1.3 What Is Economics?

Learning Objectives

  1. Define economics and identify factors of production.
  2. Explain how economists answer the three key economics questions.
  3. Compare and contrast economic systems.

To appreciate how a business functions, we need to know something about the economic environment in which it operates. We begin with a definition of economics and a discussion of the resources used to produce goods and services.

Resources: Inputs and Outputs

Economics is the study of the production, distribution, and consumption of goods and services. Resources are the inputs used to produce outputs. Resources may include any or all of the following:

  • Land and other natural resources
  • Labor (physical and mental)
  • Capital, including buildings and equipment
  • Entrepreneurship

Resources are combined to produce goods and services. Land and natural resources provide the needed raw materials. Labor transforms raw materials into goods and services. Capital (equipment, buildings, vehicles, cash, and so forth) are needed for the production process. Entrepreneurship provides the skill and creativity needed to bring the other resources together to produce a good or service to be sold to the marketplace.

Because a business uses resources to produce things, we also call these resources factors of production. The factors of production used to produce a shirt would include the following:

  • The land that the shirt factory sits on, the electricity used to run the plant, and the raw cotton from which the shirts are made
  • The laborers who make the shirts
  • The factory and equipment used in the manufacturing process, as well as the money needed to operate the factory
  • The entrepreneurship skill used to coordinate the other resources to initiate the production process and the distribution of the goods or services to the marketplace

Input and Output Markets

Many of the factors of production (or resources) are provided to businesses by households. For example, households provide businesses with labor (as workers), land and buildings (as landlords), and capital (as investors). In turn, businesses pay households for these resources by providing them with income, such as wages, rent, and interest. The resources obtained from households are then used by businesses to produce goods and services, which are sold to the same households that provide businesses with revenue. The revenue obtained by businesses is then used to buy additional resources, and the cycle continues. This circular flow is described in Figure 1.3 “The Circular Flow of Inputs and Outputs”, which illustrates the dual roles of households and businesses:

  • Households not only provide factors of production (or resources) but also consume goods and services.
  • Businesses not only buy resources but also produce and sell both goods and services.

Figure 1.3 The Circular Flow of Inputs and Outputs

The Circular Flow of Inputs and Outputs

The Questions Economists Ask

Economists study the interactions between households and businesses and look at the ways in which the factors of production are combined to produce the goods and services that people need. Basically, economists try to answer three sets of questions:

  1. What goods and services should be produced to meet consumers’ needs? In what quantity? When should they be produced?
  2. How should goods and services be produced? Who should produce them, and what resources, including technology, should be combined to produce them?
  3. Who should receive the goods and services produced? How should they be allocated among consumers?

Economic Systems

The answers to these questions depend on a country’s economic system—the means by which a society (households, businesses, and government) makes decisions about allocating resources to produce products and about distributing those products. The degree to which individuals and business owners, as opposed to the government, enjoy freedom in making these decisions varies according to the type of economic system. Generally speaking, economic systems can be divided into two systems: planned systems and free market systems.

Planned Systems

In a planned system, the government exerts control over the allocation and distribution of all or some goods and services. The system with the highest level of government control is communism. In theory, a communist economy is one in which the government owns all or most enterprises. Central planning by the government dictates which goods or services are produced, how they are produced, and who will receive them. In practice, pure communism is practically nonexistent today, and only a few countries (notably North Korea and Cuba) operate under rigid, centrally planned economic systems.

Under socialism, industries that provide essential services, such as utilities, banking, and health care, may be government owned. Other businesses are owned privately. Central planning allocates the goods and services produced by government-run industries and tries to ensure that the resulting wealth is distributed equally. In contrast, privately owned companies are operated for the purpose of making a profit for their owners. In general, workers in socialist economies work fewer hours, have longer vacations, and receive more health care, education, and child-care benefits than do workers in capitalist economies. To offset the high cost of public services, taxes are generally steep. Examples of socialist countries include Sweden and France.

Free Market System

The economic system in which most businesses are owned and operated by individuals is the free market system, also known as capitalism. As we will see next, in a free market, competition dictates how goods and services will be allocated. Business is conducted with only limited government involvement. The economies of the United States and other countries, such as Japan, are based on capitalism.

How Economic Systems Compare

In comparing economic systems, it’s helpful to think of a continuum with communism at one end and pure capitalism at the other, as in Figure 1.4 “The Spectrum of Economic Systems”. As you move from left to right, the amount of government control over business diminishes. So, too, does the level of social services, such as health care, child-care services, social security, and unemployment benefits.

Figure 1.4 The Spectrum of Economic Systems

The Spectrum of Economic Systems. Communism requires a high degree of government control and a high level of social services. Capitalism requires a low degree of government control and low level of social services. Socialism lies somewhere between the two.

Mixed Market Economy

Though it’s possible to have a pure communist system, or a pure capitalist (free market) system, in reality many economic systems are mixed. A mixed market economy relies on both markets and the government to allocate resources. We’ve already seen that this is what happens in socialist economies in which the government controls selected major industries, such as transportation and health care, while allowing individual ownership of other industries. Even previously communist economies, such as those of Eastern Europe and China, are becoming more mixed as they adopt capitalistic characteristics and convert businesses previously owned by the government to private ownership through a process called privatization.

The U.S. Economic System

Like most countries, the United States features a mixed market system: though the U.S. economic system is primarily a free market system, the federal government controls some basic services, such as the postal service and air traffic control. The U.S. economy also has some characteristics of a socialist system, such as providing social security retirement benefits to retired workers.

The free market system was espoused by Adam Smith in his book The Wealth of Nations, published in 17761. According to Smith, competition alone would ensure that consumers received the best products at the best prices. In the kind of competition he assumed, a seller who tries to charge more for his product than other sellers won’t be able to find any buyers. A job-seeker who asks more than the going wage won’t be hired. Because the “invisible hand” of competition will make the market work effectively, there won’t be a need to regulate prices or wages.

Almost immediately, however, a tension developed among free market theorists between the principle of laissez-faire—leaving things alone—and government intervention. Today, it’s common for the U.S. government to intervene in the operation of the economic system. For example, government exerts influence on the food and pharmaceutical industries through the Food and Drug Administration, which protects consumers by preventing unsafe or mislabeled products from reaching the market.

To appreciate how businesses operate, we must first get an idea of how prices are set in competitive markets. Thus, Section 1.4 “Perfect Competition and Supply and Demand” begins by describing how markets establish prices in an environment of perfect competition.

Key Takeaways

  • Economics is the study of the production, distribution, and consumption of goods and services.
  • Economists address these three questions: (1) What goods and services should be produced to meet consumer needs? (2) How should they be produced, and who should produce them? (3) Who should receive goods and services?
  • The answers to these questions depend on a country’s economic system. The primary economic systems that exist today are planned and free market systems.
  • In a planned system, such as communism and socialism, the government exerts control over the production and distribution of all or some goods and services.
  • In a free market system, also known as capitalism, business is conducted with only limited government involvement. Competition determines what goods and services are produced, how they are produced, and for whom.

Exercises

  1. If you started a business that made surfboards, what factors of production would you need to make your product? Where would you get them? Where would you find the money you’d need to pay for additional resources?
  2. Which three key questions do economists try to answer? Will answers to these questions differ, depending on whether they’re working in the United States or in Cuba? Explain your answer.

1According to many scholars, The Wealth of Nations not only is the most influential book on free-market capitalism but remains relevant today.

This is a derivative of Exploring Business by a publisher who has requested that they and the original author not receive attribution, which was originally released and is used under CC BY-NC-SA. This work, unless otherwise expressly stated, is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License.