Economics is the social science that studies the production, distribution, and consumption of goods and services.
The term economics comes from the Ancient Greek οἰκονομία (oikonomia, "management of a household, administration") from οἶκος (oikos, "house") + νόμος (nomos, "custom" or "law"), hence "rules of the house(hold)".
Current economic models developed out of the broader field of political economy in the late 19th century, owing to a desire to use an empirical approach more akin to the physical sciences. A definition that captures much of modern economics is that of Lionel Robbins in a 1932 essay: "the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses." Scarcity means that available resources are insufficient to satisfy all wants and needs. Absent scarcity and alternative uses of available resources, there is no economic problem. The subject thus defined involves the study of choices as they are affected by incentives and resources.
Economics aims to explain how economies work and how economic agents interact. Economic analysis is applied throughout society, in business and finance but also in crime, education, the family, health, law, politics, religion, social institutions, war, science and research. The expanding domain of economics in the social sciences has been described as economic imperialism.
Microeconomics
A common distinction is between positive economics (describing "what is") and normative economics (advocating "what ought to be") or mainstream economics (more "orthodox") and heterodox economics (more "radical"). The primary textbook distinction is between microeconomics ("small" economics), which examines the economic behavior of agents (including individuals and firms) and "macroeconomics" ("big" economics), addressing issues of unemployment, inflation, monetary and fiscal policy for an entire economy. Microeconomics looks at interactions through individual markets, given scarcity and government regulation. A given market might be for a product, say fresh corn, or the services of a factor of production, say bricklaying. The theory considers aggregates of quantity demanded by buyers and quantity supplied by sellers at each possible price per unit. It weaves these together to describe how the market may reach equilibrium as to price and quantity or respond to market changes over time. This is broadly termed demand-and-supply analysis. Market structures, such as perfect competition and monopoly, are examined as to implications for behavior and economic efficiency. Analysis of change in a single market often proceeds from the simplifying assumption that behavioral relations in other markets remain unchanged, that is, partial-equilibrium analysis. General-equilibrium theory allows for changes in different markets and aggregates across all markets, including their movements and interactions toward equilibrium.
Another distinction is between mainstream economics and heterodox economics. One broad characterization describes mainstream economics as dealing with the "rationality-individualism-equilibrium nexus" and heterodox economics as defined by a "institutions-history-social structure nexus".
Markets
In microeconomics, production is the conversion of inputs into outputs. It is an economic process that uses resources to create a commodity that is suitable for exchange. This can include manufacturing, warehousing, shipping, and packaging. Some economists define production broadly as all economic activity other than consumption. They see every commercial activity other than the final purchase as some form of production.
Production is a process, and as such it occurs through time and space. Because it is a flow concept, production is measured as a "rate of output per period of time". There are three aspects to production processes, including the quantity of the commodity produced, the form of the good created and the temporal and spatial distribution of the commodity produced.
Opportunity cost expresses the idea that for every choice, the true economic cost is the next best opportunity. Choices must be made between desirable yet mutually exclusive actions. It has been described as expressing "the basic relationship between scarcity and choice." The notion of opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently. Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, pleasure or any other benefit that provides utility should also be considered.
Factors of production
The inputs or resources used in the production process are called factors of production. Possible inputs are typically grouped into six categories. These factors are:
- Raw materials
- Machinery
- Labour services
- Capital goods
- Land
- Enterprise
Economic efficiency
Economic efficiency describes how well a system generates the maximum desired output a with a given set of inputs and available technology. Efficiency is improved if more output is generated without changing inputs, or in other words, the amount of "friction" or "waste" is reduced. Economists look for Pareto efficiency, which is reached when a change cannot make someone better off without making someone else worse off.
Economic efficiency is used to refer to a number of related concepts. A system can be called economically efficient if:
- No one can be made better off without making someone else worse off.
- More output cannot be obtained without increasing the amount of inputs.
- Production ensures the lowest possible per unit cost.
Specialization, division of labour, and gains from trade
Specialization is considered key to economic efficiency because different individuals or countries have different comparative advantages. While one country may have an absolute advantage in every area over other countries, it could nonetheless specialize in the area which it has a relative comparative advantage, and thereby gain from trading with countries which have no absolute advantages. For example, a country may specialize in the production of high-tech knowledge products, as developed countries do, and trade with developing nations for goods produced in factories, where labor is cheap and plentiful. According to theory, in this way more total products and utility can be achieved than if countries produced their own high-tech and low-tech products. The theory of comparative advantage is largely the basis for the typical economist's belief in the benefits of free trade. This concept applies to individuals, farms, manufacturers, service providers, and economies. Among each of these production systems, there may be:
a corresponding division of labour with each worker having a distinct occupation or doing a specialized task as part of the production effort,
correspondingly different types of capital equipment and differentiated land uses.
Adam Smith's Wealth of Nations (1776) discusses the benefits of the division of labour. Smith noted that an individual should invest a resource, for example, land or labour, so as to earn the highest possible return on it. Consequently, all uses of the resource should yield an equal rate of return (adjusted for the relative riskiness of each enterprise). Otherwise reallocation would result. This idea, wrote George Stigler, is the central proposition of economic theory, and is today called the marginal productivity theory of income distribution. French economist Turgot had made the same point in 1766.
In more general terms, it is theorized that market incentives, including prices of outputs and productive inputs, select the allocation of factors of production by comparative advantage, that is, so that (relatively) low-cost inputs are employed to keep down the opportunity cost of a given type of output. In the process, aggregate output increases as a by product or by design. Such specialization of production creates opportunities for gains from trade whereby resource owners benefit from trade in the sale of one type of output for other, more highly-valued goods. A measure of gains from trade is the increased output (formally, the sum of increased consumer surplus and producer profits) from specialization in production and resulting trade.
Supply and demand, prices and quantities
The supply and demand model describes how prices vary as a result of a balance between product availability and demand. The graph depicts an increase (that is, right-shift) in demand from D1 to D2 along with the consequent increase in price and quantity required to reach a new equilibrium point on the supply curve (S).
The theory of demand and supply is an organizing principle to explain prices and quantities of goods sold and changes thereof in a market economy. In microeconomic theory, it refers to price and output determination in a perfectly competitive market. This has served as a building block for modeling other market structures and for other theoretical approaches.
For a given market of a commodity, demand shows the quantity that all prospective buyers would be prepared to purchase at each unit price of the good. Demand is often represented using a table or a graph relating price and quantity demanded (see boxed figure). Demand theory describes individual consumers as rationally choosing the most preferred quantity of each good, given income, prices, tastes, etc. A term for this is 'constrained utility maximization' (with income as the constraint on demand). Here, utility refers to the (hypothesized) preference relation for individual consumers. Utility and income are then used to model hypothesized properties about the effect of a price change on the quantity demanded. The law of demand states that, in general, price and quantity demanded in a given market are inversely related. In other words, the higher the price of a product, the less of it people would be able and willing to buy of it (other things unchanged). As the price of a commodity rises, overall purchasing power decreases (the income effect) and consumers move toward relatively less expensive goods (the substitution effect). Other factors can also affect demand; for example an increase in income will shift the demand curve outward relative to the origin, as in the figure.
Supply is the relation between the price of a good and the quantity available for sale from suppliers (such as producers) at that price. Supply is often represented using a table or graph relating price and quantity supplied. Producers are hypothesized to be profit-maximizers, meaning that they attempt to produce the amount of goods that will bring them the highest profit. Supply is typically represented as a directly proportional relation between price and quantity supplied (other things unchanged). In other words, the higher the price at which the good can be sold, the more of it producers will supply. The higher price makes it profitable to increase production. At a price below equilibrium, there is a shortage of quantity supplied compared to quantity demanded. This pulls the price up. At a price above equilibrium, there is a surplus of quantity supplied compared to quantity demanded. This pushes the price down. The model of supply and demand predicts that for given supply and demand curves, price and quantity will stabilize at the price that makes quantity supplied equal to quantity demanded. This is at the intersection of the two curves in the graph above, market equilibrium.
For a given quantity of a good, the price point on the demand curve indicates the value, or marginal utility to consumers for that unit of output. It measures what the consumer would be prepared to pay for the corresponding unit of the good. The price point on the supply curve measures marginal cost, the increase in total cost to the supplier for the corresponding unit of the good. The price in equilibrium is determined by supply and demand. In a perfectly competitive market, supply and demand equate cost and value at equilibrium.
Demand and supply can also be used to model the distribution of income to the factors of production, including labour and capital, through factor markets. In a labour market for example, the quantity of labour employed and the price of labour (the wage rate) are modeled as set by the demand for labour (from business firms etc. for production) and supply of labour (from workers).
Demand and supply are used to explain the behavior of perfectly competitive markets, but their usefulness as a standard of performance extends to any type of market. Demand and supply can also be generalized to explain variables applying to the whole economy, for example, quantity of total output and the general price level, studied in macroeconomics.
Diminishing marginal utility, given quantification
In supply-and-demand analysis, the price of a good coordinates production and consumption quantities. Price and quantity have been described as the most directly observable characteristics of a good produced for the market. Supply, demand, and market equilibrium are theoretical constructs linking price and quantity. But tracing the effects of factors predicted to change supply and demand—and through them, price and quantity—is a standard exercise in applied microeconomics and macroeconomics. Economic theory can specify under what circumstances price serves as an efficient communication device to regulate quantity. A real-world application might attempt to measure how much variables that increase supply or demand change price and quantity.
Marginalism is the use of marginal concepts within economics. Marginal concepts are associated with a specific change in the quantity used of a good or of a service, as opposed to some notion of the over-all significance of that class of good or service, or of some total quantity thereof. The central concept of marginalism proper is that of marginal utility, but marginalists following the lead of Alfred Marshall were further heavily dependent upon the concept of marginal physical productivity in their explanation of cost; and the neoclassical tradition that emerged from British marginalism generally abandoned the concept of utility and gave marginal rates of substitution a more fundamental rôle in analysis.
Market failure
Pollution can be a simple example of market failure. If costs of production are not borne by producers but are by the environment, accident victims or others, then prices are distorted.
The term "market failure" encompasses several problems which may undermine standard economic assumptions. Although economists categorise market failures differently the following categories emerge in the main texts.
Natural monopoly, or the overlapping concepts of "practical" and "technical" monopoly, involves a failure of competition as a restraint on producers. The problem is described as one where the more of a product is made, the greater the returns are. This means it only makes economic sense to have one producer.
Information asymmetries arise where one party has more or better information than the other. The existence of information asymmetry gives rise to problems such as moral hazard, and adverse selection, studied in contract theory. The economics of information has relevance in many fields, including finance, insurance, contract law, and decision-making under risk and uncertainty.
Incomplete markets is a term used for a situation where buyers and sellers do not know enough about each other's positions to price goods and services properly. Based on George Akerlof's Market for Lemons article, the paradigm example is of a dodgy second hand car market. Customers without the possibility to know for certain whether they are buying a "lemon" will push the average price down below what a good quality second hand car would be. In this way, prices may not reflect true values.
Public goods are goods which are undersupplied in a typical market. The defining features are that people can consume public goods without having to pay for them and that more than one person can consume the good at the same time.
Externalities occur where there are significant social costs or benefits from production or consumption that are not reflected in market prices. For example, air pollution may generate a negative externality, and education may generate a positive externality (less crime, etc.). Governments often tax and otherwise restrict the sale of goods that have negative externalities and subsidize or otherwise promote the purchase of goods that have positive externalities in an effort to correct the price distortions caused by these externalities.Elementary demand-and-supply theory predicts equilibrium but not the speed of adjustment for changes of equilibrium due to a shift in demand or supply. In many areas, some form of price stickiness is postulated to account for quantities, rather than prices, adjusting in the short run to changes on the demand side or the supply side. This includes standard analysis of the business cycle in macroeconomics. Analysis often revolves around causes of such price stickiness and their implications for reaching a hypothesized long-run equilibrium. Examples of such price stickiness in particular markets include wage rates in labour markets and posted prices in markets deviating from perfect competition.
Macroeconomic instability, addressed below, is a prime source of market failure, whereby a general loss of business confidence or external shock can grind production and distribution to a halt, undermining ordinary markets that are otherwise sound.
Environmental Scientist sampling water.
Some specialised fields of economics deal in market failure more than others. The economics of the public sector is one example, since where markets fail, some kind of regulatory or government programme is the remedy. Much environmental economics concerns externalities or "public bads". Policy options include regulations that reflect cost-benefit analysis or market solutions that change incentives, such as emission fees or redefinition of property rights. Environmental economics is related to ecological economics but there are differences.
- Raw materials
- Machinery
- Labour services
- Capital goods
- Land
- Enterprise
Economic efficiency
Economic efficiency describes how well a system generates the maximum desired output a with a given set of inputs and available technology. Efficiency is improved if more output is generated without changing inputs, or in other words, the amount of "friction" or "waste" is reduced. Economists look for Pareto efficiency, which is reached when a change cannot make someone better off without making someone else worse off.
Economic efficiency is used to refer to a number of related concepts. A system can be called economically efficient if:
- No one can be made better off without making someone else worse off.
- More output cannot be obtained without increasing the amount of inputs.
- Production ensures the lowest possible per unit cost.
These definitions of efficiency are not exactly equivalent. However, they are all encompassed by the idea that nothing more can be achieved given the resources available.
Specialization, division of labour, and gains from trade
Specialization is considered key to economic efficiency because different individuals or countries have different comparative advantages. While one country may have an absolute advantage in every area over other countries, it could nonetheless specialize in the area which it has a relative comparative advantage, and thereby gain from trading with countries which have no absolute advantages. For example, a country may specialize in the production of high-tech knowledge products, as developed countries do, and trade with developing nations for goods produced in factories, where labor is cheap and plentiful. According to theory, in this way more total products and utility can be achieved than if countries produced their own high-tech and low-tech products. The theory of comparative advantage is largely the basis for the typical economist's belief in the benefits of free trade. This concept applies to individuals, farms, manufacturers, service providers, and economies. Among each of these production systems, there may be:
a corresponding division of labour with each worker having a distinct occupation or doing a specialized task as part of the production effort,
correspondingly different types of capital equipment and differentiated land uses.
Adam Smith's Wealth of Nations (1776) discusses the benefits of the division of labour. Smith noted that an individual should invest a resource, for example, land or labour, so as to earn the highest possible return on it. Consequently, all uses of the resource should yield an equal rate of return (adjusted for the relative riskiness of each enterprise). Otherwise reallocation would result. This idea, wrote George Stigler, is the central proposition of economic theory, and is today called the marginal productivity theory of income distribution. French economist Turgot had made the same point in 1766.
In more general terms, it is theorized that market incentives, including prices of outputs and productive inputs, select the allocation of factors of production by comparative advantage, that is, so that (relatively) low-cost inputs are employed to keep down the opportunity cost of a given type of output. In the process, aggregate output increases as a by product or by design. Such specialization of production creates opportunities for gains from trade whereby resource owners benefit from trade in the sale of one type of output for other, more highly-valued goods. A measure of gains from trade is the increased output (formally, the sum of increased consumer surplus and producer profits) from specialization in production and resulting trade.
Supply and demand, prices and quantities
The supply and demand model describes how prices vary as a result of a balance between product availability and demand. The graph depicts an increase (that is, right-shift) in demand from D1 to D2 along with the consequent increase in price and quantity required to reach a new equilibrium point on the supply curve (S).
The theory of demand and supply is an organizing principle to explain prices and quantities of goods sold and changes thereof in a market economy. In microeconomic theory, it refers to price and output determination in a perfectly competitive market. This has served as a building block for modeling other market structures and for other theoretical approaches.
For a given market of a commodity, demand shows the quantity that all prospective buyers would be prepared to purchase at each unit price of the good. Demand is often represented using a table or a graph relating price and quantity demanded (see boxed figure). Demand theory describes individual consumers as rationally choosing the most preferred quantity of each good, given income, prices, tastes, etc. A term for this is 'constrained utility maximization' (with income as the constraint on demand). Here, utility refers to the (hypothesized) preference relation for individual consumers. Utility and income are then used to model hypothesized properties about the effect of a price change on the quantity demanded. The law of demand states that, in general, price and quantity demanded in a given market are inversely related. In other words, the higher the price of a product, the less of it people would be able and willing to buy of it (other things unchanged). As the price of a commodity rises, overall purchasing power decreases (the income effect) and consumers move toward relatively less expensive goods (the substitution effect). Other factors can also affect demand; for example an increase in income will shift the demand curve outward relative to the origin, as in the figure.
Supply is the relation between the price of a good and the quantity available for sale from suppliers (such as producers) at that price. Supply is often represented using a table or graph relating price and quantity supplied. Producers are hypothesized to be profit-maximizers, meaning that they attempt to produce the amount of goods that will bring them the highest profit. Supply is typically represented as a directly proportional relation between price and quantity supplied (other things unchanged). In other words, the higher the price at which the good can be sold, the more of it producers will supply. The higher price makes it profitable to increase production. At a price below equilibrium, there is a shortage of quantity supplied compared to quantity demanded. This pulls the price up. At a price above equilibrium, there is a surplus of quantity supplied compared to quantity demanded. This pushes the price down. The model of supply and demand predicts that for given supply and demand curves, price and quantity will stabilize at the price that makes quantity supplied equal to quantity demanded. This is at the intersection of the two curves in the graph above, market equilibrium.
For a given quantity of a good, the price point on the demand curve indicates the value, or marginal utility to consumers for that unit of output. It measures what the consumer would be prepared to pay for the corresponding unit of the good. The price point on the supply curve measures marginal cost, the increase in total cost to the supplier for the corresponding unit of the good. The price in equilibrium is determined by supply and demand. In a perfectly competitive market, supply and demand equate cost and value at equilibrium.
Demand and supply can also be used to model the distribution of income to the factors of production, including labour and capital, through factor markets. In a labour market for example, the quantity of labour employed and the price of labour (the wage rate) are modeled as set by the demand for labour (from business firms etc. for production) and supply of labour (from workers).
Demand and supply are used to explain the behavior of perfectly competitive markets, but their usefulness as a standard of performance extends to any type of market. Demand and supply can also be generalized to explain variables applying to the whole economy, for example, quantity of total output and the general price level, studied in macroeconomics.
Diminishing marginal utility, given quantification
In supply-and-demand analysis, the price of a good coordinates production and consumption quantities. Price and quantity have been described as the most directly observable characteristics of a good produced for the market. Supply, demand, and market equilibrium are theoretical constructs linking price and quantity. But tracing the effects of factors predicted to change supply and demand—and through them, price and quantity—is a standard exercise in applied microeconomics and macroeconomics. Economic theory can specify under what circumstances price serves as an efficient communication device to regulate quantity. A real-world application might attempt to measure how much variables that increase supply or demand change price and quantity.
Marginalism is the use of marginal concepts within economics. Marginal concepts are associated with a specific change in the quantity used of a good or of a service, as opposed to some notion of the over-all significance of that class of good or service, or of some total quantity thereof. The central concept of marginalism proper is that of marginal utility, but marginalists following the lead of Alfred Marshall were further heavily dependent upon the concept of marginal physical productivity in their explanation of cost; and the neoclassical tradition that emerged from British marginalism generally abandoned the concept of utility and gave marginal rates of substitution a more fundamental rôle in analysis.
Market failure
Pollution can be a simple example of market failure. If costs of production are not borne by producers but are by the environment, accident victims or others, then prices are distorted.
The term "market failure" encompasses several problems which may undermine standard economic assumptions. Although economists categorise market failures differently the following categories emerge in the main texts.
Natural monopoly, or the overlapping concepts of "practical" and "technical" monopoly, involves a failure of competition as a restraint on producers. The problem is described as one where the more of a product is made, the greater the returns are. This means it only makes economic sense to have one producer.
Information asymmetries arise where one party has more or better information than the other. The existence of information asymmetry gives rise to problems such as moral hazard, and adverse selection, studied in contract theory. The economics of information has relevance in many fields, including finance, insurance, contract law, and decision-making under risk and uncertainty.
Incomplete markets is a term used for a situation where buyers and sellers do not know enough about each other's positions to price goods and services properly. Based on George Akerlof's Market for Lemons article, the paradigm example is of a dodgy second hand car market. Customers without the possibility to know for certain whether they are buying a "lemon" will push the average price down below what a good quality second hand car would be. In this way, prices may not reflect true values.
Public goods are goods which are undersupplied in a typical market. The defining features are that people can consume public goods without having to pay for them and that more than one person can consume the good at the same time.
Externalities occur where there are significant social costs or benefits from production or consumption that are not reflected in market prices. For example, air pollution may generate a negative externality, and education may generate a positive externality (less crime, etc.). Governments often tax and otherwise restrict the sale of goods that have negative externalities and subsidize or otherwise promote the purchase of goods that have positive externalities in an effort to correct the price distortions caused by these externalities.Elementary demand-and-supply theory predicts equilibrium but not the speed of adjustment for changes of equilibrium due to a shift in demand or supply. In many areas, some form of price stickiness is postulated to account for quantities, rather than prices, adjusting in the short run to changes on the demand side or the supply side. This includes standard analysis of the business cycle in macroeconomics. Analysis often revolves around causes of such price stickiness and their implications for reaching a hypothesized long-run equilibrium. Examples of such price stickiness in particular markets include wage rates in labour markets and posted prices in markets deviating from perfect competition.
Macroeconomic instability, addressed below, is a prime source of market failure, whereby a general loss of business confidence or external shock can grind production and distribution to a halt, undermining ordinary markets that are otherwise sound.
Environmental Scientist sampling water.
Some specialised fields of economics deal in market failure more than others. The economics of the public sector is one example, since where markets fail, some kind of regulatory or government programme is the remedy. Much environmental economics concerns externalities or "public bads". Policy options include regulations that reflect cost-benefit analysis or market solutions that change incentives, such as emission fees or redefinition of property rights. Environmental economics is related to ecological economics but there are differences.
Sustainable development portal
Most environmental economists have been trained as economists. They apply the tools of economics to address environmental problems, many of which are related to so-called market failures—circumstances wherein the "invisible hand" of economics is unreliable. Most ecological economists have been trained as ecologists, but have expanded the scope of their work to consider the impacts of humans and their economic activity on ecological systems and services, and vice-versa. This field takes as its premise that economics is a strict subfield of ecology. Ecological economics is sometimes described as taking a more pluralistic approach to environmental problems and focuses more explicitly on long-term environmental sustainability and issues of scale. Agricultural economics is one the oldest and most established fields of economics. It is the study of the economic forces that affect the agricultural sector and the agricultural sector's impact on the rest of the economy. It is an area of economics that, thanks to the necessity of applying microeconomic theories to complex real world situations, has given rise to many important advances of more general applicability; the role of risk and uncertainty, the behaviour of households and links between property rights and incentives. More recently policy areas such as international commodity trade and the environment have been stressed.
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