IRISH CASE STUDY:
Chapter 1: Economics and the Economy

The Economy as a System
by Eleanor Doyle, Department of Economics, University College Cork.

This case provides an introduction to the economic system to illustrate the interconnectedness between many of the issues addressed in the Principles of Economics course.

One of the key issues that motivates the study of Economics is how to resolve the discrepancy between resource scarcity and the numerous potential uses for those resources.  Inevitably, choices are made as to how resources are used that preclude other alternatives.  It is via the workings of the economic system that these decisions are made.  The system is made up of individuals as consumers, workers (employed and unemployed), firms and governments and the study of economics deals with all of these different features of the system.

While we can view the economy as a system, the economic decisions made within that system are based on human behaviour and individual’s preferences.  At the heart of economic decision-making is the necessity to select between alternatives.  In making a choice the decision-maker should be aware of the costs of their actions in terms of what they cannot do once they make one particular choice i.e. the opportunity cost of their decision.  Consumers decide what to buy with their available cash, and how much should be saved rather than spent.  Consumers make choices between alternative courses of action open to them based on available information.  For example, consumers’ decisions about what to buy depends on the prices of various products, their personal tastes and available income; employment choices depend on the jobs that are available, on individuals’ qualifications and the going wage.  Firms also make economic decisions as they attempt to produce and sell their products or services at prices that consumers are willing to pay.  They make their decisions based on their perceptions of what is happening in their market which is affected by consumers’ demands, the available technologies and how competing firms behave.  A firm’s choices are, therefore, bound up with what potential buyers want and what other firms are doing to compete.

The price system refers to the process through which the demand for and supply of different products are co-ordinated to bring about equilibrium prices and quantities in markets.  Decision making by individuals and firms is facilitated by the price mechanism which plays a central role in signalling information to consumers regarding how best they should use their resources (including monetary, entrepreneurial and labour resources).   It also acts as a signal to producers of the price they can expect to earn for their products.  The approach of economics involves presuming that individuals (whether consumers or producers) are rational in how they attempt to improve their situation so that they maximise their wellbeing (utility) in making their decisions.  Not all of the decisions made may be considered objectively as enhancing the overall wellbeing of society – take for instance the fashions that lead to rising expenditure on Pokemon paraphernalia or mobile phones and their accessories that might better be spent on improving education or health.  However, to hand over total control for such choices to a decision-maker of some sort would not necessarily lead to a better overall outcome.  This is because of their lack of knowledge about what constitutes the optimal use of resources to meet demands, leading to an inefficient use of resources (creating surpluses or shortages), and because such a system would take away from individuals their freedom of choice.  In fact, the dependence of a substantial proportion of the economic system on the price mechanism actually means that individuals’ choices are governed by the choices and decisions of other members of the system.  Hence the sum of all the individual choices feed into the system to generate the market prices observed; subsequent decisions are disciplined by the price mechanism.  This is what Adam Smith alludes to in his discussion of the invisible hand that guides the economy.

In centrally planned economies, such as the former Soviet Union, it is possible to examine the failures of such systems in terms of how resources were centrally controlled and allocated, guided by a ‘visible hand’, and largely dependent on the supply side of the economy.  The price mechanism was not a reflection of consumers competing demands for various goods as prices were set by central government.  Neither were prices used a signals as to where profitable opportunities lay for entrepreneurs.  A further implication of command economies is the effect on the incentive to innovate.  Innovation plays an important role in improving the processes used and goods produced within firms that feed into improving productivity and living standards.  Yet in economies where goods are provided based on central planning, and resources are largely centrally owned, individuals lack the incentives of their counterparts in ‘market economies’ to be as innovative or enterprising.  The self-interested desire to improve individual well-being that translates into broader benefits for the larger community (via employment or better technology) is more difficult to operationalise in a society where property and resources are owned centrally because individuals see less of the direct benefits.

It is true, however, that a considerable portion of the economic system involves public provision of particular goods and services where government ministers and civil servants are responsible for allocating resources to meet targets for health, education, defence etc.  This is due to market failure which arises when individuals have an incentive to wait for others to invest in providing goods that are considered desirable by everyone so that they try to free ride on other individuals’ purchases.   The price mechanism has traditionally played a less important role in the decisions about what resources should be allocated towards producing health versus education, for example.  However, governments are increasingly examining both the public goods and services and the processes via which they are provided in order to adopt more efficient provision to make the best use of available resources.

Interactions between consumers and firms are not independent of external factors because they are faced with a regulatory environment in which they must legally operate i.e. the rules and regulations set down by government in both national and international contexts.  For instance, trade agreements are set down by the World Trade Organisation (WTO) and signed by governments following prolonged discussions between government officials implying that firms in signatory countries must abide by the set rules and regulations.  The Competition Authority in Ireland was established in 1991 (see http://www.irlgov.ie/compauth) to promote greater competition in every sector of the Irish economy by tackling anti-competitive practices, and so contributing to an improvement in economic welfare. 

Economic welfare can be conceptualised using the Production Possibility Frontier which indicates the maximum feasible combinations of goods an economy can produce.  Countries producing less than the maximum possible (when all workers and machinery or equipment are employed) produce inefficiently in the sense that more could be produced if better methods were used.  The opportunity costs associated with increasing welfare can be analysed using the PPF to consider the quantity of goods that can be produced if a certain other goods are not produced.  This involves the diversion of productive resources from one use to another. 

Hence, it is via the economic system that the choice of how much of which goods to produce is made.  The choices are made dependent on what individuals demand and the technology available for production, supported by the operation of markets whereby prices provide the information regarding how best resources may be used.