Sunday, Feb. 05, 2012

Which approach to take?

I've just returned from the first lecture of the new semester to my undergraduate economics class. The topic: What's the essential economic problem, and how do we solve it? Let me share what I told the students and let you decide if they received their money and time's worth.

Every discipline has a reason for existing, but some are more obvious than others. For example, engineering teaches us how structural relationships operate; biology and zoology show us the plant and animal worlds; and psychology helps us understand our minds.

So what does economics do? Actually, economics helps us address a very common problem - how we select and use our limited resources to achieve as many of our unlimited wants and needs as we can. We see this essential problem everywhere. Households have to stretch their paychecks among a seemingly endless number of spending options. Businesses have to decide how much of their revenue to put in advertising, equipment and technology, and their workers.

And even government always faces a list of spending requests larger than their tax revenue. This is especially true at the state and local levels, where balanced budgets are required. Only the federal government appears to have an endless source of resources, but as we have recently seen with several European countries, there is a limit.

So economics is the science of choice. But who makes - and how do they make - these choices about resource use? Here is a very long and historic economic debate. Two contenders in opposite corners still compete to this day for the championship of choice.

In one corner is the command approach. One or a few people decide how resources are allocated based on some established standards. For example, it might be decided that each person should receive 3,000 calories of food daily, live in 600 square feet of housing and enjoy one week of vacation per year.

The command approach has some obvious appeals. The central decision makers can use the latest research and information to give people "what is best for them," which many might see as an advantage. Also, resources can be allocated in such a way as to give more equality in living standards between households.

But many see serious downsides to this way of solving the essential economic problem. First, the command decision-making process could be taken over by individuals who use it to favor themselves and their friends, thereby resulting in less rather than more equality. Dictatorships are a good example. Also, the system means less individual control over what each person receives and consumes.

It is on this last point that the foundation of the major alternative - the market approach - is based. In the market approach, businesses freely decide what and how much to make, and consumers decide what and how much to buy. Consumers and businesses are guided in their decisions by the prices of products and services. Higher prices are signals of greater scarcity of the product or service, so they're a motivation to consumers to conserve, but to businesses to produce more. Conversely, lower prices are signals of greater abundance of the product or service, therefore giving consumers an incentive to purchase more, but prompting businesses to shift production to other items that are less available.

Fans of the market approach like the freedom it gives to both consumers and businesses, in particular allowing consumers to fulfill their individual preferences and desires. Supporters also argue that the market approach results in a higher average standard of living than the command system.

Skeptics say the market approach can result in more disparity in living standards between consumers than the command system. They also worry that consumers might not always make the best buying decisions for their long-term health and welfare.

Most countries have chosen an economic system that is a blend of the command and market approaches. In our country, there are limitations and regulations both on what businesses can produce and sell and what consumers can buy. There's also a degree of resource reallocation between better-off and worse-off consumers that moderates disparities in living standards.

Still, the debate between the command and market approaches remains. It is most evident today in health care. One of the big decisions we as a country have to make continually is how far to move the dial between the command and market approaches to solving the essential economic problem. Like my students, you can be part of this decision.

Michael Walden is a professor and N.C. Cooperative Extension economist at N.C. State University.