This is the second chapter in the series of Basic Economics. I would like to provide
attribution, with thanks, to Textbook
Equity who in turn were
provided the source text by Professor R. Larry Reynolds, PhD, Boise State University
CHAPTER 02
THE PROBLEM OF PROVISIONING
2.1 INTRODUCTION
Society is confronted with a finite
set of resources and a given state of technology at any given point in time. As
a result, there is a finite amount of goods and services that can be produced
in that time frame. Given human desires and need for food, clothing and
shelter, it is not always possible to produce everything that everyone would
like to have. When individuals want more than can be produced they have the
economic problem of scarcity.
The problem of scarcity might be resolved by reducing individuals
wants or by increasing the output of goods and services. If the solution is to
reduce wants, which wants should be eliminated and which should be retained to
be satisfied? The individual would necessarily be required to make a choice. If
the solution was to produce more goods, which goods should be produced and how
are they to be produced? Again, the individual must make choices. In modern,
neoclassical, economic analysis (we will call this “orthodox” economics), the
problem is structured so the wants are taken as given and the problem is to
produce the goods that satisfy the greatest wants.
Scarcity requires that the individual or agent make choices. An
individual in isolation (Defoe’s Robinson Crusoe before Friday) would have to
make choices since time and resources are limited. It would be necessary to
choose whether time was to be spent catching fish, gathering coconuts, reading
or building shelter. If the choice were to catch fish, he/she would have to
choose between making a net, a fishing pole or trying to catch fish by hand.
The choice to spend an hour fishing implies that that hour cannot be used to
gather coconuts. The sacrifice of coconuts is called “opportunity cost.”
Even Robinson Crusoe’s world of isolation did not last long. When
Friday came to the island, it became necessary to decide who did what and who
got what. It is necessary to coordinate the preferences and activities of
Crusoe and Friday. Since the story of Robinson Crusoe was written by an Englishman,
Daniel Defoe (1659-1731), Crusoe is dominant and he has a greater influence on
the decisions than Friday. In 1719, the perspective of an English writer was
that aboriginals of various lands were subordinate. Still, it is necessary to
coordinate their activities.
2.2 SOCIAL INTERACTION
In a society, the behavior of the
individuals must be coordinated through social interaction. This social
interaction takes many forms ranging from cooperation to competition. In the
process of resolving the allocation problem through social interaction, a set
of institutions, organizations, beliefs, principles, perspectives and commonly
held values are created. Society, guided by these values, perceptions and
beliefs and constrained by institutions, technology and resource endowment,
must solve the problem of provisioning. The specific uses of goods and
resources must be determined. These choices involve which resources to use,
which goods to produce, who will bear the costs and who will benefit.
The basic problem is the coordination of the choices and behavior
of individuals. Finding a way to protect the autonomy of the individual while
coordinating their behavior to provide for the commonweal has been an important
goal of most great writers on social topics.
2.3 SPECIALIZATION
Specialization and the division of
labor are two important forms of social interaction that allow two or more
individuals to do what an isolated individual cannot do. Both are means to
increase the production of goods and services.
Specialization is the case where an individual (firm, organization
or country) focuses on the production of a specific good (or group of goods).
It can increase the amount of goods that can be produced. It also requires some
form of social institution to coordinate the process. If one individual
produces food and the other clothing, the two individuals must interact if both
are to have food and clothing. This interaction may be facilitated through an
institution such as the market or a transfer based on kinship, marriage,
religion or government authority. Plato suggests that the city-state is a
social construct that is used to facilitate specialization and to improve the
welfare of the members of that state.
In The Republic , Plato
[427-347 B.C.] suggests specialization as an explanation of the origins of the
city-state. Plato describes a conversation between Socrates and a group of
students. They are pondering the nature of justice. They conclude that justice
is each person doing that which they are best suited to do. The person best
suited to be a baker should be a baker: the person best suited to be a shepherd
should be a shepherd. Once individuals specialize, the city-state arises to
facilitate the transfer of goods and the necessary interactions among the
individuals. [ The Republic , Book II] Plato
tries to identify the characteristics of the ideal society. One of the focal
points is justice that is achieved by “each person doing what they are best
suited to do.” Social interaction is required because each person depends on
the other members of the community. He devises a meritocracy that is lead by
philosopher kings. To prevent nepotism and greed from influencing these philosopher
kings, Plato does not allow the philosopher kings to hold private property
rights, all of their property is held in common.
2.4 DIVISION OF LABOR
The division of labor is another form
of social interaction that allows individuals to do what the isolated person
cannot. In the division of labor, the production of a good is broken down into
individual steps. One person then performs one step in the process. No single
person produces the good alone. The actions of each individual in the
production process must be coordinated. In modern industrial societies,
production often takes place in a business firm. “Management” is regarded as
the process of coordinating the activities of the individuals within the
production process. A specific application of microeconomics to the process of
production within a firm is called “managerial economics.”
Adam Smith [1723-1790] in the Wealth of
Nations proposes that the division of labor is one of the major
elements that contribute to economic growth (the increased ability to produce
goods and services) [ The Wealth o f Nations, page 1]. The division of labor is the process of dividing a task
(work) into its component parts. Smith argues that the division of labor
increases production through improved dexterity, saving time in moving from one
task to another and improvements in tools.
Smith cautions about the effects of unrestrained use of the
division of labor,
“In the progress of the division of labor, the
employment of the far greater part of those who live by labor, that is, of the
great body of the people, comes to be confined to a few very simple operations,
frequently to one or two. But the understandings of the greater part of men are
necessarily formed by their ordinary employments. The man whose whole life is
spent in performing a few simple operations, of which the effects too are, perhaps,
always the same, or very nearly the same, has no occasion to exert his
understanding, or to exercise his invention in finding out expedients for
removing difficulties which never occur. He naturally loses, therefore, the
habit of such exertion, and generally becomes as stupid and ignorant as it is
possible for a human creature to become….But in every improved and civilized
society this is the state into which the laboring poor, that is the great body
of the people must necessarily fall, unless government takes some pains to
prevent it.
[Smith, Wealth of Nations , p 734-735]
Smith, a professor of moral philosophy, constructed a system to
explain a set of forces that would guide social and economic behavior. In The Theory of Moral Sentiments [1759] he showed
the need for justice and a system of morality. In An Inquiry into the Nature and Causes of the Wealth of Nations [1776] he describes the role of self-interest and markets. In a
third book that was destroyed at his request at the time of his death, he
describes the need for a system of jurisprudence. Two sets of students’ notes
have been used to show these basic arguments in Lectures on Jurisprudence [1762-63 and
1766 published in 1978]. Smith describes a social system that requires
morality, markets and jurisprudence to guide and constrain individual action in
a social context.
2.5 COORDINATION OF EFFORTS
Once humans use the division of labor
and specialization, it is necessary for them to coordinate their efforts. They
must interact on a variety of levels. Society is a complex set of interactions
among groups and individuals. These interactions give rise to social
institutions. The study of these interactions and institutions is “social science.” Human interaction can be studied
from a variety of perspectives. Sociology, political science, law, history,
psychology, religion, anthropology and economics are examples of social
sciences. These are often studied as separate disciplines. However, we should
remain aware they are all interrelated perceptions of human behavior. While
economics specializes in the study of the processes that coordinate human
behavior as it allocates scarce resources to satisfy unlimited wants, its
relationship to other social sciences should not be overlooked.
2.6 ECONOMIC ACTIVITIES
John Stuart Mill [1806-1873] divided
economic activities into three categories: production, distribution and
exchange. It may be helpful to think of an economic system as a process that
begins with a set of inputs (or resources) that are used for production that
must be distributed for ultimate consumption. (Mill, Principles of Political Economy, The Colonial
Press, 1900) The economy is a process of altering a set of inputs to satisfy
individual wants. In this example, the steps in the economic process are
production, distribution and consumption.
2.6.1 PRODUCTION
Production is the process of altering
inputs to increase their ability to satisfy human wants. Inputs are sometime
called “factors of production” or resources. Typically, economists will
categorize inputs as land, labor and capital. Superficially, labor is defined
as human effort used to produce goods that satisfy human wants. An input that
is a “gift of nature” is referred to as “land.” Capital is usually considered
as an input that is produced by labor but is used for the further production of
goods and services. Entrepreneurial ability was the last category of inputs to
be added as a factor of production in market oriented economies. It is usually
associated with the process of creating and innovating of new processes. The
taxonomy of inputs, its relation social structure and the nature of economics
will be considered more carefully later in the text.
2.6.2 DISTRIBUTION
Distribution usually describes the
process of allocating the goods and services that have been produced. Societies
have used market exchange, reciprocity, eminent domain, inheritance, theft and
philanthropy to distribute goods and services. The primary means of
distribution or allocative mechanisms that are used in most societies are
market exchange, reciprocity and eminent domain.
MARKET EXCHANGE
Market exchange involves a quid pro quo, i.e. an exchange of private property rights between individual
agents. The terms of the exchange are clearly specified: “I will give you this
if you will give me that.” The goods to be exchanged are clearly specified, as
are the terms of the exchange.
The participants in the exchange do not need to know each other:
they only need to know the terms of the exchange. The information requirements are
quite low. In many cases, the exchange may be made easier by social institutions.
Laws that protect buyers and sellers may facilitate the exchange. Trust may be
an important element as well.
RECIPROCITY
Reciprocity is a system of obligatory gift giving: I will do you a
favor or give you a gift, but you are then obligated to do an unspecified favor
or give me a gift at some (possibly unspecified) point in the future.
Reciprocity requires a sense of community. Kinship ties or
membership in the community is needed so that the obligation of returning a
favor is enforced by social forces. If a friend helped you move apartments one
weekend and then helped you fix your car the next weekend, your refusal to help
that person would have social repercussions. Your common friends might come to regard
you as a freeloader. Social pressure may induce you to return the favor.
2.6.2.1 EMINENT DOMAIN
Eminent domain is a redistribution of private property rights
through the authority of some organization. The individual is required to give
up their claims to private property by an authority. Usually the process of
eminent domain is legitimized by government, religion or some other authority.
PHILANTHROPY
The act of giving a gift with nothing expected in return is called
philanthropy. This is an important method of distribution in blood drives and the
donation of organs for transplantation.
INHERITANCE AND THEFT
Inheritance is the process transferring private property rights
from a dead person to an agent. The form that the inheritance laws take may
greatly influence the accumulation of wealth in a society.
Theft is the process of transferring property rights by
illegitimate force. Few societies can function if theft is widely used.
2.6.3 CONSUMPTION
The end purpose of economic activity
is to provide goods and services that can be consumed by individuals to satisfy
needs and wants. Modern, neoclassical economists generally do not like to use
the word “needs.” The use of the word “wants” is an attempt to take subjective
judgment out of the analysis.
2.6.4 COORDINATION, COMPETITION AND COOPERATION
Each society must develop a set of
social institutions (behavioural patterns) to coordinate the activities of
production, distribution and consumption. There is a wide range of forms these
institutions may take depending on the physical environment, state of technical
knowledge, social values and other factors. These institutions and behavioral
patterns may rely on competition, cooperation or some combination. Market
systems tend to focus on competition while other systems may have a larger role
for cooperation. A bicycle race is a useful metaphor. In a road race the riders
cooperate in the peleton (the large group of riders in a bicycle race) by drafting
(using the rider in front to reduce the wind drag). When a group breaks away
from the peleton, they typically form a pace line and each shares the work of
riding in front of the group. Eventually, the structure of the pace line
disintegrates and the riders compete in a sprint to the finish or they fall back
into the group. The race is a mixture of cooperation and competition.
Joan Robinson argues that an economic system “… requires a set of rules, an ideology to justify them, and a
conscience in the individual which makes him (sic) strive to carry them out.” (Robinson, p 13).
Production, distribution and consumption are interrelated. What to
produce is influenced by what individuals want to consume. What people want to consume
is influenced by the distribution process and what can potentially can be
produced. This coordination may come in the form of cooperative activities, such
as the creation of a business firm. The firm usually organizes production internally
as a cooperative process but must compete externally. Alternatively, the
coordination of activities may be accomplished by competition or some combination
of cooperation and competition.
2.7 TECHNOLOGY
Technology is knowledge about how
resources, individuals and social organization can be used to accomplish
objectives. Technology is more than a set of skills to do things. It is a
perspective about the relationships between humans and their world. Technology
is the sum total of the ways in which human societies interact with natural and
built environments. Humans seek to understand these interactions and develop
technology by combining and reorganizing existing technologies.
In economics, technology is the knowledge about the use of scarce resources
to produce goods and services that satisfy human wants. The knowledge about how
we do things, “technology,” is not limited to machines.
The discovery of a calendar or the realization that crops can be
planted on a three field rotation may be as important as the invention of the
padded horse collar, the steam engine or the PC. Knowledge about the use of
organizational structure to achieve an objective is, in a sense, a form of
technology.
The values and structure of society are connected to the state of technology.
Society is shaped by technology and at the same time is an important force in
the determination of the course of technological change. This relationship
between technology, society and the individual can be driven by curiosity
and/or material gain.
Technological change is pervasive. During some periods of history,
technology changes at a slow pace. At other times, the rate of change is more rapid
and more dramatic. During the medieval period, technological change was slow.
With the development of mechanical clocks, the plague, moveable type,
gunpowder, new techniques in art and other innovations, the “Renaissance”
(usually thought of as the 14th-17th centuries) was
a period of dramatic change. During the 17th
and 18th centuries, the “age of Enlightenment” was fueled by technological
change. The “Industrial Revolution” (which is often dated as about 1750) is
another term used to identify a period of rapid technological change. Each of
these periods involves changes in ideas, values, knowledge and social
institutions. Each altered economic and social processes.
There are opposing views as to the process of technological
change. One view is the Thomas A. Edison perspective. In this case,
technological development is driven by profits. If a technology is profitable,
it will be invented. The other view is that technology is a self-generating
process. New technology is the result of old technology(ies) being recombined
in new ways and used for new purposes. In the second view, profits cannot
create the development of technology but determine its uses.
What an individual perceives as a resource is influenced by the
nature of technology. In the 18th century, obsidian was an important resource among the inhabitants
of the western United States: uranium was not. In the 21st century, obsidian is not normally regarded as a very important
resource while uranium has become a resource.
Factor endowment may influence the direction that technology
develops. In a society with an abundance or arable land and a shortage of labor
may produce (and consume) different goods and seek different technologies to produce
them.
In the Edison view, the light bulb was invented because there was
a demand for it and it could be developed and produced for a profit. In the second
view, it is not possible to invent high-pressure steam engines, even though
they may be profitable, until the technology of metallurgy develops metals to
contain the higher pressure. Either view supports the argument that technology
builds upon itself. The creation of an internal combustion engine depended on
its connections to cannons, oil, Maybach’s spray carburetor, levers and gears.
Each of these in turn depended on other technologies. When Daimler and Maybach
built the automobile, it was the result of a series of connections between
technologies that had been developed by many people over a long period. (see
Burke, Connections, pp 175-183)
It is useful to think about technological change as a process.
First, a piece of knowledge emerges or an “invention” occurs. Second, some one
finds an application for the new knowledge (innovation) and uses it. Third is
the process of dissemination, i.e. the use of the idea is spread through out
the social system.
Each stage of technological change may produce or require significant
changes in values and social institutions. Changes in social structure or the
natural environment may encourage technological change.
Technology and the social system are interconnected. Technology
has a strong influence on the structure of society and individual behavior. The
Industrial Revolution may be thought of as a fundamental change in technology
of production that altered society. The development of the mechanical clock was
driven by the clergy’s desire to satisfy the institution of prayers at specific
times of the day.
The perception of and taxonomy of inputs or resources was
influenced by social structure. Land was associated with the nobility and the
clergy while labor was associated with the serfs. As trade developed, a
merchant class arose and became associated with capital.
2.8 ECONOMIC DECISIONS
In a simple taxonomy, individual
behavior may be influenced by rules (command), intuition, emotion, habit,
reason or some combination. Philosophers and psychologists have struggled with
the issue of fate and freewill. The issue has not been resolved. It is not
likely that it will be resolved here. The question for economics is to try to
understand and explain how humans try to resolve the problems of provisioning
and allocation.
2.8.1 RULES
If behavior is constrained or
influenced by rules, rules of thumb or habits, the nature of those rules and
the process by which the rules evolves is of interest to economists. If the
agent’s decision is constrained, the nature of those constraints is of concern.
Rules may by implicit or explicit. Explicit rules often take the
form of law and maybe imposed by governments or organizations. Generally,
explicit rules are conscious creations and must be communicated and enforced.
Social groups may also use explicit rules. Business firms, churches, and other organizations
may explicitly impose rules. Implicit rules may also be important constraints.
Implicit rules are not consciously created but must still be communicated.
Certain types of behavior are expected and influenced by such
social constructs as “manners,” mores, custom, rules of thumb and traditions.
These rules are short cuts to problem solving. If over time a particular
problem is always or nearly always resolved by a specific approach, that
approach becomes a habit or rule of thumb. These rules and habits provide ready
made solutions that do not have to be derived by reason or intuition.
2.8.2 INTUITION
In recent years, there has been a
growing interest in the interrelationship between psychology and economics.
Daniel Kahneman (Nobel Foundation prize winner) has explored intuition and
reason as thinking and decision processes. (Kahneman, pp 1449-1475) According
to Kahneman, intuition can be powerful and accurate, requires practice and is “
rapid and effortless.” The reasoning process provides a check on the intuitive
process.
2.8.3 REASON AND RATIONAL BEHAVIOR
Orthodox, modern economic analysis is
generally regarded as the study of alternative uses of resources to achieve
objectives. At a technical level, economic analysis is used to evaluate
rational decisions. Rational behavior that the agent has identified an
objective or goal and has evaluated all feasible alternatives to select the
alternative that best achieves the objective.
2.8.4 INFORMATION
Within any economic system, the agents
must have information and there must be a set of incentives to encourage
appropriate actions. Whether the economic system primarily uses market
exchange, reciprocity, eminent domain or some other allocative mechanism, the
agents must have information about preferences, inputs, technology and
alternatives.
In different economic systems, the decisions may be made by
different agents. In a planned economic system, some type of planning authority
would necessarily have to have information about the preferences of the members
of the systems, all inputs, all technology and all alternatives that are
feasible. This is an enormous requirement. In a market-oriented system based on
exchange between individual’s, the information requirement is altered. Individuals
only need to know about their own preferences and feasible alternatives. What
is required is a social system that provides for voluntary exchanges between
agents with appropriate information.
In the 1920’s and 30’s there was a debate (The Socialist
Calculation Debate) about the ability of socialist systems to acquire necessary
information. One side of the debate lead by the Austrians (Ludwig von Mises
(1881-1973) and Friedrich Hayek (1899-1992)) argued that it would be impossible
for a centrally planned economy run by rules to have the necessary information
to function. Oscar Lange (1904-1965) and Abba P. Lerner (1903-1982) argued that
if planners were cost minimizers, the appropriate information could be calculated.
This is a simplistic description of the Socialist Calculation Debate but
emphasizes the importance of information to the functioning of an economic
system.
In the Socialist Calculation Debate, Austrians argued that command
economies could not be successful because there was insufficient information to
guide decisions in the economic process. They believed that each individual had
information about their preferences and what they were capable and willing to
do. Markets were seen as the social institution that could provide information
about relative values through the voluntary, exchange interactions of
individuals. The market system was the process that provided the information
for the agents to make decisions. The Austrians argued that the command system
had no process by which information would be revealed. Lange accepted this
criticism and suggested, “market socialism” as an alternative.
Incentives are the forces that encourage or induce agents to
behave in particular ways. Duty, authority or self-interest may guide an
agent’s behavior. Since neoclassical economics is based on a consequentialist
ethic that is expressed through markets, the incentive provided by
self-interest is perceived as dominant. Other incentives may be equally as important.
Smith believed that self-interest would be constrained by systems of morality
and jurisprudence.
2.8.5 RATIONALITY AND INFORMATION
The allocation of scarce resources
requires both information and incentives for the agents. Information about the
objectives and feasible alternatives is necessary if “rational choices” are to
be made. A rational choice requires that the alternative that “best” satisfies
the objective be selected. This requires criteria to evaluate each alternative
with respect to the objective. Based on the objective, set of alternatives and
the method of evaluation, the optimal or best alternative can be selected.
There are three fundamental steps to the process of making “rational” economic
choices:
· Identify
the objective of the agent.
· Identify
all feasible alternatives that are related to the objective.
· Develop
the criteria to evaluate each feasible alternative with respect to the
objective.
