The 3 Fundamental Economic Questions
Unless you’ve taken an economics course (and maybe even if you have), you probably have the wrong idea of what economics is. Economics is obviously a very complicated and broad field of study, but what is at the most primal core of economics? Throughout my conversations with people unfamiliar with the subject, I have realized that people generally have a misconception of what economics really is at its most fundamental core. Some people seem to think of it as something close to accounting. Other people seem to think of it as close to business or entrepreneurship. Others still think of economics as having something to do with the political realm. Although they are all moving in the right direction with these definitions, they are pretty much all wrong.Economics might touch on accounting, business, entrepreneurship, politics, and many other human endeavors, but it does so only incidentally. It touches accounting because accounting is the language of finance and economic sometimes deals with things related to finance. It touches business and entrepreneurship because firms and individuals act in rational ways that economists attempt to describe. It touches political science because economists attempt to answer important questions about how societies organize themselves to produce things. It touches other things also, but only incidentally. Economics, narrowly defined, is actually something quite different than what most people believe it to be – something very different than accounting, business, or politics. Economics, at its most basic core, is the pursuit of something much simpler – it is an attempt to answer just three basic questions
Question 1: What to produce?
Question 2: For whom to produce it?
Question 3: How to produce it?
These three questions are more macro-oriented (economics can be divided into macroeconomics and microeconomics). All societies and all nations must answer these three questions.
Why do they have to be answered?
Why do all nations have to answer these questions? Because we live in a world of scarcity and we want to efficiently allocate the scarce resources that exist. In a world of unlimited resources without any scarcity of any kind, these three questions wouldn’t make sense because no choice would need to be made – everything could be produced for everyone. In a world of scarcity, however, a choice must be made, either implicitly or explicitly. By its very nature, the scarcity in our world imposes constraints upon our actions and forces an answer to those three questions. But that might be a bit too philosophical for our purposes here, so we’ll continue.
Are you surprised?
Looking at those questions, you might be puzzled. If this isn’t what you thought economics was about that’s ok. Economics is obviously a very broad field of study and goes way beyond those three questions, but pretty much everything that economics is and does emanates from an attempt to answer those three questions. That is why I love economics so much and that is why I am so intrigued by it.
Now, Let’s Dig Deeper Into the Questions
1. What is to be produced
Every society must answer this question and has answered this question since antiquity. To sustain life, water and food are required. Some for of shelter is also a primary necessity for life and safety. Society has managed to move beyond the basic necessities of life and much of the world (specifically the Western world) lives in a state of such affluence that past generations would not even be able to comprehend our lifestyles.
A society, whether that society is a small tribe in our distant past or a modern nation, must decide what is to be produced. Economics looks at this question at both a macro and a micro level, but we’ll focus on the macro level here for the purposes of explanation.
Asking, “What to produce?” might sound a bit confusing, but it shouldn’t be. The question is simple and straightforward. Economics literally is concerned with the final mix of goods and services produced by a society during a certain time interval (usually a year). The question’s answer is also easy to see or observe. You just have to look at the final mix of goods and services produced by a society. For example, we can observe the final mix of goods and services produced in the United States in a given year. Obviously there are a lot of things produced and it would be extremely difficult (if not impossible) to count or list them all, but that isn’t a problem and that isn’t a concern. The point isn’t to count or list the goods or services produced. We can understand in our mind that every year a certain mix of goods and services is produced in the United States and we can understand that this mix of goods and services is society’s answer to the question of “What to produce?”
Here are a few examples that might help illustrate the meaning of the question:
- Should we produce Fords or Cadillacs or should we produce both?
- Should we produce Mexican restaurants or Japanese restaurants or Italian restaurants or all of them plus more?
- Should we produce college educations? How about high school educations?
- Should we produce websites like Pennies and Pounds?
2. For whom to produce it?
The next logical question after it is determined (somehow) what is to be produced, is “for who?” This makes a lot of sense. After all, everything produced is for the benefit of the society. Whenever anyone makes something, it is either to benefit himself or herself directly, or it is to obtain income by selling that product or service to another. The only way to do that is to provide some sort of value to the other. Obviously, this is a bit idealistic, because sometimes useless things cloaked in a lot of marketing are sold to unsuspecting buyers, but we won’t go down that path in this piece.
Here are a few examples that might better illustrate the question:
- Who get the luxury cars and who gets the cheap compact sedans?
- Who gets a top-tier college education and who doesn’t get to even finish high school?
- Who gets the nice house in Beverly Hills and who gets the beautiful high rise apartment in Manhattan?
3. How to produce it?
Finally, once we decide what to produce and for whom, we should think about how to produce it. This question might not seem as important as the other two at first glance, but it is actually very important. How we produce something reflects our beliefs and values. It also downstaters our society’s technological abilities.
Here are a few examples to better illustrate what this question is getting at:
- Should we produce paper from non-renewable trees in the forest or renewable trees from tree farms?
- Should we use machines or people when building cars?
- Should we produce building materials in a way that ruins the environment or should we take extra, but costly, steps to ensure that the environment isn’t damaged in our production?
But wait! – There’s a fourth question!
The above 3 questions really are the main questions that economics attempts to answer, but in answering those 3 questions, a fourth question organically arises:
Question 4: Who decides?
This question is a very interesting one to answer. It makes sense to ask it, doesn’t it? We’re answering three questions. So WHO should answer them? Who should decide what to produce, for whom to produce it, and how to produce it? Question 4 has been answered in man different ways throughout history. Let’s examine two of the main ways we can answer this question:
Capitalism – We all Decide (Sort of)
In capitalism, the entire society decides how to answer the three economic questions using a magical mechanism called prices operating in what should be a free or laissez-faire market. Prices cause the invisible hand (an important economic concept first articulated by economist Adam Smith in the Wealth of Nations) to direct the flow of resources and energy towards certain things and away from others. In a properly working society or nation, the invisible hand guides the economy toward the optimal mix of goods and services and allocates those goods and services in an optimal way among the members of the society or nation. Now, what does optimal really mean? That’s beyond the scope of this piece of writing, but it is safe to say that, generally, capitalism does work in making things pretty good for most people.
The United States, Western Europe, and many other modern countries are capitalist or quasi-capitalist societies where prices guide the flow of resources and a free-market system prevails. Prices are a pretty magical thing when you think about it. Prices are sort of like a voting machine, expect you to get more votes if you have more money. Though the price function in a free market, resources are somehow magically allocated to their most efficient use without the participants of the economy having to do much more than observe what is happening in front of them and making rational decisions based on those observations. If a certain product or service has a very high price and profit margin, you might be induced to produce some of that product or service yourself. It’s as if the economy magically communicates to producers what the society wants (Of course a society can’t “want” anything in the proper sense of the word because a society isn’t a sentient being, but I hope you understand what I mean). No planning or discussion or analysis is required in such a free-market laissez-faire society, only observing things and acting in a rationally self-interested way. It’s pretty cool in my opinion, although drawbacks, inefficiencies, and inequities do exist in a free-market capitalist society.
A command economy is where a central governmental body answers the three basic economic questions. The former Soviet Union is an excellent example of a command economy. In the Soviet Union, private ownership of businesses didn’t exist and economic participants could not decide for themselves what goods or services to produce. Everyone was a government worker and a private sector didn’t really exist. You couldn’t observe extremely high prices for a certain type of product or service, for example, and then decide to open up shop and produce that product or service yourself. Instead of the messy capitalist system where prices give us information about what to do, the government body decides most things in a much more formalized approach in a command economy. The government body decides how much bread to produce, how many cars to produce, and how to produce them all. It also decides who gets them. In reality, a command economy is extremely difficult to implement well because of the nature of knowledge and, specifically, of the knowledge that is required to answer the three economic questions in the most efficient and optimal ways. The knowledge needed to answer the three questions is generally time-specific and localized. Those who have the most knowledge of what needs to happen at a particular moment (the participants of the economy) are not the ones making the decisions in a command economy. Instead, a government body that is far-remvoed makes the decisions, but it is almost impossible for that government body to have as much knowledge as the collective “mind” of the patricians for the economy. Look for articles on this later, as this is a very interesting but somewhat esoteric and difficult concept.
A Word of Caution About Capitalism vs. Command Economy
It’s important to understand that what we presented above was a very basic description of capitalism and command systems. Additionally, it’s important to realize that no nation fits a mold perfectly. Most nations that are capitalist, for example, have aspects of a command system (eg. some socialism with a generally capitalist framework). Sometimes command economies have capitalist pockets in place (eg. relatively sophisticated black markets where a more capitalist structure prevails).
Other Ways to Answer Question 4?
Those are the two main ways the questions can be answered, but let’s examine a few other possibilities for answering Question 4 (Who decides?):
Answer Question 1 (What to produce?) via voting?
It’s possible to imagine everyone voting on how to answer the three economic questions, but that would obviously be unfeasible in a complex economy such as that of the United States.
Answer Question 2 (For whom to produce it?) with an essay-writing contest?
Doesn’t that sound like a good and fair way to decide who gets what? Everyone writes and essay arguing why they need and deserve something. It might work in a utopia, but that’s obviously not feasible in the world we live for many reasons, the main one being that it would take an enormous amount of time to process and read the essays. That’s the beautify of prices and a open and free economy – no essay contest is needed! With the price function, there doesn’t have to be anything centralized deciding who gets what. Instead, things somehow work themselves out based on the forces of supply and demand. It’s a pretty incredible and elegant thing in my opinion, but it’s not very easy to deeply understand how profound the price function in a free-market economy really is without studying it and thinking about it for a long time.
Answer all three economic questions yourself?
What does that even mean? How can only YOU decide the answers to those questions? Well, if we lived in a world where each person produced every single thing for themselves, you would decide what to produce in your own little world (Question 1) and how to produce it (Question 3). Question 2 (For whom…) wouldn’t need to be answered in this self-sufficient world because everything would be for you. The problem with this is that if you had to produce everything for yourself (total self-sufficiency), you would be in poverty along with everyone else in the world. There would be no specialization, trade, or economies of scale and everyone would live as humans lived many thousands of years ago – in destitute poverty. Humanity used to live in a much more self-sufficient way, but it was never totally self-sufficient in my opinion. Some trade and some cooperation did occur even in the distant past.
This was a long piece on what started out as three simple questions. The thing is, they are not that simple. They might sound simple, but they are incredibly deep and it takes years of study and thinking to truly understand how profound the questions are and how beautifully economics attempts to answer them. That’s one of the many reasons I love economics.