there is one final question to be answered: What is the most effective allocation of resources?
There are all kinds of resources that go into production and distribution. Remember all the resources needed to make a birthday cake? There are a lot of them: an oven, a timer, ingredients, utensils, time, knowledge, and effort.
Production and distribution usually involve a long list with very different types of resources. The flour needed for the batter is a different type of resource than the oven needed to bake the batter, or the time needed for the whole process.
Deciding how to allocate resources means you have to pay attention to where the different resources come from.
It takes many different resources to make a cake.
The Factors of Production
The types of resources needed for production are known as the factors of production. There are three different factors of production: land (in economics, the term land refers to any natural resource on, under, or over the land), labor, and capital.
Land is useful for making things. Fields are used to grow food, and water or wind can be used to produce energy. And land is not just what you see on the surface of the Earth. It also includes things that can be found underground. Things like coal and iron – even steam and water come from underground. These natural resources are all useful for producing things.
Some goods spring directly from the Earth, but it takes some work on the part of humans to make all goods. Even a wild blackberry has to be picked by someone before it can be eaten. All production requires a human touch. Labor is the work that humans do to take natural resources and turn them into useful products. Sometimes the labor is physical. Sometimes the labor involves coming up with ideas. Whatever form labor takes, these human resources are just as necessary as natural resources.
Capital is the final type of resource needed for production. Capital resources are goods that have been produced by humans to make more goods. Capital includes machines like bulldozers and cement trucks. It also includes buildings like factories and other structures such as dams and oil wells.
The term capital also refers to the money used to pay for other resources. Like other forms of capital, money has been created by humans to help with the process of production.
You can see that playing the game of economics involves answering a lot of different questions. There are four fundamental questions faced by people in all economic systems.
The way these four questions are answered tells you a lot about the way decisions are made in different economic systems. When these questions are answered in different ways, you end up playing different games.
Another major element in economics is the concept of supply and demand. The fundamentals of supply and demand change depending on what type of economic system you are dealing with, however, so this concept cannot be included in the fundamental questions of economics, in general.
The Four Fundamental Questions
1. What is to be produced?
2. How is production to be organized?
3. How are goods and services to be distributed?
4. What is the most effective allocation of resources?
You have seen that there are different economic goals that can be pursued: efficiency, growth, security, equity, and freedom. It can be difficult to decide among them.
Individual people are not the only ones who choose economic goals. Entire societies also make the same choices. If it is hard enough to choose for yourself, imagine how hard it is for a whole society to agree on its economic goals! To make this decision, it helps to understand the different results that occur from pursuing different goals.
For example, what would the game look like if everyone agreed that freedom was the most important goal? To answer this, you can look at how a society that values freedom would answer the four fundamental questions of economics. This tells you what a free-market system looks like.
The free-market system, sometimes referred to as capitalism, is one of the most common economic systems on Earth. Examine how it works.
Free Choice
The first question raised by scarcity: What will be produced?
When you are alone, you can answer the question based simply on your personal needs or wants. When an entire society decides what will be produced, however, it raises a different question first: Who within society gets to make the decision? This question needs to be asked and answered before the first fundamental question.
It might seem obvious that the producers themselves should get to decide what to produce. Their role is to produce goods and services, so it makes sense to let them choose. This is exactly what happens in a free-market system: Producers are free to choose what to produce.
Producers also get to choose how to organize production, which addresses the second question. In fact, producers are free to answer all four of the fundamental questions without anyone telling them what they have to do. A capitalist society is one where allocation, production, and distribution are organized by the free choices of the producers.
The Customer Is Always Right
Capitalism leaves production decisions up to the producers, but the choices made by consumers also play an important role. Producers must eventually sell their goods and services to consumers. In a free-market system, consumers have the freedom to choose what to buy. This gives them a lot of power over producers.
Producers want the goods and services they make to be purchased and used. That means producers must pay attention to what consumers need and want. If consumers choose not to buy the goods and services they produce, the producers have to make different decisions.
Because of this, the needs and wants of consumers influence the decisions of producers. In a free-market economy, the free choices of both producers and consumers determine how the fundamental questions are answered.
Go with the Flow
A free-market system is based on the free choices of producers and consumers. The choices one group makes affect the other group. Consumers can only consume what producers produce. At the same time, producers want to make only what consumers need and want.
Because of this back-and-forth influence, capitalism has a circular flow. Influences and inputs move between producers and consumers. Economists call this a circular-flow model.
View the Circular-Flow Model below to see the circular-flow model of the free-market system.
The Circular Flow Model
The main players in the free-market game are producers and consumers. There is a circular flow of influences and inputs between them. A circle has no beginning and
