The economic activity of a society consists of activities related to the production and consumption of goods and services. Since earliest times, the primary function of organized society has been economic in nature. The other elements of civilized society -- architecture, literature, music, etc. -- emerge only after the material needs of the society have been amply provided for. Poor societies do not build great pyramids, erect magnificent cathedrals, or place men on the moon.

Everyday, all of us are involved in activities that are primarily economic in nature. To fully understand these activities, we need to create a new perspective of the world -- an economic perspective. Let's begin this task with some definitions.

Production is the creation of goods and services by combining various elements in the production process. For example, the farmer grows a wheat crop by combining his labor with the land, seed, fertilizer, and machinery.

Consumption is the destruction of goods and services to satisfy the wants and needs of people. A person who is hungry eats a meal, and the food ceases to exist as food.

Goods are tangible outputs of the production process -- the good has a physical existence. Production and consumption can be separated by time and place. The farmer grows the wheat in Iowa in May. The girl eats the bread in Georgia in September. Goods include consumer durables, consumer nondurables, and capital (producer durables).

Services are intangible outputs of the production process -- services have no physical existence. As a result, production and consumption usually occur at the same time and place. The professor gives a lecture to students in the classroom. Services include education, repair, finance, government, energy, and telecommunications.

The Economic Problem

The economic problem emerges because our desire for goods and services to consume is greater than our ability to produce those goods and services. The demand for goods and services arises from human wants. There are three types of human wants.

Biological wants are for the goods and services needed to sustain human life. These are food, shelter, and clothing. These goods are often called "necessities".

Cultural wants for are for goods and services beyond necessities in order to maintain the socially accepted standard of living. The idea of a standard of living will vary with time and place. An acceptable living standard for 1800 would not be acceptable in 2000. These goods and services are called "conveniences".

Demonstration wants are for goods and services beyond conveniences. Thanks to modern telecommunications, we all know about the lifestyles of the rich and famous, and would not mind it for ourselves. These goods and services are called "luxuries". Note that economic development means that the luxuries of yesterday become the conveniences of today!

Economists assume that human wants possess a critical characteristic that I will state as a proposition.

Proposition A: Human wants for goods and services to consume are, in the aggregate, insatiable.

We have never seen any human society enjoying want saturation, including the United States today. Sadly, the developing nations of the world often cannot even provide for life sustaining biological wants.

The supply of goods and services results from the production process. In production, various inputs are brought together and combined to create goods and services. These inputs are classified into the three "factors of production".

Land is natural resources or our endowment from nature. The payments for the use of land are called "rents" and "royalties".

Labor is all human effort, both physical and mental, used in production. The payments for labor are "wages" and "salaries".

Capital is all goods used to produce other goods and services. Capital is also called "producer durables". Capital has to be produced, and to get more capital we must reduce our production of consumer goods. The payments for capital are "interest" for debt (borrowed) capital and "profits" for equity (owner supplied) capital.

The factors of production are versatile and may be combined in different proportions to produce the same thing. The United States is capital abundant and uses machinery intensively for farming. China is labor abundant and uses people intensively for farming.

The factors of production possess a critical characteristic.

Proposition B: The factors of production, at any time, exist in fixed and limited quantities, therefore placing a ceiling on the output of goods and services.

Combining propositions A and B yields:

The Economic Problem: The wants of a society for goods and services to consume will always exceed the ability of that society to produce goods and services.

This problem poses serious policy questions to all nations, the advanced as well as the less developed. For the less developed, it is often a cruel dilemma for their economies are often hard pressed even to furnish the biological necessities. "Poverty" in the Third World is not the same as "poverty" in the United States.

Economic Efficiency and Functions

Since economic resources are scarce, they must be used efficiently. We want to produce as much goods and services as we can, and in the process, produce the goods and services needed the most.

Technical Efficiency means getting maximum production from the available land, labor, and capital resources. This is often called "full employment" or the "natural level of output". There should be no resources lying idle, especially in the long run. Getting maximum output is also equivalent to producing at the lowest possible cost.

Allocative Efficiency means producing goods and services in the best relative amounts to maximize the economic wellbeing of the society. What constitutes "best" is a source of intense debate, and even leads to armed conflict. The great wars and revolutions of the past century have, in large part, been over this question.

There are five functions an economic system performs in producing goods and services for consumption. These functions are:

1) How much to produce. The how much function relates to technical efficiency. Do we produce at a maximum level, or do we have unemployed and unused resources?

2) What to produce. The what function is very important. Do we produce capital goods or consumer goods? Do we produce goods for home consumption or for trade? All these reflect the question of allocative efficiency.

3) How to produce. The how function refers to the type of production techniques to be used. If we want technical efficiency and maximum output, we will always use the lowest cost method of production.

4) Who consumes. The bottom line, as the Little Red Hen observed, is who gets to eat the cake. The determination of who gets to consume will be reflected in what is produced. This is the core question of allocative efficiency and equity concerns.

5) Adaptability. How flexible is the economic system in responding to changes. Can the system adapt and survive economic and social challenges? Can the economy continue to achieve technical and allocative efficiency?

Different societies have performed these economic functions, and sought to achieve technical and allocative efficiency, in different ways. These ways can be classified as different economic systems. The watershed event is the industrial revolution which began in Europe in the 1700's. Before that time, we classify all economies as traditional. The industrial revolution began to spread around the world, and carried four new economic systems with it (the "isms").

The first new economic system was Capitalism or the market system. However, early capitalism left many people in poverty, while competitive markets decayed into monopolies. In response, social reformers developed alternative economic systems. Fascism and Socialism attempted to fix capitalism with a dose of government participation. Communism simply sought to overthrow capitalism. It was a struggle between the "invisible hand" of free markets and the "visible hand" of the command (planned) economy. The following table compares and contrasts these five types of economic systems.

                             ECONOMIC SYSTEMS (THE "ISMS")

Economic Function   Traditional    Capitalism    Fascism       Socialism     Communism

1. How Much to       Tradition     Market        State/Market  State/Market  State

2. What to           Tradition     Market        State/Market  State/Market  State

3. How to Produce?   Tradition     Market        Market        State/Market  State

4. Who Consumes?     Tradition     Market        State/Market  State/Market  State

5. Adaptability?     None          Yes           Some          Little        None


Type of Society:    Pre-Industrial Industrial    Industrial    Industrial    Industrial

Examples:           Third World    United States Nazi Germany  France        Soviet Union

Resource Ownership:                Private       Private       State/Private  State

Resource Control:                  Private       State/Private State/Private  State


1. The Industrial Revolution began in England and France in the 1700s, and has now spread throughout the world. The Traditional form of economic system cannot be used in an industrial society. Capitalism, Fascism, Socialism, and Communism are all modern (1800s and 1900s) attempts to develop an economic system for an industrial society.

2. All industrial societies have extensive use of capital goods, extensive division of labor, and have indirect exchange based upon the use of money.

3. State ownership of resources under Socialism and Communism reduces the choice of production techniques. The selected techniques are usually labor intensive since these societies are more concerned with full employment rather than growth.

4. Communism through its complete state ownership and control of resources is very close to the Traditional form of economic system.

5. In Pre-Industrial Europe (before 1500), the Traditional form of economic system is called Feudalism. During the Renaissance (1500 to 1700), as Europe moved towards the first industrial society, the transitional economic system is called Mercantilism. Mercantilism combined features of both modern Fascism and Socialism.