Economics generally is the study of how people allocate scarce resources among alternative uses. Economics is the social science that studies the production, distribution, and consumption of goods and services. The word ‘economics’ is from the Greek for (oikos: house) and (nomos: custom or law), hence “rules of the house(hold).”
A definition that captures much of modern economics is that of : “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 choice, as affected by incentives and resources.
One of the uses of economics is to explain how economies work and what the relations are between economic players in the larger society. Methods of economic analysis have been increasingly applied to fields that involve people (officials included) making choices in a social context, such as crime , education , the family, health, law, politics, religion , social institutions, and war .
History of Economics
Although discussions about production and distribution have a long history, economics in its modern sense is conventionally dated from the publication of Adam Smith’s The Wealth of Nations in 1776. Smith is also the founder of economics. In this work Smith defines the subject in practical terms:
Political economy, considered as a branch of the science of a statesman or legislator, proposes two distinct objects: first, to supply a plentiful revenue or product for the people, or, more properly, to enable them to provide such a revenue or subsistence for themselves; and secondly, to supply the state or commonwealth with a revenue sufficient for the public services. It proposes to enrich both the people and the sovereign.
Smith referred to the subject as ‘political economy’, but that term was gradually replaced in general usage by ‘economics’ after 1870.
Areas of study
Areas of economics may be divided or classified in various ways; however, an economy is usually analyzed in either of two ways:
* Microeconomics examines the economic behavior of agents (including businesses and households) and their interactions through individual markets, given scarcity and government regulation. Within microeconomics, general equilibrium theory aggregates across all markets, including their movements and interactions toward equilibrium.
* Macroeconomics examines an economy as a whole “top down” with a view to understanding interactions between the broadest aggregates such as national income and output, employment and inflation and broad aggregates like total consumption and investment spending and their components.
Since at least the 1960s, macroeconomics has been characterized by further micro-based modeling as to rationality of players and efficient use of market information, addressing a long-standing concern about inconsistent developments of the same subject.
The vast majority of economic theory is in terms of either macro or micro economics. However, a few authors also argue that ‘mesoeconomics’, which considers the intermediate level of economic organization such as markets and other institutional arrangements, should be considered an additional branch of economic study.Mesoeconomics “unifies and reconciles the macro and micro approaches and is a “richer” way of studying the dynamics of economics than the two traditional models.
Financial economics has traditionally been considered a part of economics, as its body of results emerges naturally from microeconomics. Today, however, finance has established itself as a separate, though closely related, discipline.
Economics can also be divided into numerous sub-disciplines including: development economics, economic geography,environmental economics, industrial organization, information economics, institutional economics, international economics, labor economics, and public finance.
Another division of the subject distinguishes positive economics, which seeks to predict and explain economic phenomena (“what is”), from normative economics (“what ought to be”), which orders choices and actions by some criterion; such orderings necessarily involve value judgments, including selection from criteria.
Separate from mainstream or neoclassical economics, which underlies most of the assumptions and techniques described in this entry, is heterodox economics. Heterodox economics refers to approaches or schools of economic thought that do not conform to mainstream economics, which has largely developed from neoclassical economics in the late 19th century. While mainstream economics may be defined in terms of the “rationality-individualism-equilibrium nexus”, heterodox economics may be defined in terms of a “institutions-history-social structure nexus“.
Language and reasoning
Economics relies on rigorous styles of argument. Economic method has several interacting parts:
* Formulation of testable 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, buying, selling, and prices.
* Collection of economic data. The data may include values of commodity prices and quantities, for example, the cost to hire a worker for a week, or the quantity purchased of a particular service.
* 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 sometimes involves advanced mathematics. For instance, an established 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.
Economics typically employs two types of equations:
(1) Identity equations are used for defining how certain economic variables are calculated or related to each other. Identity equations are tautological in that the purpose is to define rather than to explain. An example is the value of national output, the price level times the quantity of output P•Q. Another example is equation of exchange P•Q = M•V. This relates the value of national output to the money supply and velocity of money. Given values of the other three terms in the equation, velocity V can be calculated.
(2) Descriptive equations are used to explain the behaviour of the economic agent(s) examined. For example, in the quantity theory of money, velocity in the equation of exchange is hypothesized to give a positive qualitative relation between the money supply M and value of output or the price level. The point is not that V is a constant but that it is stable enough for changes in the money supply to help explain changes in the value of output or the price level.
Mainstream economics and schools of economic thought
Mainstream economics is a term used to distinguish economics in general from heterodox approaches and schools within economics. It 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 expresses an implicit relationship between competing alternatives. Such costs, considered as prices in a market economy are used for analysis of economic efficiency or for predicting responses to disturbances in a market. In a planned economy comparable shadow price relations must be satisfied for the efficient use of resources.
Economists represent incentives and costs as playing a pervasive role in shaping decision making. An immediate example of this is the consumer theory of individual demand, which isolates how prices (as costs) and income affect quantity demanded.
* Neoclassical economics as part of a Neo-classical synthesis with Keynesian macro-economics is the dominant form of economics used today, and is the main source of theory for mainstream economists. It is often referred to by its critics as Orthodox Economics. The more specific definition : “the science which studies human behavior as a relation between scarce means having alternative uses.”
* Classical economics: Also called political economy, this was the original form of mainstream economics of the Eighteenth and Nineteenth Centuries. Classical economics focuses on the tendency of markets to move to equilibrium and on objective theories of value. Neo-classical economics differs from classical economics primarily in being utilitarian in its value theory and using marginal theory as the basis of its models and equations. Marxist economics also descends from classical theory.
* Keynesian economics: This school has developed from the work of John Maynard Keynes and focused on macroeconomics in the short-run, particularly the rigidities caused when prices are fixed. It has two successors:
* Post-Keynesian economics: 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 micro foundations for their models based on real-life practices rather than simple optimizing models.
* New-Keynesian economics: 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 micro foundations and optimizing behavior but focus more narrowly on standard Keynesian themes such as price and wage rigidity.
* Marxian economics: Descended from the work of Karl Marx, this school focuses on the labor theory of value and what Marx considered to be the exploitation of labour by capital. Thus, in Marxian economics, the labour theory of value is a method for measuring the exploitation of labour in a capitalist society, rather than simply a theory of price.
* Austrian economics: This school focuses on the role of the entrepreneur creating temporary market power and being the drive for economic growth.
* Complexity economics: One of the more recent schools of thought in modern economics , complexity economics views economic systems as complex adaptive systems rather than as closed equilibrium systems.
* Agent-Based Computational Economics (ACE): ACE is the computational study of economic processes modeled as dynamic systems of interacting agents. Here “agent” is broadly interpreted as a bundle of data and methods representing a social, biological, or physical entity constituting part of a computationally constructed “virtual world.”
* Eclectic Economists: The term ‘eclectic’ means selecting and using what seems best from various sources, systems or schools of thought. Eclectic economists tend to economize to get an optimal result for the problem at hand. The assumption of utility can for example be used, not to imply that people really have such a utility, but as an efficient approximation. Such economists might be ‘main stream’ or neoclassical in one publication and do political economy in another publication.
* heterodox economics: Many schools of thought at variance with some or all of the particular microeconomic formalism of neoclassical economics have, in the past, been lumped together in this category. These include: institutional economics, Marxist economics, feminist economics, socialist economics, and green economics.
The first scientific approach to the subject was inaugurated by Aristotle, whose influence is still recognized. Adam Smith, regarded by some as the ‘father of economics’, 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. Previous definitions defined wealth as gold. Some argued that gold without increased activity simply serves to raise prices.
Stuart defined economics as “The practical science of production and distribution of wealth”; even though it does not include the vital role of consumption. For him wealth is defined as the stock of useful things.
Definitions in terms of wealth emphasize production and consumption. The accounting measures usually used measure the pay received for work and the price paid for goods, and do not deal with the economic activities of those not significantly involved in buying and selling (for example, retired people, beggars, peasants). For economists of this period, they are considered non-productive, and non-productive activity is considered a kind of cost on society.
Later modern view of economics as primarily a study of man and of human welfare, not of money. “Political Economy or Economics is a study of mankind in the ordinary business of Life; it examines that 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 (that is, $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 innate human wants and desires.
Marxist economics still focuses on a welfare definition. In addition, several critiques of mainstream economics begin from the argument that current economic practice does not adequately measure welfare, but only monetized activity, which is an inadequate approximation of welfare.
Scarcity suggests all things in the world are in finite supply. People therefore have to make choices.
Scarcity 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 concept of value is central to economics. An observable measure of it is market price.
Adam Smith defined labor as the underlying source of value, and the “labor theory of value” underlies the work classical economists. This theory argues that a good or service is worth the labor 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, Austrian School economists use the marginal theory of value.
Neoclassical economics, distinguishes value (as determined on the demand side) from cost (on the supply side), with price determined by supply and demand. In a competitive market, demand and supply interact to determine price and equate cost and value. Economic analysis considers not only the allocation of output for different uses but the distribution of income to the factors of production, including labour and capital, through factor markets.
Supply and demand
The supply and demand model describes how prices vary as a result of a balance between product availability and demand.
In microeconomic theory supply and demand attempts to describe, explain, and predict the price and quantity of goods sold in perfectly 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 quantity of a product that a consumer or buyer would be willing and able to buy at any given price in a given period of time. Most economic models assume that consumers make rational choices about how much to buy in order to maximize their utility – they spend their income on the products that will give them the most happiness at the least cost. The law of demand states that, in general, price and quantity demanded are inversely related. In other words, the higher the price of a product, the less of it consumers will buy.
Supply is the quantity of goods that a producer or a supplier is willing to bring into the market for the purpose of sale at any given price in a given period of time. Supply is often represented as a table or a graph relating price and quantity supplied. Like consumers, producers are assumed to be utility-maximizing, attempting to produce the amount of goods that will bring them the greatest possible profit. The law of supply states that price and quantity supplied are directly proportional. In other words, the higher the price of a product, the more of it producers will create.
The theory of supply and demand is crucial to explaining the market economy in that it explains the mechanisms by which prices and levels of production are set.
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. 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 the value of a good correctly. In mainstream market economics, where there are significant scarcities not factored into price, there is said to be an externalization, which is a cost or benefit to actors other than the buyer and seller, of which many examples exist, including pollution (a cost to others) and education (a benefit to others). Market economics predicts that scarce goods which are under-priced because of externalities are over-consumed , and that scarce goods that are over-priced are under-consumed. This leads into public goods theory. 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 distortion in price caused by these externalities.
Neoclassical economics is characterized by maximization (leisure time, wealth, health, and other sources of 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. If all other market variables are held constant. When the price is rising, this indicates the commodity is becoming relatively scarcer. When the price is falling, this indicates 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”.
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. This is often termed the marginal revolution in economic thought.
Development of economic thought
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.
Within macroeconomics there is, in general order of their appearance in the literature; classical economics, Keynesian economics, neo-classical synthesis, post-Keynesian economics, monetarism, new classical economics, and supply-side economics. New alternative developments include evolutionary economics, dependency theory, and world systems theory.
Criticism and contrarian perspectives
Is economics a science?
Unlike the natural sciences, economics yields no natural laws or universal constants due to its reliance on non-physical arguments, so this has led some critics, to argue economics is not a science. In general, economists reply that while this aspect presents serious difficulties, they do in fact test their hypotheses using statistical methods such as econometrics and data generated in the real world. The field of experimental economics has seen efforts to test at least some predictions of economic theories in a simulated laboratory setting .
Criticisms of economic theory and practice
Economics has been criticized for its reliance on unrealistic, unobservable, or unverifiable assumptions. One response to this criticism has been that the unrealistic assumptions result from abstraction from unimportant details, and that such abstraction is necessary in a complex real world. Rather than unrealistic assumptions compromising the epistemic worth of economics, such assumptions are essential for economic knowledge. One study has termed this explanation the “abstractionist defense”. The study concludes that that this “abstractionist defense” does not invalidate the criticism of the unrealistic assumptions.
Economics is a field of study with various schools and currents of thought. As a result, there exists a considerable distribution of opinions, approaches and theories. Some of these reach opposite conclusions or, due to the differences in underlying assumptions, contradict each other.
Although the conventional way of connecting an economic model with the world is through econometric analysis, Professor Deirdre McCloskey cites many examples in which professors of econometrics were able to use the same data to both prove and disprove the applicability of a model’s conclusions. She argues the vast efforts expended by economists on analytical equations is essentially wasted effort.
Common Fallacies in the Homo Economicus model
* Rationality = Self-Interest: This refers to the common axiom or belief shared by many mainstream economists that rationality implies self-interest and vice-versa. This does not, however, preclude altruism. Altruism can be viewed as a case in which the individual’s self-interest includes doing good for others. Other views claim that this does not leave much room for altruism, and in fact discourages it, rather like a global prisoner’s dilemma .i.e.: If “rational” people are not altruistic, then I shouldn’t be altruistic either, ad infinitum.
* Well-Being = Consumption: This refers to the common axiom or belief shared by many mainstream economists that human beings are happy when they consume, and unhappy when not consuming. Added to the other common assumption of insatiability, this implies human beings can never remain happy.
* Atomism: This refers to the common axiom or belief shared by many mainstream economists that human beings are atomistic, ie.their preferences are independant. This axiom ignores among other things: education, conditioning, advertising, marketing, conspicuous consumption, and modern quantum mechanics etc.
The most common defense of the above axioms is that they make the problem tractable.
Ethics and economics
The relationship between economics and ethics is complex. Many economists consider normative choices and value judgments, like what needs or wants, or what is good for society, to be political or personal questions outside the scope of economics. Once a person or government has established a set of goals, however, economics can provide insight as to how they might best be achieved.
Others see the influence of economic ideas, such as those underlying modern capitalism, to promote a certain system of values with which they may or may not agree. According to some thinkers, a theory of economics is also, or implies also, a theory of moral reasoning.
The premise of ethical consumerism is that one should take into account ethical and environmental concerns, in addition to financial and traditional economic considerations, when making buying decisions.
Effect on society
Some would say that market forms and other means of distribution of scarce goods, suggested by economics, affect not just their “desires and wants” but also “needs” and “habits”. Much of so-called economic “choice” is considered involuntary, certainly given by social conditioning because people have come to expect a 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. Socialists view it as a failure of economics to respect society.
The older term for economics, political economy, is still often used instead of “economics”, especially by certain economists such as Marxists. The use of this term often signals a basic disagreement with the terminology or paradigm of market economics. Political economy explicitly brings social 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 have a “political economy” department rather than an “economics” department.
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.