What Is Economics?
Economics is a social science concerned with the production, distribution, and consumption of goods and services. It studies how individuals, businesses, governments, and nations make choices about how to allocate resources.
Economics focuses on the actions of human beings, based on assumptions that humans act with rational behavior, seeking the most optimal level of benefit or utility. The building blocks of economics are the studies of labor and trade.
Since there are many possible applications of human labor and many different ways to acquire resources, it is the task of economics to determine which methods yield the best results.
Economics can generally be broken down into two categories: macroeconomics, which concentrates on the behavior of the economy as a whole, and microeconomics, which focuses on individual people and businesses.
KEY TAKEAWAYS
- Economics is the study of how people allocate scarce resources for production, distribution, and consumption, both individually and collectively.
- Two major types of economics are microeconomics, which focuses on the behavior of individual consumers and producers, and macroeconomics, which examines overall economies on a regional, national, or international scale.
- Economics is especially concerned with efficiency in production and exchange and uses models and assumptions to understand how to create incentives and policies that will maximize efficiency.
- Economists formulate and publish numerous economic indicators, such as gross domestic product (GDP) and the Consumer Price Index (CPI).
- Capitalism, socialism, and communism are types of economic systems.
Understanding Economics
One of the earliest recorded economic thinkers was the 8th-century B.C. Greek farmer/poet Hesiod wrote that labor, materials, and time needed to be allocated efficiently to overcome scarcity.
But the founding of modern Western economics occurred much later, generally credited to the publication of Scottish philosopher Adam Smith’s 1776 book, An Inquiry Into the Nature and Causes of the Wealth of Nations.
The principle (and problem) of economics is that human beings have unlimited wants and occupy a world of limited means. For this reason, the concepts of efficiency and productivity are held paramount by economists. Increased productivity and more efficient use of resources, they argue, could lead to a higher standard of living.
Despite this view, economics has been pejoratively known as the “dismal science,” a term coined by Scottish historian Thomas Carlyle in 1849. He used it to criticize the liberal views on race and social equality of contemporary economists like John Stuart Mill, though some commentators suggest Carlyle was actually describing the gloomy predictions by Thomas Robert Malthus that population growth would always outstrip the food supply.
Types of Economics
The study of economics is generally broken down into two disciplines.
Microeconomics focuses on how individual consumers and firms make decisions; these individual decision-making units can be a single person, a household, a business/organization, or a government agency.
Analyzing certain aspects of human behavior, microeconomics tries to explain how they respond to changes in price and why they demand what they do at particular price levels. Microeconomics tries to explain how and why different goods are valued differently, how individuals make financial decisions, and how individuals best trade, coordinate, and cooperate with one another.
Microeconomics’ topics range from the dynamics of supply and demand to the efficiency and costs associated with producing goods and services; they also include how labor is divided and allocated; how business firms are organized and function; and how people approach uncertainty, risk, and strategic game theory.
Macroeconomics studies an overall economy on both a national and international level, using highly aggregated economic data and variables to model the economy. Its focus can include a distinct geographical region, a country, a continent, or even the whole world.
Its primary areas of study are recurrent economic cycles and broad economic growth and development. Topics studied include foreign trade, government fiscal and monetary policy, unemployment rates, the level of inflation and interest rates, the growth of total production output as reflected by changes in the Gross Domestic Product (GDP), and business cycles that result in expansions, booms, recessions, and depressions.
Micro- and macroeconomics are intertwined. Aggregate macroeconomic phenomena are obviously and literally just the sum total of microeconomic phenomena. However, these two branches of economics use very different theories, models, and research methods, which sometimes appear to conflict with each other.
Integrating the microeconomics foundations into macroeconomic theory and research is a major area of study in itself for many economists.
Schools of Economic Theory
There are many competing, conflicting, or sometimes complementary theories and schools of thought within economics.
Economists employ many different methods of research from logical deduction to pure data mining. Economic theory often progresses through deductive processes, including mathematical logic, where the implications of specific human activities are considered in a “means-ends” framework.
This type of economics deduces, for example, that it is more efficient for individuals or companies to specialize in specific types of labor and then trade for their other needs or wants, rather than trying to produce everything they need or want on their own.
It also demonstrates that trade is most efficient when coordinated through a medium of exchange, or money. Economic laws deduced in this way tend to be very general and not give specific results: they can say profits incentivize new competitors to enter a market, but not necessarily how many will do so. Still, they do provide key insights for understanding the behavior of financial markets, governments, and economies—and the human decisions behind these entities.
Other branches of economic thought emphasize empiricism, rather than formal logic—specifically, logical positivist methods, which attempt to use the procedural observations and falsifiable tests associated with the natural sciences.
Some economists even use direct experimental methods in their research, with subjects asked to make simulated economic decisions in a controlled environment. Since true experiments may be difficult, impossible, or unethical to use in economics, empirical economists mostly rely on simplifying assumptions and retroactive data analysis.
However, some economists argue economics is not well suited to empirical testing, and that such methods often generate incorrect or inconsistent answers.
Two of the most common in macroeconomics are monetarist and Keynesian. Monetarists are a branch of Keynesian economics that argues that stable monetary policy is the best course for managing the economy, and otherwise often have generally favorable views on free markets as the best way to allocate resources.
In contrast, other Keynesian approaches favor fiscal policy by an activist government in order to manage irrational market swings and recessions and believe that markets often don’t work well at allocating resources on their own.
Economic Indicators
Economic indicators are reports that detail a country’s economic performance in a specific area. These reports are usually published periodically by governmental agencies or private organizations, and they often have a considerable effect on stocks, fixed income, and forex markets when they are released.
They can also be very useful for investors to judge how economic conditions will move markets and to guide investment decisions.
Below are some of the major U.S. economic reports and indicators used for fundamental analysis.
Gross Domestic Product (GDP)
The Gross Domestic Product (GDP) is considered by many to be the broadest measure of a country’s economic performance. It represents the total market value of all finished goods and services produced in a country in a given year or another period (the Bureau of Economic Analysis issues a regular report during the latter part of each month).
Many investors, analysts, and traders don’t actually focus on the final annual GDP report, but rather on the two reports issued a few months before: the advance GDP report and the preliminary report.
This is because the final GDP figure is frequently considered a lagging indicator, meaning it can confirm a trend but not predict a trend. In comparison to the stock market, the GDP report is somewhat similar to the income statement a public company reports at year-end.
Retail Sales
As reported by the Department of Commerce during the middle of each month, the retail sales report is very closely watched and measures the total receipts, or dollar value, of all merchandise sold in stores.
The report estimates the total merchandise sold by taking sample data from retailers across the country—a figure that serves as a proxy for consumer spending levels. Because consumer spending represents more than two-thirds of GDP, this report is very useful for gauging the economy’s general direction.
Also, because the report’s data is based on the previous month’s sales, it is a timely indicator. The content in the retail sales report can cause above-normal volatility in the market, and the information in the report can also be used to gauge inflationary pressures that affect Fed rates.
Industrial Production
The industrial production report, released monthly by the Federal Reserve, reports on the changes in the production of factories, mines, and utilities in the U.S. One of the closely watched measures included in this report is the capacity utilization ratio, which estimates the portion of productive capacity that is being used rather than standing idle in the economy.
It is preferable for a country to see increasing levels of production and capacity utilization at high levels. Typically, capacity utilization in the range of 82–85% is considered “tight” and can increase the likelihood of price increases or supply shortages in the near term.
Levels below 80% are usually interpreted as showing “slack” in the economy, which might increase the likelihood of a recession.
Employment Data
The Bureau of Labor Statistics (BLS) releases employment data in a report called the Non-Farm Payrolls on the first Friday of each month. Generally, sharp increases in employment indicate prosperous economic growth.
Likewise, potential contractions may be imminent if significant decreases occur. While these are general trends, it is important to consider the current position of the economy.
For example, strong employment data could cause a currency to appreciate if the country has recently been through economic troubles because the growth could be a sign of economic health and recovery.
Conversely, in an overheated economy, high employment can also lead to inflation, which in this situation could move the currency downward.
Consumer Price Index (CPI)
The Consumer Price Index (CPI), also issued by the BLS, measures the level of retail price changes (the costs that consumers pay) and is the benchmark for measuring inflation.
Using a basket that is representative of the goods and services in the economy, the CPI compares the price changes month after month and year after year.
This report is one of the more important economic indicators available, and its release can increase volatility in equity, fixed income, and forex markets. Greater-than-expected price increases are considered a sign of inflation, which will likely cause the underlying currency to depreciate.
Types of Economic Systems
Societies have organized their resources in many different ways through history, deciding how to use available means to achieve individual and common ends.
Primitivism
In primitive agrarian societies, people tend to self-produce all of their needs and wants at the level of their household or tribe. Families and tribes would build their own dwellings, grow their own crops, hunt their own game, fashion their own clothes, bake their own bread, etc.
This economic system is defined by very little division of labor and results in low productivity, a high degree of vertical integration of production processes within the household or village for what goods are produced, and relationship-based reciprocal exchange within and between families or tribes rather than market transactions.
In such a primitive society, the concepts of private property and decision-making over resources often apply at a more collective level of familial or tribal ownership of productive resources and wealth in common.
Feudalism
Later, as civilizations developed, economies based on production by social class emerged, resulting in feudalism and slavery. Slavery involved production by enslaved individuals who lacked personal freedom or rights and were treated as the property of their owners.
Feudalism was a system where a class of nobility, known as lords, owned all of the lands and leased out small parcels to peasants to farm, with peasants handing over much of their production to the lord. In return, the lord offered the peasants relative safety and security, including a place to live and food to eat.
Capitalism
Capitalism emerged with the advent of industrialization. Capitalism is defined as a system of production whereby business owners (entrepreneurs or capitalists) organize productive resources, including tools, workers, and raw materials, to produce goods for sale in order to make a profit and not for personal consumption.
In capitalism, workers are hired in return for wages; owners of land and natural resources are paid rents or royalties for the use of their resources, and the owners of previously created wealth are paid interest to forgo the use of some of their wealth so that the entrepreneurs can borrow it to pay wages and rents and purchase tools for hired workers to use.
Entrepreneurs apply their best judgment of future economic conditions to decide what goods to produce, and they either earn a profit if they decide well or suffer losses if they judge poorly.
This system of market prices, profit, and loss as the selection mechanism as to who will decide how resources are allocated for production are what defines a capitalist economy.
These roles (workers, resource owners, capitalists, and entrepreneurs) represent functions in the capitalist economy and are not separate or mutually exclusive classes of people. Individuals typically fulfill different roles with respect to different economic transactions, relationships, organizations, and contracts to which they are a party.
This may even occur within a single context, such as an employee-owned co-op where the workers are also the entrepreneurs or a small business owner-operator who self-finances his firm out of personal savings and operates out of a home office and thus acts simultaneously as an entrepreneur, capitalist, landowner, and worker.
The United States and much of the developed world today can be described as broadly capitalist market economies.
Socialism
“Socialism is a form of the cooperative production economy. Economic socialism is a system of production where there is limited or hybrid private ownership of the means of production (or other types of productive property) and a system of prices, profits, and losses are not the sole determinants to establish who engages in the production, what to produce, and how to produce it. Segments of society band together to share these functions.
Production decisions are made through a collective decision-making process and within the economy,
some but not all economic functions are shared by all. These might include any strategic economic functions that affect all citizens.
These would include Public Safety (police, fire, EMS), National Defense, resource allocation (utilities. like water, and electricity), education, and more. These are often paid for through income or use taxes levied on the remaining tactically independent economic functions (individual citizens, independent businesses, foreign trade partners, etc).
Modern socialism contains certain elements of capitalism, such as a market mechanism and some centralized control over some resources. If more of the economy’s control is centralized in ever-increasing ways, it may eventually become more akin to communism.
Note that socialism as an economic system can and does occur under various forms of government, from the Democratic Socialism of the Nordic countries to more authoritarian strands found elsewhere.
Communism
Communism is a form of command economy whereby nearly all economic activity is centralized and coordinated through the state-sponsored central planners. A society’s theoretical economic strength can be marshaled to the benefit of the society at large.
Executing this, in reality, is far more difficult than in theory, in that it requires no conflicting or competing entities within society to challenge the allocation of resources.
Note that instances of economic communism in the modern era have also been coupled with an authoritarian form of government, although this need not be the case in theory.