Economics is the social science studying theproduction, distribution and consumption of goods and services. It describes them in terms of the tradeoffs between competingalternatives as observed through measurable quantities such as input, price and output.
Economists study human behavior and welfare as a relationship between scarce means (which have other uses) and sociallyrequired ends. ( Lionel Robbins , 1935 ) The field comprises a number of (potentially irreconcilable) theories about systems of production anddistribution. Aspects receiving particular attention in economics are resource allocation, production, distribution or trade , and competition .
Understanding choices by individuals and groups is central. With scarcity, choosing one alternative implies forgoing anotheralternative (the opportunity cost ). For instance, learning oneskill implies time not spent learning another. In a market setting, the currently dominant theory is that scarcity is quantifiedby price relationships.
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 adoptutilitarian objectives. One example of this is the idea of a utilityfunction , which is assumed to be the means by which individual economic actors decide what makes them "happy" and whatdecisions they make in pursuit of that happiness.
Economics is said to be positive when itattempts to explain the consequences of different choices given a set of assumptions and normative when it prescribes a certain route of action. Since failures of economic systems have lead to famines,depressions and pressures that lead to war and revolution, economics has been referred to as "the dismal science", and its studyis filled with both utopian aspirations, and polemical condemnations. In the end, the study of economics attempts to rootdisputes in matters of measurable fact, rather than ideology or bias.
Areas of study in economics
Economics is usually divided into two main branches:
Attempts to join these two branches or to refute the distinction between them have been important motivators in much of recenteconomic thought, especially in the late 1970s and early 1980s . Today, the consensus view is arguably that good macroeconomics has solid microeconomic foundations; i.e. itspremises 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.Some of these subdisciplines include: international economics, labour economics, welfare economics, resource economics,environmental economics, managerial economics, financial economics, urban economics, and spatial economics.
There are also methodologies used by economists whose underlying theories are important.
Other subdivisions are possible. Finance has traditionally been considered a partof economics - as its body of results emerges naturally from microeconomics - but has today effectively establisheditself 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 economicsanalysis focuses on decision making, it can be applied (with varying degrees of success) to any field where people are faced withalternatives - education , marriage , health , etc. Public Choice Theory studies how economic analysis can apply to those fields traditionally consideredoutside of economics. The areas of investigation in Economics therefore overlap with other social sciences, including political science and sociology . See political economy for the study ofeconomics in the context of political science. The most prevalent political economy is loosely called capitalism .
Supply and Demand
Mainstream economics does not assume a priori that markets are preferable toother forms of social organization. In fact, much analysis is devoted to cases where so-called market failures lead to resource allocation that is suboptimal by some standard. In such cases,economists may attempt to find policies that will avoid waste; directly by government control, indirectly by regulation thatinduces market participants to act in a manner consistent with optimal welfare, or by creating 'missing' markets to enableefficient trading where none had previously existed. This is studied in the field of collective action .
Mainstream economics centers around the relationship between supply and demand . Supply can be said to be the amount of a given commodity available at a given price, and demand can be said to be the amount of a commodity that would bepurchased at a given price. Mainstream economic theory centers on creating a series of supply and demand relationships,describing them as equations, and then adjusting for factors which produce "stickiness" between supply and demand. Analysis isthen done to see what "trade offs" are made in the "market" which is the negotiation between sellers and buyers. Analysis is doneas to what point the ability of sellers to sell becomes less useful than other opportunities. This is related to "marginal" costs- or the price to produce the last unit that can be sold profitably, versus the chance of using the same effort to engage in someother activity.
It should be noted that on supply and demand curves both are drawn as a function of price. Neither is represented as afunction of the other. Rather the two functions interact in a manner that is representative of market outcomes. The curves alsoimply a somewhat neutral means of measuring price. In practice any currency or commodity used to measure price is also thesubject of supply and demand.
The market 'clears' at the point where all the supply and demand at a given price balance. That is, the amount of a commodityavailable at a given price equals the amount that buyers are willing to purchase at that price. It is assumed that there is aprocess that will result in the market reaching this point, but exactly what the process is in a real situation is an ongoingsubject of research. Markets which do not clear will react in some way, either by a change in price, or in the amount produced,or in the amount demanded. Graphically the situation can be represented by two curves; one showing the price-quantitycombinations buyers will pay for, or the demand curve , one showing thecombinations sellers will sell for, or the supply curve . The market clearswhere the two are in equilibrium, that is where the curves intersect. In a general equilibrium model, all markets in all goods clear simultaneously and the 'price' can bedescribed entirely in terms of tradeoffs with other goods. For a century most economists believed in Say's Law , which states that markets, as a whole, would always be clear and in balance.
But for there to be trading between supply and demand, there must be some theory as to how people make decisions.
Much of economics assumes that individuals seek to maximize their happiness or utility: however, whether they rationally attempt to optimize their well-being given available information is asource of much debate. In this view, which underpins much of economic writing, individuals make choices between alternativesbased on their estimation of which will yield the best results. Many important economic ideas, such as the "efficient markethypothesis" rest on this view of decision making.
However, this framework, once called " homo economicus " - has fordecades been the focus of unease even by those who apply it. MiltonFriedman once defended the idea by saying that inaccurate assumptions could produce accurate results. Alfred Marshall wascareful to differentiate the tendency to maximize happiness, with maximizing economic well being. The limits of rationality havebeen the subject of intense study, for example Herbert Simon 's model for" bounded rationality ", which was awarded a Nobel Prize in1978. More recently, irrational behavior and imperfect information have increasingly been the subject of formal modelling, oftenreferred to as behavioral economics, for which Daniel Kahneman won aNobel Prize in 2002. An example is the growing field of behavioralfinance which combines previous theory with cognitivepsychology .
The new model of information and decision making focuses on asymetrical information, when some participants have key factsthat others do not, and on decision making based, not on the economic pressures, but on the decisions of other economic actors.Asymmetrical information and behavioral dynamics lead to different conclusions: in a world of asymmetrical information, marketsare generally not efficient, and inefficiences grow up as means of hedging against information. While not yet universallyaccepted, it is increasingly influential in policy, for example the writing of Joseph Stiglitz and financial modelling.
In order to measure the ebb and flow of supply and demand, a measurable value is needed, the oldest and most commonly used isPrice, or the going rate of exchange between buyers and sellers in a market. Price theory, therefore, charts themovement 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 andconvenience. 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 is when changes to aneconomy occur through price, where 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 observed fact that in manymarkets prices do not move fluidly. Economic policy often revolves around arguments as to what is causing "economic friction", orprice stickiness, and which is, therefore, preventing the supply and demand from reaching equilibrium.
Another area of economic controversy is on whether price measures value correctly. In mainstream market economics, where thereare 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.
Because scarcity and decision are central to economic theory, the question of what is the basic trade-off in economics is ofcentral importance. In every economic theory, there is a basic exchange of two or more ultimately scarce commodities. For AdamSmith, it was defined as the trading of time, or convenience, for money. For example, a person could live near town, and pay morefor rent or his domicile, or live farther away and pay less, "paying the difference out of his convenience".
This view, that the primary trade-off involved in economics is between time and money, has several challengers. Each of thesebases its view of scarcity on a different fundamental trade-off. A small number of economists prefer to define economics as thestudy of how and why people trade ; this definition implies relative scarcity.
In economic theory, the price level is determined by the "marginal" cost and "marginal" utility. The price of all goods willbe the cost of making the last one that people will purchase, the price of all the employees in a firm will be the cost of hiringthe last one the firm 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 an individual gets out of a purchase versus purchasing less. Marginal rewardsare often subjected to "diminishing returns", getting less reward out of more production or consumption - the 10th candy bardoesn't 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 analyzehow economic systems will react. Marginal cost of production divides costs into "fixed" costs which must be paid regardless ofhow many of a commodity are produced, and "variable costs". The marginal cost is the variable cost of the last unit, plus thepercentage of fixed costs. Marginalism states that when the profit from the next unit will be zero, that unit will not beproduced.
It could be argued that beneath an economic theory is a theory of value#economics . Value can be defined as the underlying activity which economics describes and measures. It is whatis "really" happening.
Adam Smith defined "labor" 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 "labor theory of value" argues that a good orservice is worth the labor that it takes to produce. For most, this value determines a commodity's price. This labor theory ofprice and the closely related cost-of-production theory of value dominates the work of most classical economists, butthey are far from the only accepted basis for "value". For example neoclassical economists and AustrianSchool economists prefer the marginal theory ofvalue .
"Market theory" argues that there is no "value" separate from price, that the market incorporates all available informationinto price, and that so long as markets are open, that price and 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 relationshipto that basic scarcity. Theories based on economics being limited by energy or based on a "gold standard" are of this type.
All of these value theories are used in current economic work.
Economic language and reasoning
Economics relies on rigorous styles of argument more than other social sciences. This is at least, the purported ideal ofprofessionals in the field. Economic methodology has several interacting parts;
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 the identical to what is oftenreferred to as mathematical economics ; this includes,but is not limited to, an attempt to set microeconomics , in particulargeneral equilibrium on solid mathematical foundation. Some reject mathematical economics: The Austrian School of economics believes that anything beyond simple logic is often unnecessary andinappropriate for economic analysis. In fact, the entire empirical-deductive framework sketched in this section may be rejectedoutright by this school. However, we believe the framework sketched here represents accurately the current predominant view ofeconomics.
Development of economic thought
The term economics was coined around 1870 and popularized by Alfred Marshall , as a substitute for the earlier term political economy which has been used through the 18-19th centuries, with Adam Smith , DavidRicardo and Karl Marx as its main thinkers and which today is frequentlyreferred 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".
Modern economic thought is usually considered to have begun with Adam Smith in the late 18th century , although earlier thinkers such as the Spanish Scholastics and the physiocrats made important contributions. For an overview of precursors to Smith as well as an overview ofschools that have developed later, see history ofeconomic thought . Modern mainstream economics can be said to begin with Mills focusing on what was then called "politicaleconomy" on "wealth" which he defined exclusively in relation to the exchange value of objects, or what would now be called price . "Classical Economics," as the economic work of the period is called, forms thefoundation of micro-economics .
The central idea promoted by Smith was that the competition between various suppliers and buyers would produce the bestpossible distribution of goods and services, because it would encourage individuals to specialize and improve their capital, soas to produce more value with the same labor. As with its contemporaneous idea of evolution , it rests on the belief that large systems can be self-regulating by the activity of their parts,without specific direction. Smith's formulation is called the "invisible hand" and is still the centerpiece of market economics, and capitalism inparticular.
In the 19th century, Karl Marx synthesized a variety of schools of thoughtinvolving the social distribution of resources, including the work of Adam Smith, as well as socialism and egalitarianism, andused the systematic approach to logic taken from philosopher Hegel to produce "Das Kapital". His work was the most widely adhered-to critique of marketeconomics during much of the 19th and 20th centuries. The Marxist paradigm of economics is not generally held in high regard bymarket economists, though some concepts from his work are occasionally used in mainstream contexts, particularly in labor economics and in political economy . The term Marxian is in some contexts usedto describe work which accepts concepts from his work but does not necessarily subscribe to the political thrust of Marxist thought.
The late 19th century also saw the "marginal revolution" or neo-classical economics, which altered the basis of economic reasoning to includge concepts such as marginalism and opportunitycost . In addition to Marshall, the work of Carl Menger was influential indisseminating the framework of economics as the opportunity cost of decisions made at the margins of economic activity.
In the early 20th century, economics became increasingly statistical, and the study of econometrics became increasingly important. Statistical treatment of price, unemployment, money supply andother variables, as well as the compiling of these statistics, became more and more central to economic writing and disputeswithin the field of economics.
Macroeconomics diverged from microeconomics with Keynes inthe 1920s , and was codified in the 1930s byKeynes and others, particularly John Hicks . It grew in popularity as a reactionto the Great Depression . Keynes had been an influential exponent ofthe importance of central banking and government involvement in economic affairs, as well as a critic of the political economy ofthe post World War I period. His "General Theory" encapsulated bothcriticisms of classical theory that had been levelled by ThorsteinVeblen and others, as well a method for economic management of aggregate demand. For an overview of a number of competingschools, see macroeconomics .
Many economists use a combination of Neoclassical microeconomics and Keynesian macroeconomics. This combination, sometimesknown as the Neoclassical synthesis, was dominant in Western teaching and public policy in the years following World War II and up to the late 1970s. The neoclassical school was challenged by monetarism , formulated in the late 1940's and early 1950's by Milton Friedman and associated with the University of Chicago and also by supply-side economics .
In principle, economics can be applied to any type of economic organization. However. the majority of economic theory centersaround systems where goods are exchanged in the market - where buyers and sellers seekto maximize their results by trading. The dominant form of market economics focuses onsocieties where property is owned by individuals, money has a rational basis, and profit comes from utilizing labor and capitalto produce goods to be sold in the market - or capitalism . However, economictheory is also applied to markets where the control of capital is in the hands of the state or society, which include socialism and mercantilism , and tosocieties where the allocation of resources is not through the market, but through political mechanisms, generally referred to ascommand economies, which includes communism and other forms of totalitarianism . Many economists assert that it is impossible to avoid the"Invisible Hand" of the Market, and hence all societies can be modelled through market dynamics, though this viewpoint hasvehement opponents across the political spectrum.
The development of economics as a field of study is closely related to the rise of capital as the primary determining factorof production and trading, hence its most detailed and precise work has dealt with the institutions belonging to marketsocieties, and most specifically to capitalist and socialist societies. To what extent economics must be adjusted to be appliedto earlier forms of social organization has been the source of discussion. Generally, mainstream economists mostly feel that thebasic framework of economics is relevant and flexible enough to be applied to virtually any form of society. Marxist economicsasserts that history is divided into eras which are determined by which two classes, which are struggling to control the means ofproduction - that is slaves and masters, peasants and royalty, wage workers and capitalists - and that mainstream economics onlyapplies to those societies which are "objectively" industrial, that is to say, societies which are capable of industrialproduction based on their own knowledge and resources. (See Marxism , particularly"The Hegelian Roots of Marxism".)
In the late 20th Century three of the areas of study which are producing change in economic thinking are: risk based ratherthan price based models, imperfect economic actors, and treating economics as a biological science , based on evolutionary norms rather thanabstract exchange.
The study of risk has been influential, which viewed variations in price over time asmore important than actual price. This particularly applies to financial economics where risk-return tradeoffs are the crucialdecisions to be made.
The most important area of growth has been in the study of information and decision. Examples of this school include the workof Joseph Stiglitz . Problems of asymmetric information and moralhazard, both based around information economics, profoundly affect modern economic dilemmas like executive stock options , insurance markets, and third-world debt relief.
Finally, there are a series of economic ideas rooted in the conception of economics as a branch of biology, including the ideathat energy relationships rather than price relationships determine economic structure, and the use of fractal geometry to createeconomic models. (See Energy Economics )
In its infancy is the application of non-linear dynamics to economic theory, as well as the application of evolutionary psychology . So far the most visible work has been in the area of applying fractals tomarket analysis, particularly arbitrage . (See Complexity inEconomics )
Another infant branch of economics is neuroeconomics . This combinesneuroscience, economics, and psychology to study how we make choices.
Economics and other disciplines
There is some degree of tension between economics and theories of ethics ,historically a branch of philosophy, which emphasizes how we ought to conduct ourselves and balances of rights and duties . Moderneconomics deals with this tension explicitly - according to some thinkers a theory of economics is also, or implies also, atheory of moral reasoning . One way economists deal with this is toqualify discussions of economicchoice by noting that "all else being equal..." referring to moral or social factors that are supposedly held equivalent forall 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 - forinstance, when fueling a fire one is usually concerned with finding the wood, and not so much with finding the air to burn itwith. 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 onespecies 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 wherein economics is a subset ofecology.
A third premise is that economics suggests market forms and other means ofdistribution of scarce goods that do not just affect "desires and wants" but also "needs" and "habits". Much of so-calledeconomic "choice" is involuntary, certainly given the conditioning thatpeople have to expect certain quality of life . This leads to one ofthe most hotly debated areas in economic policy: namely the effect and efficacy of welfare policies. This is viewed as a failureto respect economic reasoning by libertarians , who argue thatredistribution of wealth is morally and economically wrong. And viewed as a failure of economics to respect society by socialists , who argue that disparities of wealth should not have been allowed in thefirst place. This led to both 19th century labour economics and 20th century welfare economics before being subsumed into human development theory .
The debates above are all quite old. The term economics was coined in around 1870, and popularised by influential"neoclassical" economists such as Alfred Marshall . Prior to this thesubject had been known as political economy and referred to "the economy of polities" - competing states . The older term is still often used instead of economics,especially by radical economists such as Marxists who strongly question assumptionsof "mainstream" technical and quantitative economics. Use of this term often signals a basic disagreement with the terminology orparadigm of market economics. Political economy explicitly brings political considerations into economic analysis and thereforetends 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 economicsdepartment.
Information theory has been applied to economics since thework of Ronald Coase in the 1930's. However, with Herbert Simon and Johnvon Neumann in the 1950's, it gathered a more specific formalism as part of game theory . This emphasises that the decision-making process itself iscostly
Marxist economics generally denies the trade-off of time for money. In the Marxist view, concentrated control over the meansof production is the basis for the allocation of resources among classes. Scarcity of any particular physical resource issubsidiary 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 ofcosts. That is, market economics assumes that a good which is underpriced, is overconsumed. Externalization of cost, in thisview, 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 oldtradition of viewing economic relationships as being based on the scarcity of energy, rather than price, as the central featureof economics.
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