Every society -- primitive (hunting and gathering), agrarian, or industrial; capitalistic or socialistic/communistic; more or less "developed" -- confronts three basic and intertwined problems (the three coordination tasks): what to produce, how to produce it, and how to distribute production to the different members of society.
The methods and mechanisms used to solve these problems may differ among different kinds of societies, but the problems themselves are universal. The key aspect underneath this economic problem is scarcity. That is, the heart of the problem is that we don't have sufficient resources to fully satisfy everybody's wants (cf., utopia).
Consider these three problems more formally:
(1) What goods and services shall be produced, and in what quantities?
This question concerns the allocation of scarce resources among competing alternative uses. Various resources -- natural resources (including minerals, hydroelectric power), land, labor, and capital can be utilized to produce a variety of goods and services. We refer to these productive resources as inputs or factors of production, often using "land" as shorthand for land and natural resources more generally. Likewise, these inputs are used to produce output (cf., production function).
The overriding fact of economic life is that there are never enough productive resources to satisfy all of the wants of society's members (cf., needs vs. wants). Hence, the question of what and how much to produce is effectively a question of resource allocation.
Any economy must have some mechanism for making decisions about the problem of resource allocation. In "free-market" economies, decisions about the allocation of resources are made principally through the price system. Under communism and some forms of socialism, more of these decisions are made by central planners. Economists are interested in the consequences for resource allocation of different kinds of decision making.
(2) By what methods shall goods and services be produced?
As a general rule, there is more than one way in which a commodity can be produced (cf., corn output as a function of inputs of land, labor, fertilizer, and machinery). Different production techniques can produce the same quantity of output using different combinations of inputs (wide applicability -- cf., knowledge of economics as a function of lecture attendance, reading of the textbook, ability, etc.). These different techniques reflect the state of existing technology -- i.e., society's pool of knowledge concerning how inputs can be transformed into outputs.
Given the existing technology, the fact that resources are scarce means that only a limited amount of resources can be produced from them. A key consideration in the choice of production techniques is thus to avoid inefficiency; to use those techniques that will maximize production, given the state of technology and existing resources. [Economists are interested in distinguishing between efficient and inefficient methods, in determining how the choice of efficient methods can be assured, and in learning why inefficient methods are sometimes chosen.]
(3) How shall the supply of goods be distributed/allocated among the members of society?
This question concerns the forces that govern the distribution of total income -- society's production of goods and services. We can look at the distribution of income along numerous dimensions -- e.g., among workers, capitalists, and landowners; among blacks, whites, Asians, and Hispanics; by occupation, etc. [Economists want to know what determines how a nation's total income is distributed among the population. Economists are also interested in the consequences of government policies designed to change the distribution of income by using devices such as progressive income taxes, welfare programs, nad programs like social security.]
These three fundamental economic problems are interrelated, in the sense that solving any one of them has implications for solving the other two. Hence, we may regard the problems of WHAT - HOW - FOR WHOM as constituting "the economic problem."
There are additional questions that preoccupy economists. For example:
(4) Are the country's resources being fully utilized, or are some lying idle and thus going to waste? Here, the concern is with aggregate inefficiency.
(5) Is the purchasing power of money and savings constant, or is it being eroded by inflation? The focus of this question is on the general level of prices.
(6) Is the economy's capacity to produce goods and services growing or remaining the same over time? The concern of this last question clearly is on economic growth.
Macroeconomics, Microeconomics, and the Circular Flow
These latter three questions deal with macroeconomics, which is the study of the determination of economic aggregates such as total output, total employment, the level of prices, and the pace of economic growth. The first three questions, by contrast, are problems in microeconomics, which is the branch of economics that deals with the allocation of resources and the distribution of income, as they are affected by the workings of the price system and by various government policies.
The differences between micro and macro can be seen in the context of a circular-flow diagram of the economy. The behavior and activities of millions of households, numerous businesses, and local/state/federal governments interact to determine the aggregates that are the focus of macroeconomics. Microeconomics, on the other hand, focuses on these individual units -- particularly households and businesses -- and on the forces that influence their behavior. Micro also examines the way individual product and factor markets function.
Economic Science and Policy
Economics is a social science because it deals with a system determined by human behavior. However, economists often use formal mathematical models of the economy, and in that way behave like natural scientists (except that we have no laboratory; consequently, we often use the assumption of "other things equal" or ceteris paribus as a means of isolating the effects of specific factors).
An important distinction in economics is that between positive and normative. Positive statements refer to what is (and may be correct or incorrect), whereas normative statements refer to what should be. For example, the statement "we should raise the minimum wage to help low-income workers" is a normative statement, and reflects a value judgment. By contrast, the statement that "raising the minimum wage will reduce employment of low-wage workers" is a positive statement (which, in principle, can be tested against the facts and either accepted or rejected). This distinction comes into play in economics because of the policy orientation of economic science.
Before turning to the policy aspect, it is worth noting that economics is rather unique among the social sciences. This is true for two key reasons:
1. we have models where we make certain assumptions to begin with and then draw conclusions; and
2. we worry about equilibrium.
We should briefly note the existence of four broad objectives of public policies pertaining to economics: efficiency, equity, growth, and stability (of employment, prices, and economic growth). The second of these goals is inherently a normative question (dealing with fairness; reasonable people may disagree about what is fair). The latter two goals have a distinct macroeconomic focus, and we will return to discuss them at several points later in the course.
© 1996 David Shapiro
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