The fundamental feature of economic life is that people find themselves in a situation of scarcity and, hence, are forced to make choices. Technical and scientific progress has led to enormous increases in output per head during the last century (especially during the last 60 years), but peoples’ appetites for material satisfactions have also increased and more than kept pace with the growth in productivity.
In all societies people want more than they are capable of producing. At any given moment in time the supply of economic resources is limited so that more of one thing can be produced only if less of something else is produced. Likewise incomes are limited and in spending our incomes we have to choose between alternatives. Economists use the term opportunity cost to describe the idea of measuring cost in terms of alternatives foregone.
Faced with the problem of unlimited wants and limited means of satisfying these wants, all societies have to make decisions on resource allocation, that is, how to deploy the limited resources so as to maximise economic welfare. The basic economic problems facing all societies are:
- What goods and services to produce?
- How these goods and services should be produced?
- For whom these goods and services should be produced?
Questions 1 and 2 represent problems of production, while question 3 is a problem of distribution.
In traditional societies where the way of life has remained unchanged for hundreds or perhaps thousands of years, these economic problems are solved by ancient custom. The traditional methods of production and distribution are faithfully followed by each generation.
One way in which economic problems may be dealt with is for the government (or state) to take ownership and control of economic resources. It can then allocate these resources and control production according to some national plan (which will also determine the distribution of the national output or resources). This type of economic system is described as a Command Economy or Centrally Planned Economy. An alternative way of dealing with the problem of resource allocation is for the government to play a very minor role and for the market forces of demand and supply acting through the Price Mechanism to determine the nature of the output, the methods of production and the distribution of national output. This type of economy is known as a Market or Capitalist Economy, a major feature of which is the private ownership of land and capital. In a market economy a person’s willingness and ability to pay the price is the major determinant of the quantities and variety of the different goods and services produced.
Most societies contain some elements of all three types of economic system but in the modern world there is a clear distinction between countries which have adopted a Socialist or Communist System where centralised planning and public ownership of resources predominate, and Mixed Economies where the state has an important influence on economic activity but where the operation of markets forces and the price mechanism are allowed to play a major part in the allocation of resources. Private ownership of land and capital is an important characteristic of Mixed Economies but not of Centrally Planned economies.
Economics is regarded as a science because Economists use scientific methods to develop and test their theories. Hypotheses which attempt to explain how one thing (e.g. price) is related to another (e.g. supply) are formulated on the basis of assumptions or, more likely, on the basis of observed behaviour. These hypotheses (e.g. ‘ a higher price will call forth greater supply ‘) are then tested to see if they fit the facts of economic life. If such a hypothesis is supported by factual evidence it is then framed as an economic ‘law’ or theory. A successful theory is one which can be used with a high degree of reliability to predict the outcome of certain events. When facts emerge which refute the theory it must be discarded and a search undertaken for a more satisfactory theory.
Since economics deals with human behaviour, economists cannot test their theories in laboratory experiments; they can only be tested against events as they unfold. The fact that the behaviour of any one individual is highly unpredictable does not invalidate the formulation of economic theories because the subject is concerned with the behaviour of large groups (e.g. the workers in an industry, the consumers of a particular product, or the members of a trade union). It is possible to make successful predictions about the behaviour of large groups, while there is always some degree of disagreement between economists on the merits of alternative theories (and new and unproven theories are always emerging), the major disputes arise on questions of economic policy. This is understandable because while a fair measure of agreement is likely to be achieved on questions of how the economic system works, it is highly probable that the question of how it should work will lead to controversy.
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Revised on 03/02/2009