No Such Thing as a Free Lunch: Principles of Economics (Part 8)

I can observe the game theory is applied very much in economics. Generally, it would be wise to get into the mathematics as much as seems reasonable because the economists who use more mathematics are somehow more respected than those who use less. That's the trend.

John Forbes Nash, Jr.

The Economic Problem: Scarcity and Choice

(Part E)

by

Charles Lamson

Economic Systems

Command Economies

In a pure command economy, the basic economic questions are answered by a central government. Through a combination of government ownership of state enterprises and central planning, the government, either directly or indirectly, sets output targets, incomes, and prices.

It is an understatement to say that planned economies have not in general fared well. In fact, the planned economies of eastern Europe and the former Soviet Union including the Russian Republic completely collapsed. China remains committed to many of the principles of a planned economy, but reforms have moved it sharply away from pure central planning.

Laissez-Faire Economies: The Free Market

At the opposite end of the spectrum from the command economy is the laissez-faire economy. The term laissez-faire, which, translated literally from French, means "allow [them] to do," implies a complete lack of government involvement in the economy. In this type of economy, individuals and firms pursue their own self-interest without any central direction or regulation; the sum total of millions of individual decisions ultimately determines all basic economic outcomes. The central institution through which a laissez-faire system answers the basic questions is the market, a term that is used in economics to mean an institution through which buyers and sellers interact and engage in exchange.

The interactions between buyers and sellers in any market range from simple to complex. Early explorers of the North American Midwest who wished to exchange with Native Americans did so simply by bringing their goods to a central place and trading them. Today the Internet is revolutionizing exchange. A jewelry maker in upstate main can exhibit wares through digital photographs on the web. Buyers can enter orders or make bids and pay by credit card.

In short, some markets are simple and others are complex, but they all involve buyers and sellers engaging in exchange. The behavior of buyers and sellers in a laissez-faire economy determines what gets produced, how it is produced, and who gets it.

The following posts in this analysis explore market systems in great depth. A quick preview is worthwhile here, however.

Consumer Sovereignty In a free, unregulated market, goods and services are produced and sold only if the supplier can make a profit. In simple terms, making a profit means selling goods or services for more than it costs to produce them. You cannot make a profit unless someone wants the product that you are selling. This logic leads to the notion of consumer sovereignty: the mix of output found in any free market system is dictated ultimately by the tastes and preferences of consumers, who "vote" by buying or not buying. Businesses rise and fall in response to consumer demands. No central directive or plan is necessary.

Individual Production Decisions: Free Enterprise Under a free market system, individual producers must also figure out how to organize and coordinate the actual production of their products or services. The owner of a small shoe repair shop must alone buy the needed equipment and tools, hand signs, and set prices. In a big corporation, so many people are involved in planning the production process that in many ways corporate planning resembles the planning in a command economy. In a free market economy, producers may be small or large. One person who hand paints eggshells may start to sell them as a business; a person good at computers starts a business designing websites. On a larger scale, a group of furniture designers may put together a large portfolio of sketches, raise several million dollars, and start a bigger business. At the extreme are huge corporations like Microsoft, Mitsubishi, and Intel, each of which sells tens of billions of dollars worth of products every year. Whether the firm's are large or small, however, production decisions in a market economy are made by separate private organizations acting in what they perceive to be their own interest.

In a market economy, individuals seeking profits are free to start new businesses. Because new businesses require capital investment before they can begin operation, starting a new business involves risk. A well-run business that produces a product for which demand exists will succeed: a poorly-run business or one that produces a product for which little demand exists now or in the future is likely to fail. It is through free enterprise that new products and new production techniques find their way into use. 

Proponents of free market systems argue that free enterprise leads to more efficient production and better response to diverse and changing consumer preferences. If a producer produces inefficiently, competitors will come along, fight for the business, and eventually take it away. Thus in a free market economy, competition forces producers to use efficient techniques of production. It is competition, then, that ultimately dictates how outputs are produced.

Distribution of Output In a free market system, the distribution of output---who gets what---is also determined in a decentralized way. The amount that anyone household gets depends on its income and wealth. Income is the amount that a household earns each year. It comes in a number of forms: wages, salaries, interest, and the like. Wealth is the amount that households have accumulated out of past income through savings or inheritance.

To the extent that income comes from working for a wage, it is at least in part determined by individual choice. You will work for the wages available in the market only if these wages (and the things they can buy) are efficient to compensate you for what you give up by working. Your leisure certainly has a value also. You may discover that you can increase your income by getting more education or training. You cannot increase your income, however, if you acquire a skill that no one wants and can pay for.

Price Theory The basic coordinating mechanism in a free market system is price. A price is the amount that a product sells for per unit, and it reflects what society is willing to pay. Prices of inputs---labor, land, and capital---determine how much it costs to produce a product. Prices of various kinds of labor, or wage rates, determine the rewards for working in different jobs and professions. Many of the independent decisions made in a market economy involves the weighing of prices and costs, so it is not surprising that much of economic theory focuses on the factors that influence and determine prices. This is why microeconomic theory is often simply called price theory.

In sum, in a free market system, the basic economic questions are answered without the help of a central government plan or directives. This is what the "free" in free market means---the system is left to operate on its own with no outside interference. Individuals pursuing their own self-interest will go into business and produce the products and services that people want. Others will decide whether to acquire skills; whether to work; and whether to buy, sell, invest, or save the income that they earn. The basic coordinating mechanism is price.

Mixed Systems, Markets, and Governments

The differences between command economies and laissez-faire economies in their pure forms are enormous. In fact, these pure forms do not exist in the world; all real systems are in some sense "mixed." That is, individual enterprise exists and independent choice is exercised even in the economies in which the government plays the major role.

Conversely, no market economies exist without government involvement and government regulation. The United States has basically a free market economy, but government spending increased to 44 percent of the GDP in 2020 from 35.68 percent in 2019 (U.S. Bureau of Economic Analysis). Across the U.S., nearly 24 million people---a little over 15 percent of the workforce are involved in military, public, and national service at the local, state and federal levels. Of this number, approximately 16 million are employed in state and local governments (brookings.edu). They also redistribute income by means of taxation and social welfare expenditures, and they regulate many economic activities.

One of the major themes in this analysis, and indeed in economics, will be the tension between the advantages of free, unregulated markets and the desire for government involvement. Advocates of free markets argue that such markets work best when left to themselves. They produce only what people want; without buyers, sellers go out of business. Competition forces firms to adopt efficient production techniques. Wage differentials lead people to acquire needed skills. Competition also leads to innovation in both production techniques and products. The result is quality and variety, but market systems have problems too.

Even staunch defenders of the free enterprise system recognize that markets systems are not perfect. First, they do not always produce what people want at lowest cost---there are inefficiencies. Second, rewards (income) may be unfairly distributed, and some groups may be left out. Third, periods of unemployment and inflation rate recur with some regularity.

Many people point to these problems as reasons for government involvement. Indeed, for some problems government involvement may be the only solution. However, government decisions are made by people who presumably, like the rest of us, act in their own self-interest. While governments may indeed be called on to improve the functioning of the economy, there is no guarantee that they will do so. Just as markets may fail to produce an allocation of resources that is perfectly efficient and fair, governments may fail to improve matters. We will return to this debate many times throughout this analysis.

*MAIN SOURCE: CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 36-39*

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