The Most Important Economic Principle

that you have never heard of

The central problem that any economy has to resolve is that resources are scarce, while human needs — or rather, desires — are unlimited. Any economy has, at a given point in time, only a certain amount of productive capacity. Given this limit, the central questions of economics can be reduced to just two. How do you decide what gets produced? And once produced, how do you decide who gets to use it, or more accurately, consume it? In simple terms, what gets produced, and how is it distributed?

For example, consider a hypothetical economy where there is enough iron this year to produce fifty tractors or one hundred cars, or some combination thereof — for example, twenty-five tractors and fifty cars. Who decides what gets produced? And once produced, who decides how these tractors or cars are distributed? There may be one hundred cars produced, but three hundred families who want a car. How do you decide which families get a car, and which ones have to wait for the following year?

Modern economies, i.e. economies that produce a variety of goods and services, through a process that involves specialization of labor, and consequentially, fragmentation of production combined with exchange through trade (I only make cars, and rely on others to produce bread, clothing, and so on), have solved this fundamental issue of production and distribution in two contrasting ways.

In a free market or capitalist economy, both questions are answered through the price mechanism. The production capacity of the economy is diverted to whatever is most profitable, because the price that consumers are willing to pay is an indication of what is most in demand at any point in time. And your ability to consume is also determined by whether you can afford to pay for it or not; in the example given above, the price of the one hundred available cars would rise to a point where only the richest one hundred (out of the three hundred families that want a car) would be able to afford it.

In a planned or socialist economy, in contrast, the decision of production and distribution is made by fiat, or in practical terms, by a bureaucracy. This means that, in this socialist economy, there would still be two hundred families who would fail to receive a car, except that the allocation (distribution) of these cars would have been determined through a bureaucratic procedure.

In other words, it will always be true that, in a capitalist economy, some families will be unable to afford at least some of the goods and services that are available. Conversely, in a socialist economy, there will always be some people who are unable to receive some of the available goods and services, because of rationing. These are not flaws in the system — they are a consequence of the fact that the productive capacity is less than what people desire, and distribution will therefore always be uneven.

Take the arguments that are dumped back and forth between those in favor of a socialized medical care system (such as the one that exists in Canada) and one based on ability to pay (such as the American one). The Canadians blame the Americans for having a system that gives amazing care to those who can afford it, while letting millions slip through without even a basic level of care. The Americans, on the other hand, point to people who have to wait for six months before they can get some surgical procedure done in Canada. Both these criticisms miss the point completely: because resources are scarce, there will always be people waiting for some medical procedure in Canada, and there will always be some people who will not be able to afford the same procedure in USA. Both countries effectively ration medical care; the only difference is that one does it explicitly, while the other does it through the ability to pay.

Of course, the principle of scarcity is by no means universal, meaning that it does not necessarily apply to all goods and services. For example, the capacity for production of bread is now so high that there is no conceivable scenario under which someone in USA would not be able to afford bread, while this may not have been true a hundred years ago. In a similar way, one can imagine a hyper-efficient future world, where the American economy has become so productive that anyone can afford a brand-new Cadillac every year; but even then, in that future economy, there will be some things that are not affordable for everyone — say a private jet, or a round trip ticket to Mars.

So what is the most important principle that you have never heard of? It is simply this: there can be no distribution without production.

You may be tempted, at this point, to say well, duh. Isn’t that kind of self-evident? But the reason why this is so important is that socialist economies, by and large, have been very good at distribution — if by good, you mean relative equality, or at least “fairness” of distribution. But they have not been as good as capitalist economies in production. While we can make arguments for and against both systems of organizing production and distribution, it is worthwhile to keep in mind that many things we take for granted today, in the sense of easy accessibility (like the production of bread), were at one time also scarce items. And the productivity increases that led to these items becoming ubiquitous, in the sense of no longer being subject to scarcity, were a result of technological innovations that could only have occurred under a capitalist free market economy.

Make of this what you will.