Hypertext  for Economics 100 Online
contents copyright K.J. Rea 2000, all rights reserved.

The Economic Problem

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Production Possibilities

Methods of Allocation

Origins of the  Market Economy


Nothing is to be had for nothing.
—Epictetus (AD 100)

For most of the world's population it is obvious that human wants exceed the means of satisfying them. Outside the developed industrialised countries, in the "third world", the great bulk of the population teeters on the edge of subsistence, eking out a meagre living as best they can and dreaming of a future in which they will have more. Yet, even in the "rich" countries, the industrialized democracies of the world, where the average standard of living is the highest in human history, most people also find that they cannot satisfy all their material wants. 

For reasons which are worth thinking about, but which we won't take time to investigate here, even in the United States, Japan, and other affluent countries, a minority cannot afford the "necessities" of life, a minimum of food, clothing, shelter. Others, the great majority, can satisfy their basic needs, but live in hope of acquiring more — a better car, a house in the country, an expensive annual vacation. Even that smallest minority, the "super rich", seldom seem able to reach the point of satiation. 

This suggests, then, that "wants" are incapable of ever being satisfied. No matter how much we have, it appears to be "human nature" to want more. 

Some moralists — and growing numbers of environmentalists — suggest that we should address this problem by reducing our wants, but this approach seems to have only a limited appeal in modern materialistic societies, rich or poor. The preferred alternative (rightly or wrongly) has been to try to increase the supply of goods and services so as to satisfy as many wants as possible. Great advances have been made in this endeavour, especially in the last two centuries, and this "progress" may yet continue. Whether or not there are absolute limits to the productive potential of the world in the long term will be considered further in the concluding part of this course. What is more relevant here is the indisputable fact that, at any particular point in time, or even in any short period of time (such as a year), there are limits to the quantities of want-satisfying goods and services we can produce.



This fundamental perception has been at the heart of economics as a discipline since its beginnings in the 18th century. In trying to think clearly and systematically about it, economists have developed some particular definitions which remain useful. Ultimately, every community’s ability to satisfy its wants is limited by the available supplies of the productive inputs required. These productive inputs are called resources. Broadly defined, resources have traditionally been divided into three categories corresponding to the classic factors of production—land, labour, and capital. 

In economics, land (or natural resources) includes not only all agricultural land and land suitable for building on, but also such things as forests, minerals in the ground, and hydro-electric sites on rivers. The supply of labour is the sum of the physical and mental effort which can be drawn upon for productive purposes. Capital is a more elusive factor of production. Real, physical, capital consists of goods which have been produced for the purpose of producing other goods. Machinery and equipment, factories and other structures used in production are important examples. (In some contexts "capital" may refer to a stock of financial assets, but this use of the term will not be needed until much later in this course). Unless otherwise indicated, references to "capital" will mean real capital in the physical sense. 

Over any relatively short period of time, the total supplies of land, labour and capital may be taken as fixed. This limits the possible output of goods and services. But, given enough time, the supplies of productive factors can be increased. For example, land resources can be expanded by developing new uses for things occurring in the natural environment (e.g. uranium, once not a resource, but after the invention of nuclear power technology, a significant one), or by exploration and development (e.g. finding and opening new mines). 

As for labour, its supply can be increased over time through natural increase of the population or through net immigration. It may also be increased by having a larger proportion of the total population enter the job market. In most of the industrial countries in recent decades there has been a great increase in the proportion of women, especially married women, seeking employment outside the home. 

The supply of capital can be increased by using some of our scarce resources to produce "goods for use in further production" instead of goods for immediate consumption. This, as we will see, is a two-step process involving saving (which is defined as abstaining from consumption) and investing (defined as the creation of capital goods). Saving is a necessary precondition for investing for, by not consuming as much as we could consume, some resources are freed for use in producing capital goods rather than consumption goods. (The reason behind diverting resources from meeting current consumption needs to supporting capital creation is that the capital goods so produced will permit a larger output of consumption goods in the future. But note that this can be a painful process in societies where current incomes are low and people will suffer if resources are directed toward real capital creation instead of being used for current consumption. One of history's most terrible instances of this was Joseph Stalin's drive to accelerate the industrialization of the Soviet Union in the late 1920s.) 

Given enough time, then, it may be possible to increase the available supplies of economic resources in a country, but they will still remain "scarce." The evidence for this scarcity of resources is that they are not "free." If anyone wants to use an economic resource they have to pay a price for it. This price is an indicator of the resource’s scarcity (and how high or low the price is indicates its relative scarcity compared to other resources). 

Resources may be privately or publicly owned. In the western industrial countries most agricultural land, for example, is privately owned, but many other natural resources, such as forests and minerals in the ground, are treated as public property and their use controlled directly by government. Whatever the form of ownership, economists call the payment made to the owners of such land resources rent (not to be confused with the ordinary, more limited use of the term to describe the payment made for the use of residential or business space). 

Labour today is always privately "owned," except in the case, perhaps, of prisoners in some countries. Everyone is familiar with the forms the payment to labour takes—wages, salaries, fees, tips, commissions, bonuses. (The distinctions among these forms are unimportant for most purposes and the term "wages" will be used to represent all of them throughout this course.) 

Capital, like land, may be privately or publicly owned. In the industrial democracies most capital is privately owned, but publicly-owned capital is not uncommon. For example, electric-power generating plants and distribution systems are often owned and operated by government agencies, although the extent of such public ownership varies considerably from one country to another. 

Because capital in the real sense of a machine or a factory is usually either purchased outright from a manufacturer or built by those who will use it, there is no simple way of specifying the payment made for its use as there is in the case of land and labour. There is, however, a close connection between the processes of saving and capital creation (investing). Investors must obtain the use of funds set aside by savers if they are to acquire or create capital goods. The payment made for the use of these funds is called interest. Because capital is productive, it is capable of generating a flow of returns to its owners over time. This flow of earnings attributable to a machine or other real capital good is what enables its owners to pay interest to the savers who have financed its acquisition or production. 

Sometimes economists identify a fourth factor of production, "entrepreneurship". The contribution to production by a person who initiates a business, organises the inputs of productive factors, and assumes the risk involved in producing goods for sale is perhaps important enough in a free-enterprise type of economy to warrant separate recognition, although it could also be thought of as simply another form of labour. When entrepreneurship is separately identified, the return to it may be called "profit", but the appropriate meaning of this term is often contentious. 

An important characteristic of all kinds of resources is that they are often versatile in the uses to which they may be put. Particular resources may be used to produce many different kinds of useful things. A hectare of land in the countryside might be used to grow grapes or be used as the site for a shopping plaza. A worker’s time might be used to produce part of an automobile engine or, if laid off from such a job, a hamburger lunch at a fast food restaurant. A computer system may be used to make airline reservations or to assist in medical research. It is, of course, this versatility in use that at least in part accounts for the importance of "choice" in dealing with the economic problem.


Production Possibilities

Because resources are scarce, but versatile, utilising them to create particular goods and services requires an act of choice. Choosing to use land, labour, and capital to produce food means that these particular supplies of raw materials, worker-hours and produced goods for use in further production are not available to produce any of the thousands of other alternative outputs we might want. The number of decisions which must be made in the real world concerning the allocation of resources among competing uses are numerous and the process of choosing is complex. 

Here we encounter for the first time a characteristic of economics as a discipline: the use of simplifying assumptions to make complex processes understandable. In trying to understand how resources are allocated among competing uses, we can make it easier by assuming that instead of there being a multitude of alternative uses for scarce resources, there are only two. Any conclusions reached about this highly simplified case may then (with due care) be extended to more general (and more realistic) situations. 

Knowing how to simplify one’s description of reality without neglecting anything essential is the most important part of the economist’s art. —James S. Duesenberry (1958)

Imagine, then, a situation in which a decision must be made whether to use scarce resources to produce food or poetry. To simplify further, suppose only one resource, labour, has to be allocated between these two kinds of output and that we have only one week in which to do it. If this community is very poor, all the available labour will have to be assigned to the task of producing food, in which case the quantity of food produced will be maximised and the production of poetry minimised. If all available resources were devoted to producing food, there would be no poetry. If all available resources were devoted to producing poetry, there would be no food produced. Every unit of resources used for one kind of production will mean a reduction in the amount of the other which can be produced. Realistically, the choice will probably be between producing some food and some poetry. The important thing is the trade-off between the two. The cost of producing poetry is the value of the food which is given up in order to have it. This is called the "opportunity cost" of poetry. Or, if you prefer, the opportunity cost of producing food is the poetry which has to be sacrificed to have it.

Click on graphic for Flash animation.
Production Possibilities Curve

The numbers chosen for the example are, of course, completely arbitrary. The specific relationship between the quantity of food which has to be given up to produce an additional amount of poetry will depend in practice on many things, but most generally on the productive capabilities of the factor inputs available. It is entirely likely that some workers, for example, will be better able to produce food than poetry and vice versa. If this is so, as we switch workers from one line of production to another, and if we first transfer the most able at the new employment, as we continue the process we will find that the average efficiency of workers in the new employment will decline. This is why the "production possibilities frontier", the curve made up of the points corresponding to various combinations of the two goods, is bowed outward from the origin. As you trace what happens moving down the curve from left to right, notice that it takes a larger and larger sacrifice of poetry to obtain an additional unit of food. In other words, the "opportunity cost" of food increases as more of it is produced. This is closely associated with another concept we will develop more fully later in the course, "marginal cost", which is the opportunity cost of having one additional unit of a good.

Given enough time, a society may be able to increase the supplies of its productive factors and, perhaps by devising new methods of using them (technical change), become capable of expanding its production of all goods and services. In the production possibilities diagram this would be shown by a shift in the curve outward from the origin.

Click on graphic for Flash animation
An increase in resources shifts the PP curve outward

Some further features of the production possibilities relationships will be introduced in the lecture, but for now attention will focus on the fundamental fact that producing more of one thing requires NOT producing some other thing, which means that every society has had to adopt or devise some system for making  these crucial decisions as to how its scarce resources will be used. 


Methods of Resource Allocation

Anyone faced with the task of devising such a system would likely begin with the assumption that some kind of elaborate administrative system would be needed to determine what goods should be produced and how resources should be allocated to achieve the desired outcomes — and such systems have, of course, been devised. 

Historically, a variety of institutional arrangements have existed in which economic decisions were controlled by religious, military, or other organizations capable of exerting control over people's behaviours. In recent times, the economy of the former Soviet Union was based on the idea that a central bureaucracy could be relied upon to make the necessary decisions concerning resource use and the distribution of income. China has also used such a system and today Cuba remains a boutique example of such a centrally planned and directed economy. 

A very different approach, which might at first thought seem rather implausible, would be to leave individuals — producers, consumers, buyers, sellers, workers, employers — free to do whatever they might choose to do, limited only by certain general legal restraints, in the expectation that they would somehow be able to interact harmoniously and, in effect, control one another. This is the idea underlying a "market-based" economy. Much of the theory we will be studying in this course relates to how such a system works, or is imagined to work.


Origins of the Market Economy

The term "market" is used in economics to refer to any situation in which buyers and sellers come together (either in person or by other means) to negotiate transactions involving goods and services. In this general sense markets are probably ubiquitous and may be thought of as having existed throughout human history. But the term "market economy" or "market system" refers to a system of social organisation in which free competitive markets and the search for private profit dominate relationships among individuals, define individual identities, and determine an individual’s status in life. 

The market economy (unlike markets, which have probably always existed in some form or another) is a relatively recent phenomenon in human history, dating from sometime in the 15th or 16th century. Prior to that time, economic life in western Europe, as in most of the rest of the world, was organised within a system of traditional values administered by local authorities responsible for controlling most aspects of economic life. (While this "ancient history" may seem irrelevant to some readers, it is worth taking a look at here, because many of the ongoing disagreements about how modern economic life should be organized will make a lot more sense if they can be viewed in a historical context.)

Prior to the industrialization of Western Europe which began in England in the late 18th Century, agriculture was the predominant industry and it was usually organised according to the old feudal principles by which peasants and other classes of agricultural workers were "bound to the land", deriving their living and their position in society from the specific nature of their relationship to the land they worked. Above the peasants, the local lord of the manor exercised control over the production and distribution of the products of their labour in accordance with time-honoured principles which defined the rights and obligations of the parties concerned. In the towns, small-scale industrial activities were governed by associations of craftsmen, the guilds, which set standards, regulated prices and ensured that the traditional rights and responsibilities of these components of society were respected. At the top of the social pyramid, a land-owning aristocracy was maintained by the payments of rents and dues from the lower orders of society. To the extent that commercial activity extended beyond the local community it was dominated by trade in luxuries — spices, wines, jewels and other expensive goods which could stand the cost of transport over long distances and which were destined for the households of the elite. Markets operated in this system, but they were subordinate to other instruments of social control. 

In a market economy prices are (supposedly) determined by the interaction of self-interested buyers and sellers, a process which will be studied in subsequent parts of this course. In the economy of pre-15th century Europe (as in many economies today) prices were (supposedly) determined by other considerations, notably what was "fair" or morally defensible. Christian doctrine, as interpreted by the Catholic scholars and teachers of the Middle Ages, for the most part relegated economic activity to a secondary level, certainly ranking it below the attaining of moral virtue and a secure place in the afterlife. The "right" price for a good or service was consequently seen as one which would enable the seller to maintain his or her traditional place in society and nothing more. Christian scripture was explicit with respect to the dangers inherent in seeking material benefits, failing to accommodate the needs of others rather than oneself, or charging borrowers for the use of money (the sin of "usury"). 

But with the increase in trade, commerce and other forms of activity stimulated by the geographical exploration of the world in the 15th and 16th centuries, the flood of money into Europe from the Spanish discoveries in the Americas, the growth of the great commercial cities of western Europe, and the rise of the nation states, it became increasingly difficult for the theologians to treat commercial and other forms of economic activity with condescension or contempt. They reacted to the emerging market economy by devising a new ethical foundation for it. This can be illustrated by the concept of the "just price", as elaborated by the great 13th century Italian theologian Thomas Aquinas who sought to show how it was necessary for producers to charge prices which would enable them to obtain raw materials and the services of workers plus an appropriate living for themselves. Prices lower than this would result in producers going out of business, reducing supplies of the goods they were producing, which would in turn cause prices to rise to the "correct" level. 

By the early 16th century the Catholic Church in Europe had made some progress in accommodating its interpretation of traditional Christian principles and the emerging realities of an increasingly market-oriented economy. The Protestant Reformation carried the process further. While Martin Luther and his followers were motivated in their dissent from Catholicism by their disapproval of the Church’s own involvement in commercial life, they themselves laid the foundation for a new justification for commercial activity. While the Catholic theologians had found ways to show that engaging in gainful economic activity was not necessarily inconsistent with personal salvation, the Protestants found that it could actually be a way to attain it! Not only could a rich person hope to enter the Kingdom of Heaven, being rich could be taken as evidence that an individual had fulfilled his or her God-given destiny. But how is one to become successful in this way? The answer, as generations of parents would begin telling their children, was simple: work hard, avoid leisure ("the Devil finds work for idle hands"), respect authority, be frugal ("a penny saved is a penny earned"), invest wisely, resist temptation, look ahead. Failure to heed these precepts implied certain ruin. 

The development of these new attitudes is documented in one of the classic works on the development of modern Europe, R.H. Tawney’s Religion and the Rise of Capitalism. In it Tawney writes: 

To countless generations of religious thinkers, the fundamental maxim of Christian social ethics had seemed to be expressed in the words of St. Paul to Timothy: "Having food and raiment, let us be therewith content. For the love of money is the root of all evil." Now, while, as always, the world battered at the gate, a new standard was raised within the citadel by its own defenders. The garrison had discovered that the invading host of economic appetites was, not an enemy, but an ally. Not sufficiency to the needs of daily life, but limitless increase and expansion, became the goal of the Christian’s efforts. Not consumption, on which the eyes of earlier sages had been turned, but production, became the pivot of his argument. Not an easy-going and open-handed charity, but a systematic and methodical accumulation, won the meed of praise that belongs to the good and faithful servant. The shrewd, calculating commercialism which tries all human relations by pecuniary standards, the acquisitiveness which cannot rest while there are competitors to be conquered or profits to be won, the love of social power and hunger for economic gain—these irrepressible appetites had evoked from time immemorial the warnings and denunciations of saints and sages. Plunged in the cleansing waters of later puritanism, the qualities which less enlightened ages had denounced as social vices emerged as economic virtues. They emerged as moral virtues as well. For the world exists not to be enjoyed, but to be conquered. Only its conqueror deserves the name of Christian. For such a philosophy, the question, "What shall it profit a man?" carries no sting. In winning the world, he wins the salvation of his own soul as well. (Religion and the Rise of Capitalism: An Historical Study, Murray, London, 1926, pp. 248-49) These prescriptions subsequently became incorporated in the now familiar "secular materialism" characteristic of contemporary western society. Does this matter to our understanding of modern economics? Perhaps very much. It may be that the "success" of the modern market economies may be attributed to the work ethic, the emphasis on saving and investing, and a personal commitment by large numbers of people to the idea of economic "progress," all of which may be traced back to the resolution of the moral dilemma posed by the conflict between individual self interest and the individual’s responsibility to others. (Something similar may be seen working itself out closer to our own time. The explosive growth of the economies of Japan, Southeast Asia, and China, is attributed by some analysts to the influence of traditional Confucian and other spiritual values which may be playing a part similar to that of the Protestant ethic in European/American development.) 

The importance of such spiritual or other cultural values for economic development is not, however, well understood. Modern studies of the processes of economic change show no general pattern in this regard. One authority in the field, W.A. Lewis, suggests that, in general, anything that diverts individuals from material concerns is probably antithetical to growth. "If a religion," he writes, "lays stress upon material values, upon work, upon thrift and productive investment, upon honesty in commercial relations, upon experimentation and risk-bearing, and upon equality of opportunity, it will be helpful to growth, whereas in so far as it is hostile to these things, it tends to inhibit growth." (W. Arthur Lewis, The Theory of Economic Growth, 1955, Allen and Unwin, London, pp. 101-7.)

But, while the work ethic and the emphasis on material success may plausibly be credited with providing an incentive to individuals to be worthwhile, productive members of the community, the same set of principles has a darker side. What of those who failed the test? If economic success was an indicator of good moral character and good behaviour, was economic failure evidence of the opposite? If so, it followed that the poor had only themselves to blame. Poverty was evidence of bad character and sinful behaviour. Should the rich then help the poor? Some have thought not. The Social Darwinists of the late 19th century, for example, inclined to the view that well-intentioned measures to alleviate the plight of the poor were counterproductive because they interfered with the "natural" processes by which the human race was improved through evolution. 

Herbert Spencer (1820-1903), the best-known representative of this school of thought, wrote in his widely-read book, Social Statics (1865) that, "by weeding out those of lowest development and partly by subjecting those who remain to the never ceasing discipline of experience, nature secures the growth of a race who shall both understand the conditions of existence and be able to act up to them." Spencer’s chief North American disciple, the American William Graham Sumner (1840-1910), addressing the issue of how great wealth could be justified, proclaimed confidently that millionaires are created as a result of the same process of "natural selection". In his view, the huge incomes and luxurious life-styles of the business elite were simply the consequence of the kind of valuable work they did and represented what he called "a bargain for society". 

Another aspect of the market economy concept which some critics have found disturbing is the way nature and human existence came to be objectified, turned into commodities to be bought and sold. Karl Polanyi (1886–1964), who provides one of the most thorough analyses of the rise of the market system in western Europe in his book, The Great Transformation (published in 1944), notes that economists came to view labour, land, and capital as commodities which could be priced and exchanged as if they were the same as other commodities, such as bread or an automobile. Polanyi thought they were actually very different,  because, unlike other commodities, these productive factors are not "produced" for the purpose of being sold. This is obvious in the case of land, which, is essentially "nature". We can manipulate it and use it, but we cannot create it. We are ourselves a part of it. Is it not remarkable that we can think of nature as something to be bought and sold in a search for profit? As for "labour", what we are really referring to is the productive behaviour of human beings, something which is inseparable from "life" itself. Except in societies which condoned slavery, human life is not produced for profit. There is more to life than working. Capital is, of course, produced, but is it deliberately produced for profit? This is more difficult, because capital is an elusive "thing". But Polanyi, who defines capital as both the instruments used in further production and the knowledge which enables us to use them, contended that capital is largely a product of social interaction which comes into being in the course of social development, the evolution of social structures and processes. Nobody "caused" the Industrial Revolution to happen. 

If the special characteristics of land, labour and capital be granted, so what? Polanyi’s answer is that if we treat these "fictitious commodities", as he called them, as if they are ordinary commodities and if we make them subject to the rule of the market, we are in fact turning over to the market nature, life, and society. In The Great Transformation he writes: 

...never before our own time were markets more than accessories of economic life. As a rule, the economic system was absorbed in the social system, and whatever principle of behavior predominated in the economy, the presence of the market pattern was found to be compatible with it.... A market economy is an economic system controlled, regulated, and directed by markets alone; order in the production and distribution of goods is entrusted to this self-regulating mechanism. An economy of this kind derives from the expectation that human beings behave in such a way as to achieve maximum money gains.... Accordingly, there are markets for all elements of industry, not only for goods (always including services) but also for labor, land, and money, their prices being called respectively commodity prices, wages, rent, and interest. (The Great Transformation, Beacon Press, Boston, 1957, pp. 68-9.) Thus, nature, life and society became subject to the operation of markets. Not surprisingly, those who felt threatened or put at a disadvantage by such a mechanism sought some protection, turning to the political process and the institutions of government to modify or limit the operations of markets. How far such limitations on the power of markets should go has always been, and still is, a matter of debate.