| Economics is the social science that studies production and consumption through measurable variables.
It 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 analyzes the behavior 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.
Economic assumptions
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 bid up the market price. Conversely, prices will tend
to fall when the quantity supplied exceeds the quantity demanded. This price-quantity adjustment mechanism causes the market to
approach an equilibrium point, a point at which there is no longer any impetus to change. This theoretical point of stability is
defined as the point where producers are prepared to sell exactly the same quantity of goods as the consumers want to buy.
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.
Price
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
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 maximisation 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".
Marginalism
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 analyze
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.
Value
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 labor 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
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
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 fueling 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.
Further reading
"An Inquiry into the Nature and
Causes of the Wealth of Nations" (http://www.bartleby.com/10/) by Adam Smith
(abridged version)
External links
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