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Exploring Business

v5.0 Karen Collins
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1.4 What Is Economics?

Learning Objectives

  1. Define “economics.”

  2. Identify the factors of production businesses use to produce goods and services.

  3. Identify the three key economic questions and explain how economists answer these three questions.

  4. Compare and contrast pure capitalism and pure socialism.

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

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

  1. Land and other natural resources

  2. Labor (physical and mental)

  3. Capital, including buildings and equipment

  4. 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) is 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 . The factors of production used to produce a shirt would include the following:

  1. 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

  2. The laborers who make the shirts

  3. The factory and equipment used in the manufacturing process, as well as the money needed to operate the factory

  4. 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, which 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 1.7, which illustrates the dual roles of households and businesses.

  1. Households not only provide factors of production (or resources) but also consume goods and services.

  2. Businesses not only buy resources but also produce and sell both goods and services.

The Circular Flow of Inputs and Outputs

Watch this clip to experience an active version of this figure.

Figure 1.7 The Circular Flow of Inputs and Outputs

This diagram shows two boxes in the middle of the circular flow. The boxes are labeled Businesses and Households.The top inner arrow flows from Households to Businesses and says Pay revenues for outputs; the bottom inner arrow flows from Businesses to Households and says Pay incomes for inputs. The top outer arrow flows from Businesses to Households and says Outputs - Goods and services (products). The bottom outer arrow flows from Households to Businesses and says Inputs - Labor, Capital, Land and Buildings, and Entrepreneurship.

Source: FlatWorld

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 —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 pure capitalism, pure socialism, and mixed market economies (which rely on both the market and the government to allocate resources). Some economists classify as a political and economic system, while others classify it as a political system only. For our purposes, we will classify communism as a political system. Few countries have a communist government: China, Vietnam, Cuba, and Laos.

Pure Capitalism

The economic system in which most businesses are owned and operated by individuals is . In a capitalist market, many factors influence how goods and services are allocated, including supply and demand, prices, and competition. Business is conducted with only limited government involvement.

Pure Socialism

Under , industries that provide essential services, such as utilities, banking, and health care, are 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 pure 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.

Mixed Market Economy

Though it’s possible to have a pure communist system or a pure capitalist () system, virtually all economic systems are mixed. A 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, are becoming more mixed as they adopt capitalistic characteristics and convert businesses previously owned by the government to private ownership through a process called .

Comparison of Pure Capitalism and Pure Socialism

Figure 1.8

Although it’s possible to have a pure capitalist economy or a pure socialist economy, most economies are mixed (an economy that relies on both markets and the government to allocate resources).

An image of a post with two yellow signs: the top one says “CAPITALISM” and points northward and the bottom sign says “SOCIALISM” and points westward.

Source: © Shutterstock, Inc.

In comparing and contrasting pure socialism and pure capitalism, it helps to consider the answers to these three questions:

  1. Who owns the property?

  2. How are prices set?

  3. How much economic planning is done by the government?

In a pure capitalist economy:

  1. Property Ownership—Businesses, factories, land, and other factors of production are privately owned by individuals or groups of individuals. Business owners earn income from their ownership. The “profit motive” encourages owners to run their companies efficiently.

  2. Price Setting—Prices of goods, services, and labor are set by business owners with little or no interference by the government. The price of a particular good or service is based on demand for the good and its availability.

  3. Central Planning—There is very little central planning. Business owners, rather than the government, decide what goods or services should be produced, how they should be produced, and how they should be distributed. The government rarely interferes in these decisions.

In a pure socialist economy:

  1. Property Ownership—The government owns all essential factors of production, including land and other natural resources, factories, airlines and railroads, schools, and hospitals. Varying degrees of private ownership are allowed, but there are strict limits on the ownership of key economic assets to ensure they are managed for the collective benefit of society. The government is in charge of the production and distribution of all goods and services.

  2. Price Setting—The government sets prices for goods and services. It also dictates the amount of wages paid to workers for their labor. All workers are paid about the same amount.

  3. Central Planning—The government in a pure socialist country engages in extensive central planning. The first step in the planning process is to create a central plan, most likely a five-year plan. The second step is to allocate resources (factories, labor, etc.) according to the plan. The final step is to prioritize the production of goods and services based on the plan.

Advantages of Pure Capitalism

Pure capitalism provides freedom of choice to companies and consumers. Business owners are free to offer goods and services that consumers want. Products are produced as efficiently as possible to keep costs low and maximize profits. Efficient operations and competition among companies provide consumers with a variety of low-priced, high-quality products. Consumers are free to purchase the goods and services they want and can afford. 

Disadvantages of Pure Capitalism

Under pure capitalism, business owners are driven to make a profit in order to prosper and survive. Profits benefit owners, providing them with substantial income and wealth. But the drive on the part of business owners to make a profit requires them to increase efficiency and cut costs. As one of the main costs for any organization is the wages paid to workers, cutting costs often means keeping the wages of workers low. Low wages in turn drive income inequality.

The profit motive is also linked to pollution and damage to health. Companies that are trying to keep costs as low as possible have little incentive to invest in equipment or processes that will reduce their negative impact on the environment. Instead, they may dispose of their waste and toxic chemicals into our waterways, land, and air without regard to the damage caused to the environment or people’s health.

Finally, the profit motive feature of capitalism compels owners to achieve monopolistic power for their companies. Holding a monopoly gives the owners the ability to influence the quantity and price of a good or service. It can then limit the quantity of the good or service to create demand while at the same time raising its price. In addition, holding a monopoly allows the company to avoid risk by preventing competitors from entering the industry.

Advantages of Pure Socialism

The main advantage of pure socialism is that it creates income equality. This makes everyone equal, closing the gap between the rich and the poor. All individuals in a pure socialist society are provided with free basic services, including health care and education. It can do this because the government owns and controls all hospitals and schools. Everyone who is able to work is given a job, which eliminates unemployment. There are no privately owned monopolies; pricing of goods and services is regulated by the state.

Disadvantages of Pure Socialism

Under pure socialism, the government is in charge of the distribution of all goods and services. It dictates where you work, how much you are paid, what goods and services are available to you, how much you must pay for these goods, etc. The complete control of every aspect of your life leaves you with no personal freedom. If you do not like your assigned job, you cannot leave. If you believe you should get a raise, you cannot get one. If you do not like the food available in the government-owned stores, you have to buy it or starve.

Another disadvantage of pure socialism is that workers can be unmotivated. For example, let’s say you live in a pure socialist country and have a job that you don’t like. You can do one of two things:  work very hard or be unmotivated and work very little. Which do you choose? Under pure socialism, it does not matter. You will still keep your job and your salary will remain the same. The same is true for your manager. Perhaps your manager is inefficient but has been at the company for a long time. Will the manager lose their job? No, he will keep it because he has seniority. Now, let’s say you’re interested in starting a business. Will you do this?  Probably not, because you may not be able to keep any or all of the profits if it is profitable. In some socialist systems, all profits must be shared with society. In other socialist systems, there are restrictions on the level of profit business owners can accumulate, and excess profits might be subject to taxation or redistribution to ensure economic equality.

As mentioned earlier, everyone is entitled to have their basic needs met. Let’s say your need is to have an implanted and infected wisdom tooth taken out. To get an appointment with a dentist, you have to go through the government. But, it will likely take quite a while, perhaps weeks or even months, before you get to see a dentist. Bureaucracies move slowly, particularly government bureaucracies. But you have no choice but to wait. You cannot go to a dentist on your own. You just have to remain in pain until the government schedules the removal of your tooth.

The U.S. Economic System

Like most countries, the United States features a mixed market system: primarily capitalism, but with some characteristics of a socialist 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 Medicare to those over age sixty-five.

To appreciate how businesses operate, we must first get an idea of how prices are set in competitive markets. Thus, Chapter 1, Section 5 “Perfect Competition and Supply and Demand” begins by describing how markets establish prices in an environment of perfect competition.

Comparing Economic Systems

Take a few minutes to complete an online exercise that reinforces your understanding of the characteristics of different economic systems.

Key Takeaways

  1. Economics is the study of the production, distribution, and consumption of goods and services.

  2. 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?

  3. In comparing capitalism and socialism, you should consider these questions: Who owns the property? How are prices set? How much economic planning is done by the government?

  4. An advantage of capitalism is that it provides individuals with personal freedom. A disadvantage is that owners make profits, which can lead them to make decisions that are not in the best interest of society.

  5. An advantage of pure socialism is that it creates income equality. A disadvantage is that individuals have little personal freedom.

Before going to the next section of this chapter, take a few minutes to take an online quiz to test your knowledge of the material covered in this section. Quizzes can be found by clicking on the Self-Study tab in the online reader.

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.

  3. Compare and contrast capitalism and pure socialism. Identify advantages and disadvantages for each system. If you had to pick one or the other to live under, which would you select? Would you prefer a mixed economy? Why or why not?