Introduction to the subject matter of economics: the
economic problem. Resource allocation: alternative
approaches, the free market versus central planning.
Discuss the meaning of "resource allocation" and outline
the main alternative methods of allocating resources.
Concepts for Review:
Economic resources, resource allocation,
production possibility curves, supply, demand,
competition, profitability and the free market,
central planning and bureaucracy, factors of
production, distribution of income, factor
The accepted definition of economics is that it is a social science that
seeks to analyze and describe the production, distribution, and
consumption of wealth.
Why do we have to study economics? To answer the following sets of
Who decide what to produce? (what goods and services to produce?)
Who decide how to produce? (what social organization, what political
organization, what production organization)
Who decide for whom to produce? (luxury goods for the wealthy or basic
goods for the poor?
What is economics?
Last century, F. Engels wrote that "economics is not concerned with
things but with relations between persons, and in the final analysis
between classes; these relations however are always bound to things
and appear as things" (F. Engels, in "Das Volk", No.14, August 6, 1859).
In the last one hundred years, though, economics became a semi-science,
or witchcraft, dedicated to explain relations between commodities,
prices, profits and wages, and, moreover, to justify the
capitalist system of production.
Taking liberties with the concept of "science", any
textbook on capitalist economics will say that:
"Economics is the science of allocating resources to produce goods and
services for the survival and improvement of standard of living of
the human species."
Because the production of goods and services entails using up natural
resources and also emitting toxic chemicals which pollute and destroy
natural ecosystems, economics also is the science of producing goods
and services without endangering the survival of future generations.
There are alternative definitions of economics, which are the outcome
of particular ideologies. The best known definition of economics is the
one that justifies the existence of the market as the most efficient
system for allocating resources based on a very simple assumption:
--there are not enough resources for producing the goods and services
that human population demands, therefore some people will enjoy them
and some other will not. Some people will produce goods and services
to sell them at a profit. Other people will buy them. Therefore, the
market will make sure that those who can afford them will enjoy goods
and services, those who cannot afford them will not enjoy them.
See Róbinson Rojas, Notes on economics: assuming scarcity, and
Notes on economics: about obscenities, poverty and inequality
From the above, capitalist economic analysis was born. Capitalist
economic analysis is one type of economic analysis not the only one.
Because capitalist economic analysis is taught in the modern world as
if it was the only economic theory available and appear in the texbooks
on economics as just "economics", I am going to use, for analytical
purposes only, the capitalist notion of economics:
"Without matter and motion, there will be no physics; without living
things, there would be no biology; and without SCARCITY, there would be
no economics. SCARCITY is the condition where our wants are greater than
the limited resources available to satisfy those wants. Scarcity is the
basic economic problem that all individuals and societies face. Since
there will be no economics without scarcity, ECONOMICS is defined as the
SCIENCE OF SCARCITY. Specifically, it is THE SCIENCE OF HOW INDIVIDUALS
AND SOCIETIES DEAL WITH THE FACT THAT WANTS ARE GREATER THAN THE LIMITED
RESOURCES AVAILABLE TO SATISFY THOSE WANTS." ( R. Arnold, "Economics",
Second Edition, West Publishing Company, 1992)
From here it follows that scarcity implies choice for some individuals
-i.e those on low income. The latter can have good A but not B. Some will
not have either, but the wealthy individuals can have A and B. The market
place, as one can see is a very efficient allocator of resources.
Moving the assumption of scarcity to the society level, choices become
clearer. Consider the classical textbook example:
"Three legislators are having a discussion. "We need more schools", says
legislator A. "Indeed we do", says legislator B, "but not at the expense
of a stronger national defense. First we must rebuild our defenses, and
then later we will build more schools."..."You are both misguided", says
legislator C. "What we need to do first is to take better care of the
unfortunate among us: the old, the sick, and the poor".
The "economic problem" is posed by capitalist economic analysis as
follows: at the present level of the economy, more resources for
education mean fewer resources for defense, or more resources for
defense mean less resources for the welfare state. This given level
of economic capacity which makes necessary to choose, is called
THE PRODUCTION POSSIBILITY FRONTIER. The frontier will be pushed forward
only with advances in technology and/or access to more resources (which
explains wars of conquest, for example).
Choices then imply opportunities or alternatives forfeited. In capitalist
economics the most highly valued opportunity or alternative forfeited
when a choice is made is called OPPORTUNITY COST.
Thus, in the production possibility frontier seen above, the opportunity
cost of producing more weapons can be measured in the resources negated
to education, etc.
In the price of goods, opportunity costs play a very important role in
allocating the share of that price taken by profits. More on this later.
An economic system is the organizations and methods used to determine
WHAT goods and services are produced, HOW they are produced, and for
WHOM they are produced.
In general, an economic system is the outcome of political consensus or
political imposition. If we define the capitalist system as one in which
a minority in society decides what, how and for whom to produce through
organizing the process of production hiring labour to transform raw
materials in goods and services utilizing means of production like
machinery or knowledge, we have a continuum of capitalist economic
systems going from market economies to planned economies:
-in the market economies, the owners and managers of capital (means of
production) decide what, how and for whom to produce;
-in the planned economies, the managers of capital (there are no individual
owners) decide what, how and for whom to produce;
In both economic systems, a mix of market and planned economies can also
be present, like in industrialized countries in the 1950s, 1960s and
1970s. The latter is known as "a mixed economy". People's Republic of
China is a well known case of "mixed economy" in the 1990s.
In a planned economy a group of central planners make economic decisions
for society. Former USSR is a classical example of a planned economy,
where the central planners were members of the communist party becoming
the core of a ruling elite in that society, which is the main feature
of what is known as 'bureaucratic socialism': a social stratified society
where a group of people become wealthier than the rest of the population
and take the political, economic, ideological and cultural leadership
to meet the needs of the social group in power, largely in a similar way
as it happens in market economies. Both are cases of class stratified
societies with dramatic inequalities becoming the outcome of the dynamics
of the economic system in operation. We will come back to this in lecture
THE TOOLS FOR CAPITALIST ECONOMIC ANALYSIS
Seven concepts make up the theoretical foundations of capitalist
economic analysis, the seven concepts tailored to justifiy the main
assumption (scarcity) which makes of the capitalist market notion a
sort of "natural law". The concepts are:
The capitalist economist will utilise an analytical model based upon
First assumption: consumers will buy more goods if the price per unit
of the good is reduced, and viceversa. Thus, the
lower the price, the more the demand, the more
the supplier will sell pocketing more profits.
Second assumption: producers will produce more goods only if the price
of the good increases, because more production will
mean higher costs per unit. Thus, the producer's
interest in producing will be related to higher
In arithmetic terms, both assumptions can be expressed as follows:
Good A Quantity Quantity
Price per unit Demanded Produced Economic
$ (thousands) (thousands) outcome
9 1 9 excess of supply
8 2 8 excess of supply
7 3 7 excess of supply
6 4 6 excess of supply
5 5 5 market equilibrium
4 6 4 deficit of supply
3 7 3 deficit of supply
2 8 2 deficit of supply
1 9 1 deficit of supply
From above, is clear that "the market" will tell suppliers that
if they produce 5,000 units of good A they will do good business
selling all the output. On the other hand, consumers who can afford
to pay a price of 5 or higher, will be satisfied, and the market
will provide them with what they need. But, the consumers who cannot
afford a price of 5, and only they would buy at 4 or less, will be
"excluded" from the market.
The above shows that "an efficient capitalist market" will supply
goods only to those who can buy the goods at the price consistent
with suppliers' "maximization of profits". Thus, the market,
suits the needs of the suppliers and not of the consumers.
The question is, why then, suppliers don't produce (in our model) at
a lower price, let us say 4 or 3, and satisfy more customers?
The answer is, the suppliers will maximise profits at 5, and not
below that, even when still the will accrue profits. Let us work
with our model again, this time from the point of view of profits.
Assumption: 10 per cent of total revenue is profits.
Total revenue is calculated multiplying unit price by
per Quantity Total Total
unit demanded revenue profits
$ (0,000) 0,000 $ 10% of total revenue
9 1 9 0.9
8 2 16 1.6
7 3 21 2.1
6 4 24 2.4
5 5 25 2.5 here profits are at a maximum
4 6 24 2.4
3 7 21 2.1
2 8 16 1.6
1 9 9 0.9
NOTE: the first column represents the downward section of an
economy of scale function, which, of course, will be U shaped.
From above, is clear that suppliers will not produce more than 5,000
units because at that level of output they maximise profits.
Therefore, from the point of view of market clearance, and
profit maximisation, the capitalist system will produce BELOW
THE POTENTIAL MAXIMUM.
If we think of the maximum profits point as a representation of
maximum economic efficiency, then, of course, the maximum
output ( and therefore employment) point at the bottom of the table,
will represent the maximum "social efficiency":
per Quantity Total Total
unit demanded revenue profits
$ (0,000) 0,000 $ 10% of total revenue
9 1 9 0.9
8 2 16 1.6
7 3 21 2.1
6 4 24 2.4
5 5 25 2.5 - maximum economic efficiency
4 6 24 2.4
3 7 21 2.1
2 8 16 1.6
1 9 9 0.9 - maximum social efficiency
The above shows the contradiction between economic efficiency
and social efficiency in the capitalist mode of production.
The gap between them will change in size depending of the
outcomes of the class struggle between owners of means
of production ( capitalists ) and owners of labour power
( workers ). Thus, a non-economic variable is necessary for making
a particular society more socially efficient. A variable that
belongs to the realm of politics. Moreover, if we assume the
imperative of social justice, then we must change the way in which
we think about the economic problematic: instead of looking at it
as a technical issue, we must look at it as an ethical issue.
Therefore ethics and economics become a totality. Economics should not
exist without ethics. Both together will make the basis for building
a just society and dismantle an unjust society. See Adam Smith and Karl
Marx on this, and then Amartya Sen for a contemporary approach.
The above also means that the free-market system cannot guarantee
full employment (producing at the maximum potential), and cannot
guarantee maximum output of goods needed by the consumers.
In a word, the market system MEET THE INTERESTS OF THE SUPPLIERS
and not the interests of the consumers. Consumers are supplied only
to the point where profits are maximum for the supplier. This is
one of the main reasons why the market creates unemployment and
lack of satisfaction for a large sector of society.
Graphic representation of the above arguments with the data from
the above tables:
9 * *supply
8 * *
7 * *
6 * *
5 *--------------->here market clears at a price of 5
4 * * and a quantity of 5,000
3 * * Suppliers and consumers
2 * * who can afford the price
1 * *demand agreed
1 2 3 4 5 6 7 8 9
Changes in DEMAND can occur as the effect of changes in
income -if more income is present more units at the
same prices can be bought.
price -more units at lower price will be bought.
price of equivalent goods -
ALSO, advertising and the availability of credit (which is a form of
change in income)
SUPPLY is determined by:
changes in the prices of the factors of production:
2.- raw materials
3.- fuel and power
4.- rate of interest
(nevertheless, movements in factor prices may be offset by changes in
the productivity of the factors so that factor cost may not change very
7.- taxation and subsidies
Depending on relative levels of demand and supply, levels of wages
and profits will change, widening their differences or narrowing them.
Also, relative scarcity of labour or relative plenty of labour will
make fluctuate levels of wages, and also levels of unemployment will
vary, and finally, welfare state could change. The added effects of the
above will shape distribution of income. It does seem that in the last
twenty years or so there is a stron tendency to extreme polarization
in the distribution of income.
Even if markets are competitive, some markets may still fail because
they suffer from the presence of side effects economists call
An externality is a cost or benefit imposed on people other than the
consumers and producers of a good or service.
Externalities are also called SPILLOVER EFFECTS or NEIGHBORHOOD EFFECTS.
People other than consumers and producers who are affected by these
side effects of market exchanges are called THIRD PARTIES.
Externalities may be either negative or positive; that is, they may be
detrimental or beneficial.
MARKET FAILURE means the market mechanism does not achieve desirable
results. Sources of market failures include lack of competition,
externalities, public goods, and income inequality. Although
controversial, government intervention is a possible way to correct
Different shades of lack of competition are in real life the cause of
market failure. There must be competition among both producers and
consumers for markets to function properly. In "Wealth of Nations",
Adam Smith stated: "people of the same trade seldom meet together but
the conversation ends in a conspiracy against the public, or in some
diversion to raise prices". (A. Smith, "An Inquiry into the Nature and
Causes of the Wealth of Nations", Random House, 1937, p. 423). This
famous quote clearly underscores that, in the real world, business will
seek ways to replace consumer sovereignty with "big business
sovereignty". What happens when a few firms rig the market and they
become the market's boss? By restricting supply through artificial
limits on the output of a good, firms could enjoy higher prices and
profits. As a result, firms may waste resources and retard technology.
(from I.B. Tucker III, "Survey on Economics", West Publishing Co., 1995)
In economics, usually reserved for situations in which the
resources available for producing output are insufficient to
satisfy wants. This is different to saying that they are
insufficient to satisfy demand since demand relates to an
expression of want backed by money.
This concept of relative scarcity in relation to wants is
widely held to define the raison d'etre of economics since,
otherwise, there would be no need to think about the 'best'
allocation of resources.
In affluent societies, however, it may be that wants are all
met in some sections of the community. If so, satiation is
said to exist. The likely outcome of such a situation is that
wants will be 'created' by advertisements, social pressures
etc. ( see J. K. Galbraith's work)
More recently, economists have also been obliged to deal with
the concept of absolute scarcity (i.e. the fact that the
absolute size of resources is fixed in quantity and, once
used, may often not be used again). This is particularly so
with fossil fuels. (From D. W. Pearce, "Modern Economics",