Economics (in Greek Οικονομικά) derives from the Greek word Eco(οίκω=house) and nemo(νέμω=distribute) is the social science that studies the allocation of scarce resources (often production and consumption) through measurable variables. This involves analysing the production, distribution, trade and consumption of goods and services. Economics is said to be positive when it attempts to explain the consequences of different choices given a set of assumptions, or a given set of observations, and normative when it prescribes that a certain action should be taken.
The subject is broadly divided into two main branches: microeconomics, which deals with individual agents, such as households and businesses, and macroeconomics, which considers the economy as a whole, in which case it considers aggregate supply and demand for money, capital and commodities. Aspects receiving particular attention in economics are resource allocation, production, distribution, trade, and competition. Economics may in principle be, and increasingly is, applied to any problem that involves choice under scarcity or determining economic value, in fact, the allocation of scarcity is considered basic to many definitions of economics.
Some economists use price and supply and demand to create economic models in order to predict the consequences of decisions or events, it also analyses the behaviour of whole societies. (See also Sociology, Political economy, History)
Traditionally economics focused on the satisfaction of material wants and still is largely concerned with this, but economists have also studied topics from marriage to the death penalty to optimal political institutions. Economics studies choice subject to constraints.
Areas of study in economics
Economics is usually divided into two main branches:
Microeconomics, which examines the economic behaviour of individual actors such as businesses, households, and individuals, with a view to understand decision making in the face of scarcity and the allocation consequences of these decisions.
Macroeconomics, which examines an economy as a whole with a view to understanding the interaction between economic aggregates such as national income, employment and inflation. Note that general equilibrium theory combines concepts of a macro-economic view of the economy, but does so from a strictly constructed microeconomic viewpoint.
Attempts to join these two branches or to refute the distinction between them have been important motivators in much of recent economic thought, especially in the late 1970s and early 1980s. Today, the consensus view is arguably that good macroeconomics has solid microeconomic foundations. In other words, its premises ought to have theoretical and evidential support in microeconomics.
Economics can also be divided into numerous subdisciplines that do not always fit neatly into the macro-micro categorization. These subdisciplines include: international economics, labour economics, welfare economics, neuroeconomics, information economics, resource economics, environmental economics, managerial economics, financial economics, urban economics, development economics, and economic geography.
There are also methodologies used by economists whose underlying theories are important.
Other subdivisions are possible. Finance has traditionally been considered a part of economics – as its body of results emerges naturally from microeconomics – but has today effectively established itself as a separate, though closely related, discipline.
There has been an increasing trend for ideas and methods from economics to be applied in wider contexts. Since economic analysis focuses on decision making, it can be applied, with varying degrees of success, to any field where people are faced with alternatives – education, marriage, health, etc. Public choice theory studies how economic analysis can apply to those fields traditionally considered outside of economics. The areas of investigation in economics therefore overlap with other social sciences, including political science and sociology. The most prevalent political economy is loosely called capitalism.
See political economy for the study of economics in the context of political science, and socioeconomics for the study of economics in the context of sociology.
Supply and demand
Main article: Supply and demand.
In microeconomic theory supply and demand attempts to describe, explain, and predict the price and quantity of goods sold in competitive markets. It is one of the most fundamental economic models, ubiquitously used as a basic building block in a wide range of more detailed economic models and theories.
In general, the theory claims that where goods are traded in a market at a price where consumers demand more goods than businesses are prepared to supply, this shortage will tend to increase the price of the goods. Those consumers that are prepared to pay more will lead to an increase in the market price. Conversely, prices will tend to fall when the quantity supplied exceeds the quantity demanded. This process continues until the market approaches an equilibrium point, a point at which there is no longer any impetus to change. When producers are willing to supply the same quantity as buyers are willing to buy, the market is at equilibrium point where both the buyers as well as the sellers are agreeable to the price level.
The theory of supply and demand is important in the functioning of a market economy in that it explains the mechanism by which many decisions about resource allocation are made.
In order to measure the ebb and flow of supply and demand, a measurable value is needed. The oldest and most commonly used is price, or the going rate of exchange between buyers and sellers in a market. Price theory, therefore, charts the movement of measurable quantities over time, and the relationship between price and other measurable variables. In Adam Smith's Wealth of Nations, this was the trade-off between price and convenience. A great deal of economic theory is based around prices and the theory of supply and demand. In economic theory, the most efficient form of communication comes about when changes to an economy occur through price, such as when too much supply leads to lower prices, and too much demand leads to higher prices.
In many practical economic models, some form of "price stickiness" is incorporated to model the fact that prices do not move fluidly in many markets. Economic policy often revolves around arguments about the cause of "economic friction", or price stickiness, and which is, therefore, preventing the supply and demand from reaching equilibrium.
Another area of economic controversy is about whether price measures value correctly. In mainstream market economics, where there are significant scarcities not factored into price, there is said to be an externalization of cost. Market economics predicts that scarce goods which are under-priced are over-consumed (See social cost). This leads into public goods theory.
Scarcity and plenitude
Main article: Scarcity
Scarcity is central to economic theory, although its application is primarily to the physical realm; the rise of the knowledge economy however points to a realm where creativity invites plenitude. Economics per se is about meeting needs, economic analysis is fundamentally about the maximization of something (leisure time, wealth, health, happiness - all commonly reduced to the concept of utility) subject to constraints. These constraints - or scarcity - inevitably define a trade-off. For example, one can have more money by working harder, but less time (there are only so many hours in a day, so time is scarce). One can have more radishes only at the expense of, say, fewer carrots (you only have so much land on which to grow food - land is scarce).
Adam Smith considered, for example, the trade-off between time, or convenience, and money. He discussed how a person could live near town, and pay more for rent of his home, or live farther away and pay less, "paying the difference out of his convenience".
Main article: marginalism
In marginalist economic theory, the price level is determined by the marginal cost and marginal utility. The price of all goods will be the cost of making the last one that people will purchase, and the price of all the employees in a company will be the cost of hiring the last one the business needs. Marginalism looks at decisions based on "the margins", what the cost to produce the next unit is, versus how much it is expected to return in profit. When the marginal return of an action reaches zero, the action stops. Marginal utility is how much more happiness or use a person receives from a purchase in contrast with buying less. Marginal rewards are often subject to diminishing returns: Less reward is obtained from more production or consumption. For example, the 10th bar of chocolate that a person consumes does not taste as good as the first, and so brings less marginal utility.
Marginalism became increasingly important in economic theory in the late 19th century, and is a tool which is used to analyse how economic systems will react. Marginal cost of production divides costs into "fixed" costs which must be paid regardless of how many of a commodity are produced, and "variable costs". The marginal cost is the variable cost of the last unit. Marginalism states that when the profit from the next unit will be zero, that unit will not be produced.
The marginalist theory of price level runs counter to the classical theory of price being determined by the amount of labour congealed in a commodity.
It could be argued that beneath an economic theory is a theory of value. Value can be defined as the underlying activity which economics describes and measures. It is what is "really" happening.
Adam Smith defined "labour" as the underlying source of value, and "the labour theory of value" underlies the work of Karl Marx, David Ricardo and many other classical economists. The "labour theory of value" argues that a good or service is worth the labour that it takes to produce. For most, this value determines a commodity's price. This labour theory of price and the closely related cost-of-production theory of value dominates the work of most classical economists, but those theories are far from the only accepted basis for "value". For example, neoclassical economists and Austrian School economists prefer the marginal theory of value.
"Market theory" argues that there is no "value" separate from price, that the market incorporates all available information into price, and that so long as markets are open, that price and the value are one and the same. This theory rests on the idea of the "rational economic actor". This was originally asserted by Mill.
Another set of theories rest on the idea that there is a basic external scarcity, and that "value" represents the relationship to that basic scarcity. These theories include those based on economics being limited by energy or based on a "gold standard".
All of these value theories are used in current economic work.
Economic language and reasoning
Economics relies on rigorous styles of argument. Economic methodology has several interacting parts:
- Collection of economic data. These data consist of measurable values of price and changes in price, for measurable commodities. For example: the cost to hire a worker for a week, or the cost of a particular commodity, and how much is typically used.
- Formulation of models of economic relationships, for example, the relationship between the general level of prices and the general level of employment. This includes observable forms of economic activity, such as money, consumption, preferences, buying, selling, and prices. Some of the models are simple accounting models, while others postulate specific kinds of economic behaviour, such as utility or profit maximization. An example of a model that illustrates both of these aspects is the classical mathematical formulation of the Keynesian system involving the consumption function and the national income identity. This article will refer to such models as formal models, although they are not formal in the sense of formal logic.
- Production of economic statistics. Taking the data collected, and applying the model being used to produce a representation of economic activity. For example, the "general price level" is a theoretical idea common to macroeconomic models. The specific inflation rate involves taking measurable prices, and a model of how people consume, and calculating what the "general price level" is from the data within the model. For example, suppose that diesel fuel costs 1 euro a litre: To calculate the price level would require a model of how much diesel an average person uses, and what fraction of its income is devoted to this —but it also requires having a model of how people use diesel, and what other goods they might substitute for it.
- Reasoning within economic models. This process of reasoning (see the articles on informal logic, logical argument, fallacy) sometimes involves advanced mathematics. For instance, an established (though possibly unexamined) tradition among economists is to reason about economic variables in two-dimensional graphs in which curves representing relations between the axis variables are parametrized by various indices. A good example of this type of reasoning is exhibited by Paul Krugman's online essay, There's something about macro. See also the article IS/LM model. One critical analysis of economic reasoning is studied in Paul Samuelson's thesis, Foundations of Economic Analysis: he identifies a class of assertions called operationally meaningful theorems which are those that can be meaningfully formulated within an economic model. As usual in science, the conclusions obtained by reasoning have a predictive as well as confirmative (or dismissive) value. An example of the predictive value of economic theory is a prediction as to the effect of current deficits on interest rates 10 years into the future. An example of the confirmative value of economic theory would be confirmation (or dismissal) of theories concerning the relation between marginal tax rates and the deficit.
Formal modelling is motivated by general principles of consistency and completeness.
Formal modelling has been adopted to some extent by all branches of economics. It is not identical to what is often referred to as mathematical economics; this includes, but is not limited to, an attempt to set microeconomics, in particular general equilibrium, on solid mathematical foundations. Some reject mathematical economics: The Austrian School of economics believes that anything beyond simple logic is often unnecessary and inappropriate for economic analysis. In fact, the entire empirical-deductive framework sketched in this section may be rejected outright by that school. However, the framework sketched here accurately represents the current predominant view of economics.
Development of economic thought
Main article: History of economic thought.
The term economics was coined around 1870 and popularized by influential "neoclassical" economists such as Alfred Marshall, as a substitute for the earlier term political economy, which referred to "the economy of polities" – competing states. The term political economy was used through the 18th and 19th centuries, with Adam Smith, David Ricardo and Karl Marx as its main thinkers and which today is frequently referred to as the "classical" economic theory. Both "economy" and "economics" are derived from the Greek oikos- for "house" or "settlement", and nomos for "laws" or "norms".
Economic thought may be roughly divided into three phases: Premodern (Greek, Roman, Arab), Early modern (mercantilist, physiocrats) and Modern (since Adam Smith in the late 18th century). Systematic economic theory has been developed mainly since the birth of the modern era.
Schools of economic thought
There have been different and competing schools of economic thought pertaining to capitalism from the late 18th century to the early day. Important schools of thought are Classical economics, Marxian economics, Keynesian economics, Neoclassical economics, Austrian School, New classical economics and associative economics. There are other schools of economics as well. These schools of thought have developed over the years, and have fundamental disagreements with one another. Some people have observed that the schools of economic thought often reflect who is in power in the society, for example, communist countries hold to Marxian economics while in a capitalist country like the United States, the predominant school of thought shifts every few decades between Keynesian economics and Neoclassical economics (and sometimes New classical economics).
Neo-classical economics begins with the premise that resources are scarce and that it is necessary to choose between competing alternatives. That is, economics deals with tradeoffs. With scarcity, choosing one alternative implies forgoing another alternative - the opportunity cost. The opportunity costs creates an implicit price relationship between competing alternatives. In addition, in both market oriented and planned economies, scarcity is often explicitly quantified by price relationships.
Associative Economics is based on the idea that economic life is the shared responsibility of every human being.
Understanding choices by individuals and groups is central. Economists believe that incentives and desires play an important role in shaping decision making. Concepts from the Utilitarian school of philosophy are used as analytical concepts within economics, though economists appreciate that society may not adopt utilitarian objectives. One example of this is the idea of a utility function, which is assumed to represent how economic agents rank the choices given to them. A given economic alternative can be thought of as a vector where the entries are answers to questions like "How many eggs should I buy?", "How many hours should I spend with my kids?", and "How much money should I set aside for later?". Then the utility function ranks these from best to worst, and the agent gradually learns to choose the best-ranked choice in the feasible set of his alternatives.
Economics and other disciplines
There is some tension between economics and theories of ethics, historically a branch of philosophy, which emphasizes how people ought to conduct ourselves and balances of rights and duties. Modern economics deals with this tension explicitly: According to some thinkers, a theory of economics is also, or implies also, a theory of moral reasoning. One way economists deal with this is to qualify discussions of economic choice by noting the qualifier "all else being equal..." referring to moral or social factors that are supposedly held equivalent for all choices that one might make.
For exploration of this issue, see the moral purchasing article.
Another premise is that economics fits within a finite ecosystem where there are at least some abundant resources. For instance, when fuelling a fire, people are usually concerned with finding the wood, and not with finding the air to burn it with. Economics explicitly does not deal with free abundant inputs – one criticism is that it often conflicts with ecology's view of what affects what. Human beings are, according to ecologists, merely one species participating in a vast energy system on this planet – economy is a subset of ecology that deals with just one species' habits and wants.
See nature's services for the economic view of ecology and green economics for the view in which economics is a subset of ecology.
A third premise is that economics suggests market forms and other means of distribution of scarce goods that affect not just "desires and wants" but also "needs" and "habits". Much of so-called economic "choice" is involuntary, certainly given the conditioning that people have to expect certain quality of life. This leads to one of the most hotly debated areas in economic policy: namely, the effect and efficacy of welfare policies. Libertarians, view this as a failure to respect economic reasoning. They argue that redistribution of wealth is morally and economically wrong. And socialists view it as a failure of economics to respect society. They argue that disparities of wealth should not have been allowed in the first place. This led to both 19th century labour economics and 20th century welfare economics before being subsumed into human development theory.
The older term for economics, political economy, is still often used instead of economics, especially by radical economists such as Marxists who strongly question assumptions of mainstream technical and quantitative economics. Use of this term often signals a basic disagreement with the terminology or paradigm of market economics. Political economy explicitly brings political considerations into economic analysis and therefore tends to be more normative. Some mainstream universities (such as the University of Toronto and many in the United Kingdom) have a "political economy" department rather than an "economics" department.
Information theory has been applied to economics since the work of Ronald Coase in the 1930s. However, with Herbert Simon and John von Neumann in the 1950s, it gathered a more specific formalism as part of game theory. This emphasises that the decision-making process itself is costly.
Marxist economics generally denies the trade-off of time for money. In the Marxist view, concentrated control over the means of production is the basis for the allocation of resources among classes. Scarcity of any particular physical resource is subsidiary to the central question of power relationships embedded in the means of production.
The question of the environment is viewed, in the traditional economic framework, as being related to the externalization of costs. That is, market economics assumes that underpriced goods are overconsumed. Externalization of cost, in this view, will be corrected by pricing the overconsumed resources which are being used, for example the work of Lester Thurow and also see Pigovian taxes. Not all economics study accepts this paradigm, and, instead, there is a seven-decade-old tradition of viewing economic relationships as being based on the scarcity of energy, rather than price, as the central feature of economics.
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"An Inquiry into the Nature and Causes of the Wealth of Nations" by Adam Smith (abridged version)
Last updated: 10-17-2005 18:06:42