Fascinating economy

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.

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.