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Economics (from the Greek οίκος [oikos], 'house', and νομος [nomos], 'rule', hence "household management") is a social science that studies the production, distribution, trade and consumption of goods and services. Economics is said to be normative when it recommends one choice over another, or when a subjective value judgment is made. Conversely, economics is said to be positive when it tries objectively to predict and explain consequences of choices, given a set of assumptions and/or a set of observations. The choice of which assumptions to make in building a model as well as which observations to highlight is, however, normative.
Economics, which focuses on measurable variables, 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. Economic logic is increasingly applied to any problem that involves choice under scarcity or determining economic value.
The mainstream economic paradigm is a combination of neoclassical economics and macroeconomics called the neo-classical synthesis. Various schools of heterodox economics seek to explain economic phenomena using different assumptions, formalisms or basic paradigmatic assumptions.
Definitions of economics
Broadly speaking, economics is a social science, and its area of study is human activity involved in meeting needs and wants. However, beyond this there are a range of definitions, past and present which have been applied, first to the term political economy and then to the modern term economics. John Maynard Keynes once remarked that "Economics is the science of thinking." Broadly the history of the study moved from the study of "wealth" to "welfare" to the idea studying trade-offs.
The earliest definitions of political economy were simple, elegant statements defining it as the study of wealth. Adam Smith, generally regarded as the father of economics, author of An Inquiry into the Nature and Causes of the Wealth of Nations (generally known as The Wealth of Nations) defines economics simply as "The science of wealth." Smith offered another definition, "The Science relating to the laws of production, distribution and exchange." Wealth was defined as the specialization of labor which allowed a nation to produce more with its supply of labor and resources. This definition divided Smith and Hume from previous definitions which defined wealth as gold. Hume argued that gold without increased activity simply serves to raise prices.
John Stuart Mill defined economics as "The practical science of production and distribution of wealth"; this definition was adopted by the Concise Oxford Dictionary. For Mill wealth is defined as the stock of useful things.
Definitions in terms of wealth emphasize production and consumption, and do not deal with the economic activities of those not significantly involved in these two processes (for example, retired people, beggars). For economists of this period, non-productive activity is a cost on society. This interpretation gave economics a narrow focus that was rejected by many as placing wealth in the forefront and man in the background; John Ruskin referred to political economy as a "Bastard science, the science of getting riches."
Later definitions evolved to include human activity, advocating a shift toward the modern view of economics as primarily a study of man and of human welfare, not of money. Alfred Marshall in his 1890 book Principles of Economics wrote, "Political Economy or Economics is a study of mankind in the ordinary business of Life; it examines the part of the individual and social action which is most closely connected with the attainment and with the use of material requisites of well-being."
The welfare definition was still criticized as too narrowly materialistic. It ignores, for example, the non-material aspects of the services of a doctor or a dancer. A theory of wages which ignored all those sums paid for immaterial services was incomplete. Welfare could not be quantitatively measured, because the marginal significance of money differs from rich to the poor (i.e. $100 is relatively more important to the well-being of a poor person than to that of a wealthy person). Moreover, the activities of production and distribution of goods such as alcohol and tobacco may not be conducive to human welfare, but these scarce goods do satisfy human wants.
Marxist economics still focuses on a welfare definition. In addition several critiques of mainstream economics begin from the argument that current economic theory does not adequately measure welfare, but only monetized activity.
This definition allowed a potentially broader field of study, but it, too, has its critics. It is most amenable to those who consider economics a pure science, but others object that it reduces economics merely to a valuation theory. It ignores how values are fixed, prices are determined and national income is generated. It also ignores unemployment and other problems arising due to abundance. This definition cannot apply to such Keynesian concerns as cyclical instability, full employment, and economic growth.
The focus on scarcity continues to dominate neoclassical economics, which, in turn, predominates in most academic economics departments. It has been criticized in recent years from a variety of quarters, including institutional economics and evolutionary economics).
Areas of study in economics
Economics is usually divided into two main branches:
- Microeconomics, which examines the economic behavior of individual actors such as businesses, households, and individuals, with a view to understand decision making in the face of scarcity and the 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. Some authors (e.g. Kurt Dopfer and Stuart Holland) also argue that 'mesoeconomics', which considers the intermediate level of economic organization such as markets and other institutional arrangements, should be considered a third branch of economic study.
Economics can also be divided into numerous sub-disciplines that do not always fit neatly into the macro-micro categorization. These sub-disciplines include: international economics, labour economics, welfare economics, neuroeconomics, information economics, resource economics, ecological economics, environmental economics, managerial economics, financial economics, urban economics, mathematical economics, development economics, industrial organization, retail economics, war economics, public finance, agricultural economics, transport economics, media economics, monetary economics, economic history, economic psychology, economic sociology, economic anthropology, economic archaeology, and economic geography.
There are also methodologies used by economists whose underlying theories are important.
- The most significant example may be econometrics, which applies statistical techniques to the study of economic data. Computational economics relies on mathematical methods, including econometrics.
- Another trend which is more recent, and closer to microeconomics, is to use social psychology concepts (behavioural economics) and methods (experimental economics) to understand deviations from the predictions of neoclassical economics.
- Evolutionary economics often deals with the otherwise difficult questions related to the role of 'routines' and 'capabilities' in explaining heterogeneity in firm outcomes. It is arguably an even older theory than biological evolution, and differs from biological evolution in many details. Innovation can be the product of rational thought. Recombination can be continuous and can involve many 'parents'. And selection is not only natural but also rational, since economic agents can decide to abandon an inferior technology or behavior, rather than die with it.
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.
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.
To define, Demand is the utility maximizing choice of a consumer. It is a strong desire backed by purchasing power with the willingness to purchase within a given period of time. Supply on the other hand is the quantity of goods that a producer or a supplier is willing to bring into the market for the purpose of sale, at a given price in a given period of time.
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. At this point the market is said to "clear".
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.
Main Article: 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 an increase in supply leads to a lower price, or an increase in demand leads to a higher price.
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.
Main article: Scarcity
Scarcity is central to economic theory, known more commonly as the Economic Problem, or Basic Economic Problem. 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, for example, fewer carrots (you only have so much land on which to grow food - land is scarce).
Scarcity is defined as: when the price is zero, the quantity demanded exceeds the quantity supplied. Price is a measure of relative scarcity. When the price is rising, the commodity is becoming relatively scarcer. When the price is falling, the commodity is becoming relatively less 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 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.
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 labor 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 behavior, 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 their 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 parameterized 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 adapted 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 (Welfare definition), 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 Mercantilism, Kameralism, Physiocracy, Manchester school, Protectionism, Fiscalism, Monetarism, Classical economics, Marxian economics, Keynesian economics, Post-Keynesian economics, Neoclassical economics, Institutional economics, Austrian School, Evolutionary economics, Dependency theory, World systems theory, and New classical economics.
Modern 'mainstream' economics
Most academic economics today 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 cost 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.
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. Then the utility function ranks available choices from best to worst, and the agent gradually learns to choose the best-ranked choice in the feasible set of his alternatives.
Most economists also acknowledge the existence of market failure and many insights from Keynesian economics. They look to game theory and asymmetric information to solve problems on a microeconomic level. Many important insights on collective behavior (e.g. emergence of organizations) have been incorporated from institutional economics via new institutionalism.
Economists who believe that models based on utility maximisation are applicable to a wide range of activities, including the very long term and the non-economic, are often referred to as neoclassical economists.
On a microeconomic level, some economists extend economic analysis to all personal decisions. An alternative can be thought of as a vector where the entries are answers not only to questions like "How many eggs should I buy?", but also "How many hours should I spend with my kids?", and "How long should I spend brushing my teeth?".
An alternative school - one of the successors to the Keynesian tradition with a focus on macroeconomics. They concentrate on macroeconomic rigidities and adjustment processes, and research microfoundations for their models based on real-life practices rather than simple optimizing models. Generally associated with Cambridge, England and the work of Joan Robinson.
The other school associated with developments in the Keynesian fashion. These researchers tend to share with other Neoclassical economists the emphasis on models based on microfoundations and optimizing behavior but focus more narrowly on standard Keynesian themes such as price and wage rigidity. These are usually made to be endogenous features of these models, rather than simply assumed as in older style Keynesian ones. The Nobel prize winners Joseph Stiglitz and George Akerlof are generally thought of as New-Keynsians.
There are many types of economist, and many of them are considerably outside the mainstream. Socialist economics, green economics, Austrian economics, and Old Keynesian economics still have many voices in academia.
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 such as Mr. John Syko, 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 ceteris paribus ("all other things held constant...") referring to moral or social factors that are (for the sake of argument) 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.
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 certain economists such as Marxists. 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 is therefore openly normative, although this can be said of many economic recommendations as well, despite claims to being positive. 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 emphasizes 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 at their true social marginal cost. See Pigovian tax.