HOW A PRIVATE-ENTERPRISE SYSTEM SOLVES THE BASIC ECONOMIC PROBLEMS

Consider now how a private-enterprise system allocates resources to solve four basic economic problems.

How the Market system Decides What To Produce

Under a private-enterprise, free-price system, onsumers control what is produced. Consumers register their preferences through the amount of money they spend on various goods and services.The more you want something, the more money you will spend on it and the higher price you will be willing to pay for it. This is how the price system decides which are the most important goods and services to produce.

But one point is vital. In order to count, consumers’ demands have to be backed up with dollars. No matter how badly you want a Buick and a fine house, your desires become effective in the market only to the extent they are backed up by the ability to pay. The price mechanism is hardboiled, impersonal. It produces Cadillacs for millionaires when poor youngsters have no toys.

Prices reflect not how much consumers “need” goods and services, but how much they are willing and able to pay for them.

How the Market system Gets the Goods Produced

Businessmen are out to make profits, and they find profits where selling prices are higher than costs. Thus, businessmen move to those industries where consumers bid prices up, and where their own ingenuity and other factors such as plentiful labor and materials can bring costs down. Workers and owners of other productive resources generally move toward higher-pay, away from lower-pay jobs, though their decisions are also influenced by their preferences on location, working conditions, and the like. This combination of consumers’ demands, workers’ job preferences, and businessmen’s desire for profits gets the goods produced that consumers want most, at the lowest possible cost.

Thus, the businessman is essentially a link between consumers and productive resources. His social function is to organize productive activity in the most efficient (lowest-cost) way possible, and to channel productive resources toward industries where consumer demand is strongest. Profits are the mainspring of the system the carrot in front of the profit-seeker. In seeking profits, the businessman performs a vital social function.

How the Market system Distributes Products

Who gets the goods that are produced? The price system allocates them to those who have the desire and the income to buy them. There are two steps in this process.

The first is the distribution of money incomes. We earn our incomes primarily by working for businessmen, helping to produce the goods and services consumers want. The prices we get for our services depend on how much we are worth to the businesses we work for. Competition forces the businessman to pay each of us about what we contribute to the sale value of what he is producing. The incomes we receive in this way largely determine what we can afford to buy.

The second step is the distribution of goods and services among those with money income to pay for them. The price of each commodity is bid up until the buyers least able and willing to pay for it are eliminated. This does not necessarily mean that low-income buyers are eliminated completely. Often it means that they can afford only a few units at the price established, while higherincome groups can afford more. Poor people buy steaks, but not many. In other cases, such as mink
coats and country estates, the poor are eliminated from the market.

How the Market system Decides  Between  Present  and Future: Economic Growth

As was indicated above, we can use our productive resources either for current consumption or for capital accumulation (that is, machinery, buildings, and so on) to help increase future production. That is, by building new factories and other productive facilities, we can shift the economy’s production possibilities curve out. Here again, the private-enterprise system depends largely on the free decisions of consumers and profitseekers to allocate resources between present and future.

Looking at the growth process in money terms, we must save some of our incomes and invest in building new factories and the like, rather than spending everything on consumption.In our individualistic economy, each person and each businessman decides how much of his income he wants to save. If these savings are a large proportion of our total income, investment can be large relative to current consumption and thu economy will grow rapidly. If we save only a small portion of our total income and investment is correspondingly small, the growth in productive capacity will be slow.

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But here the private-enterprise system may have trouble. Sometimes when people save, businessmen don’t see enough potential gain in making new investments in capital goods to match, or use up, the savings. Then the savings “lie idle” instead of being spent. This means unemployment and depression. The economy wastefully operates inside the production-possibilities frontier. Other times, businessmen grow unduly enthusiastic over future prospects and invest far beyond the rates at which people plan to save. This speeds up capital accumulation and economic growth. But it also may bring overinvestment and inflation.

Excess productive capacity develops; factories can’t sell their output; investment is cut back; workers are laid off. Thus, miscalculations and overbuilding can mean uneven growth, with inflationary booms and ensuing depressions.

Solving  All the Problems Simultaneously

FIG. 2-3 The cIrcular flew of economic activity.
THE CIRCULAR FLOW OF ECONOMIC ACTIVITY

These four major decisions are not made separately. Rather, they are all interdependent. The economic system is a huge, interconnected set of markets, each with many buyers and sellers.All four big decisions are simultaneously the outcome of millions of free, individual choices by people largely concerned with their own private welfare. Since most buyers buy in many different markets, what they buy of one good affects what they will buy of another. Most sellers must compete with many other sellers for the labor they hire, the raw materials they use, the dollars they borrow to build their plants. The process of production both provides goods to meet consumer demands and generates incomes for workers who are in turn consumers. And each consumer constantly chooses between saving or buying something now with his income.

The private-enterprise, free-price system, then, makes all four of its major decisions simultaneously, each composed of millions of concurrent self-interest subdecisions by consumers, workers, businessmen, bankers, and other participants in the economic process. How all these complex decisions are simultaneously and continuously made and how they interact in our economic system is the core of the study of economics.’ (Remember that we’re temporarily omitting a big group of desired goods and services those produced by governments where demand is reflected through different channels.)

THE CIRCULAR FLOW
OF SPENDING AND PRODUCTION

It is important to see that income in a private-enterprise economy flows around a circle.Businesses pay wages, interest, and other income to the public. The public, as consumers, spends this income back to businesses in payment for finished goods and services. This demand, in turn, leads businessmen to hire workers to produce more goods and services for consumers.

Figure 2-3 shows this circular flow of income.The inner line shows consumers spending tobusinesses (top half) and businesses spending back to the public through paying wages and interest (bottom half). The outer line shows the

In mathematical terms, it may be helpful to think of all these interdependent markets and decisions as a large system of simultaneous equations. In fact, one of the first clear perceptions of the entire process was by Leon Walras, one of the first mathematical economists, who saw it just that way about a century ago.

corresponding reverse flow of productive services and final products. On the bottom half, labor and other productive services are being hired by business from the public. On the top half, finished goods are moving from businesses to consumers.

Which comes first, business spending or consumer spending? This is a chicken-and-egg question. The main point is that neither can go on for long without the other. Consumers without jobs and incomes make for very poor business. And a
business with products that no one buys is a good bet for bankruptcy. Economic activity in a private-enterprise system is a continuous flow of productive services and finished products, facilitated by a matching counterfiow of money spending, and guided by the price system into thousands of different product channels with in the main streams shown in the diagram.

You can readily see that this picture is over-simplified. The government has been left out. And there’s no place for savings and production of capital goods that aren’t sold to consumers. But the simple picture points up the central role of the circular-flow process. Unless there is a continuous flow of money-spending by businesses to the public and by the public to businesses, we’re in trouble. If something dams up the flow of spending, depression and unemployment result, and the economy wastefully operates inside its production frontier.