes in Cuba and North Korea can be described as planned economies, although this type of economic system is not just found in communist countries. It is applicable wherever the economic resources of a nation are directly controlled by some centralized authority. The UK became a planned economy during the years of the Second World War when the government took control of all important economic affairs. Planned economies can also be referred to as command or collectivist economies. OWNERSHIP AND CONTROL OF RESOURCES Although economic planning may be employed in societies where property is privately owned, it seems realistic to assume that a fully planned economy means one in which all the important means of production are publicly owned. In communist and socialist societies (which are the most important examples of planned economies) all land, housing, factories, offices, power stations, transport systems, and so on are usually owned by the state. The logic of public ownership in these societies is based upon the desire for a fairer distribution of income and wealth. Private ownership of property leads to great inequalities of wealth, and this, in turn, means that the wealthier groups are able to exercise great economic power Such a situation implies great inequalities of opportunity. The better-off members of society are able to use their greater wealth to obtain superior education, better health services, more

Compiled by: Saddique Ansari (0300-6344901)

1

AS Economics

Lecture Notes

effective training and better business opportunities. The elimination, or severe limitation, of private ownership is seen, therefore, as the most effective way of removing these inequalities of opportunity. It is also argued by the supporters of the planned economy that only the direct ownership of the means of production can give the state the full control that it needs in order to carry out its economic plan. FORMS OF COLLECTIVE CONTROL In planned economies land and capital may be owned collectively rather than individually but this does not mean that control of these resources has to be centralised. In some planned economies the state keeps a tight control on the use of economic resources and all important economic decisions are taken by powerful central committees. They decide what should be produced, how and where production should take place, and how the output should be shared among the people. This is described as bureaucratic organisation, because the running of such an economy will require large numbers of planners and administrators to draw up and operate the national plan. Alternatively, although the ultimate ownership of resources may be in the hands of the state, the control and day-today running of the farms, factories, offices and shops may be handed over to cooperative groups of workers and consumers. These organisations are usually described as workers collectives, as opposed to the state enterprises which are controlled directly by the government. One important feature of a society in which property is publicly owned is that there will be no form of personal income which is derived from the ownership of property. In the market system incomes take the form of wages, interest, rent and profits -- the last three of which arise from the ownership of various types of property. PRODUCTION DECISIONS The administrators in a planned society face a most complex task. They must begin by making a survey of the productive potential of the economy. This involves looking at the resources of workers, machines, factories, offices, etc.. the country has and what can be produced with them. First, assessments must be prepared showing the outputs which might be produced by the mines, farms, factories, etc., together with estimates of the capacities of the transport networks and the capacities of the other service industries. Decisions on the quantities and varieties of goods and service to be produced must then be made and each unit of production (e.g. each farm or factory) will be given a target output for the period of the plan -- normally five years. The next task is to allocate the necessary supplies of materials, equipment, and labour to the various units of production. A modern economic system is exceedingly complex. The output of any one factory is dependent upon supplies from many different sources. The fitting together of all these planned outputs into one huge national plan is a formidable task. In fact it is virtually impossible for central planners to fix targets and resource allocation for every single farm, factory, office and shop. The planners are more likely to give directives (orders) to whole industries. Whilst the ways in which the targets set down in these orders may be left to local decisions at the industry and factory levels, it is most probable that the allocations to various industries of the more vital resources (e.g. new capital) will be centrally controlled. In order to co-ordinate resources and output for each industry planners usually employ input-output analysis. This involves estimating what inputs, i.e. resources, firms need in the form of materials, labour, machinery, etc. and what output they are capable of producing. Then the planners check where the inputs can come from and where the output can go -- either to other firms or to consumers and that the inputs and output match. A flow chart of inputs and output is drawn up. DISTRIBUTION DECISIONS While it is possible, although very difficult, to subject the outputs of goods and services to complete control by planners, it is much more difficult to use these methods in the markets for labour and consumer goods and services. In respect of industrial investment (i.e. capital goods), defence requirements, and social investment (e.g. schools, hospitals, housing) the necessary allocations of resources can be directly controlled and the outputs firmly determined. In the case of consumer goods and services, however, there are restraints on the planners" ability to use direct controls. Ideally, the complete planning of production should be accompanied by the complete planning of distribution. What is produced can then be allocated to consumers by some kind of physical rationing scheme. Workers could be paid in kind, receiving vouchers which entitle them to various quantities of different goods and services. In this manner the pattern and volume of consumption could be matched exactly to the planned output. Such a system might operate perfectly well in a poor country where all resources are committed to the bare necessities of life. In a more developed economy, however, consumers are likely to demand a large measure of freedom of choice in how they spend their

2

Compiled by: Saddique Ansari (0300-6344901)

AS Economics

Lecture Notes

income. Allowing for freedom of choice in the consumers' market makes the planners' problems much more difficult. It is very unlikely that the spending plans of consumers will exactly match the production targets of the planners. This does not mean that direct planning will not work; it means the plan must contain some flexibility so that production can respond to the various surpluses and shortages as they appear in the consumer markets. ASSESSING CONSUMER DEMAND There are various ways in which planners can test consumer demand -- assuming, that is, that they wish to respond to it. They might conduct a continuous poll or carry out surveys of public attitudes and preferences. Alternatively they could allow the goods and services to be sold in free markets. Goods and services which are in short supply will rise in price whilst those in surplus will fall in price. These price movements could then be used as indicators to producers as to which industries should expand their outputs and which should contract output. Planners may, however, regard such price movements as an inequitable means of testing the market (e.g. a shortage of bread might cause its price to rise beyond the means of the poor). The state may, therefore, fix prices, and where shortages arise the good or service may be physically rationed. In this case it would be the movements in retail stocks (the shortages and the surpluses) which act as indicators to the planners. LABOUR MARKET DECISIONS There are similar problems to be dealt with in the market for labour. Whilst iron ore, machines, lorries and so on can be distributed directly to the different industries, workers will not usually continue to accept such direction. They will demand some degree of freedom in choosing their jobs and the part of the country in which they wish to work. Getting the right amounts of labour in the right places to meet the production targets cannot normally be achieved by the direction of labour; it must be done by inducement. As is the case with consumer goods and services, it means that some limited use must be made of the price mechanism. Firms which are short of labour will have to be given permission to offer higher wages in order to attract labour from other sources. In the longer run the state can influence the supplies of the different types of labour by providing more and better training facilities for those skills which are in short supply and reducing the intake of trainees for occupations where demand is declining. MARKET ECONOMIES An economic system characterized by private ownership, price mechanism and profit objectives is called market economy or free market economy. A society may attempt to deal with the basic economic problems by allowing free play to what are known as market forces. The state plays little or no part in economic activity. Most of the people in the world now earn and spend in economies in which market forces play a significant role. The market system of economic organisation is also commonly known as a free enterprise, or laissez-faire, or capitalist system. Strictly speaking the pure market or laissez-faire system has never existed. Whenever there has been some form of political organisation, the political authority has exercised some economic functions (e.g. controlling prices or levying taxation). It is useful, however, to consider the way in which a true market system would operate because it provides us with a simplified model, and by making modifications to the model it is possible to approach more realistic situations. The framework of a market system contains six essential features:

? private property ? freedom of enterprise and choice ? self-interest as the dominating motive ? competition ? a reliance on the price system ? a very limited role for the government. PRIVATE PROPERTY The institution of private property is a major feature of a market economy. It means that individuals have the right to own, control, and dispose of land, buildings, machinery, and other natural and man-made resources. Man-made aids to production such as machines, factories, docks, oil refineries and road networks are known as capital. Private property not only confers the right to own and dispose of real assets, it provides the owners of property with the right to the income from that property in the form of rent, interest, and profits. Although all non-human resources can be privately owned, labour cannot be bought and sold in the same way. Except in slave societies, labourers own themselves, whilst land, buildings, and machinery are owned by others. Owners of land and capital purchase the services of labour in order to operate their factories, offices, farms, shops and so on.

Compiled by: Saddique Ansari (0300-6344901)

3

AS Economics

Lecture Notes

FREEDOM OF ENTERPRISE AND CHOICE Freedom of enterprise means that individuals are free to buy and hire economic resources, to organise these resources for production, and to sell their products in markets of their own choice. Persons who undertake these activities are known as entrepreneurs. These people are risk takers and such people are free to enter and leave any industry. Freedom of choice means that owners of land and capital may use these resources as they see fit It also means that workers are free to enter (and leave) any occupations for which they are qualified, although this is a rather meaningless freedom when there is a high level of unemployment. Finally it means that consumers are free to spend their incomes in any way they wish. This freedom of consumer choice is usually held to be the most important of these economic 'freedoms'. The consumer is regarded as being sovereign since it is the way in which s/he chooses to spend his income which determines the ways in which society uses its economic resources. In the model of a market system, producers respond to consumers' preferences -- they produce what consumers demand. SELF-INTEREST Since a market system is based on the principle that individuals should be free to do as they wish, it is not surprising to find that the motive for economic activity is self-interest. Each unit in the economy attempts to do what is best for itself. Firms will act in ways which, they believe, will lead to maximum profits (or minimum losses). Owners of land and capital will employ these assets so as to obtain the highest possible rewards. Workers will tend to move to those occupations and locations which offer the highest wages. Consumers will spend their incomes on those things which yield the maximum satisfaction. Advocates of the market system such as Adam Smith argue that the individual pursuit of self-interest leads to the maximum public good. 'By pursuing his own interest he (the individual) frequently promotes that of society more effectually than when he really intends to promote it.' COMPETITION Economic rivalry, or competition, is another essential feature of a free enterprise economy. Competition, as economists see it, is essentially price competition. The model of the market economy envisages a situation where, in the market for each commodity, . there are large numbers of buyers and sellers. Each buyer and seller accounts for an insignificant share of the business transacted and hence has no influence on the market demand or market supply. It is the forces of total demand and total supply which determine the market price, and participants, whether buyers or sellers, must take this price as given since it is beyond their influence or control. In theory at least, competition is the regulatory mechanism of the market system. It limits the use of economic power since no single firm or individual is large enough or strong enough to control a market and exploit the other buyers and sellers. MARKETS AND PRICES Perhaps the most basic feature of the market economy is the use of the price mechanism for allocating resources to various uses. The price system is an elaborate system of communications in which innumerable free choices are totalled and balanced against each other. The decisions of producers determine the supply of a product; the decisions of buyers determine the demand. The interactions of demand and supply cause changes in market prices and it is these movements in market prices which bring about the changes in the ways in which society uses its resources. A simple example can illustrate this. A particular product proves to be increasingly popular with consumers. Increasing demand outstrips supply at the existing price, a shortage develops and price increases. This rise in price makes production more profitable, so that existing firms will tend to expand their outputs and new firms will be attracted to this industry. More and more resources will move into the industry because the greater profitability will enable firms to offer higher rewards in order to bid labour and capital away from other uses. The opposite process will apply when the demand for a product is declining. Price movements act as indicators and provide an essential link between consumers' preferences and producers' profit-seeking decisions. In a market economy, price has another important function -- it acts as a rationing device. Price serves to ration scarce goods and services among the people who are demanding them. Where the supply of a good or service is insufficient to meet the demands of prospective buyers at the existing price, the market price will rise and continue to rise until the quantity demanded is just equal to the existing supply. Those unable to pay the higher prices will be eliminated from the market. Price rations scarce goods to those who can afford to pay the price. If supply exceeds demand, the price will fall, bringing in more buyers (and expanding the purchases of existing buyers) until a price is established which equates the quantities being demanded and supplied. Note that price rations goods and services, not on any basis of need or want, but on the basis of the ability to pay the price.

4

Compiled by: Saddique Ansari (0300-6344901)

AS Economics

Lecture Notes

The price mechanism allocates resources to different uses on the basis of consumer 'votes'. The act of purchasing a product is. in effect, a vote for the production of that product. Under this system those with the greater purchasing power have more votes. This might be regarded as an inequitable system especially where there is great inequality in the distribution of income. MIXED ECONOMIES An economic system that combines elements of a free market (Private enterprises) and state control and ownership of resources (Public sector) is called mixed economy. As noted above, there is some use of the market mechanism in planned economies. Likewise there is some measure of state control in market economies. Indeed, there are no pure planned or pure market economies in the world. Where there are both public (i.e. a state) sector and a private sector (where non-government firms and individuals decide what is produced), the economy is called a mixed economy. It has features of both a command and a market economy. All economies have some degree of state intervention and are essentially mixed economies. A mixed economy, as the name implies, is a mixture of a planned economy and a free enterprise economy. In practice, no pure planned economies or free enterprise economies exist in the world. They are paradigm models. What we call free enterprise economies are economies where most resources are allocated by the market mechanism. What are called planned economies are economies where most resources are allocated by the planning process. Mixed economies are economies where the balance between allocation by the market mechanism and allocation by the planning process is much more equal. Characteristics: A mixed economy possesses a number of characteristics. The main actors: The four main types of actor within the system are consumers, producers, factor owners and government. Motivation In the private sector of the economy, consumers, producers and factor owners are assumed to be motivated by pure self-interest. The public sector, however, is motivated by considerations of the 'good' of the community. Ownership: The factors of production are partly owned by private individuals and organisations, but the state also owns a significant proportion. Competition: In the private sector of the economy there is competition. In the state sector, however, resources will be allocated through the planning mechanism. This implies that consumers are offered choice of goods and services within the private sector of the economy but little or no choice within the public sector. Government: Government has a number of important functions. One is to regulate the economic activities of the private sector of the economy. It needs, for instance, to ensure that competition exists and that property laws are upheld. Another function is to provide not just public goods but also merit goods, like education and health care. These may be provided directly by the state, or provision may be contracted out to private firms but still paid for out of tax revenues. The state may also choose to own key sectors of the economy, such as the railways, postal services and electricity industries. Many of these will be natural monopolies. THE DEGREE OF MIXING There is considerable controversy about the degree of mixing that should take place in a mixed economy. In 1998, 60.8 per cent of GDP was accounted for by public spending in Sweden compared to 46.9 per cent in Germany, 40.2 per cent in the UK and 33 per cent in the free market economy of the USA. In Sweden, there is much greater government spending per capita than, say, in the USA. This means that in Sweden compared to the USA all citizens have access to medical care free at the point of consumption, there are generous state pensions, automatic retraining for those made unemployed and free child care for all working mothers. However, there is a cost. Taxes in Sweden are much higher than in the USA. The fundamental issues concern the following. ? To what extent should the state ensure that all its citizens enjoy a minimum standard of living? For instance,

should the state provide insurance for those who become unemployed? Should it in effect guarantee them a job by training longer term unemployed workers until they succeed in obtaining work? Do citizens have a right to free medical care? ? To what extent should there be inequalities in society? The degree of inequality in an economy like Sweden is far less than in the USA. Inequality in the UK increased as public expenditure during the 1980s as a proportion of GDP was cut in the 1980s.

Compiled by: Saddique Ansari (0300-6344901)

5

 ................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download