Understanding choices by individuals and groups is central in economics. With scarcity, choosing one alternative implies forgoing another alternative; economists refer to the best alternative forgone by taking another choice as the opportunity cost. For instance, learning one skill implies time not spent learning another. In a market setting, the currently dominant theory is that scarcity is often quantified by price relationships.
Economists believe that incentives and desires together play an important role in shaping decision making. Concepts from the Utilitarian school of philosophy are used as analytical concepts within economics, though economists appreciate that society may not adopt utilitarian objectives. One example of this is the idea of a utility function, which is assumed to be the means by which individual economic actors decide what makes them "happy" and what decisions they make in pursuit of that happiness.
The word economy comes from the Greek oikos- for "house" and nomos for "laws" or "norms". Originally, the term economics was used for different contexts: the house, a town, a city (the "polis" in Greek).
After this "change", the term "political economy" has been used to denote the "classical economy" of the 19th century, with Adam Smith, David Ricardo and Karl Marx as its main thinkers, in recent years the term has also been used to describe the study of production systems which are not viewed through the lens of price, but through descriptions of the network of relationships and requirements involved in a particular economy. There are also those who use the terms economics and political economy as interchangeable.
Table of contents
Areas of study in economics
Economics is usually divided into two main branches:
- Microeconomics, which examines the economic behaviour of individual actors such as firms, households, and individuals, with a view to understand decision making in the face of scarcity and the allocation consequences of these decisions.
- Macroeconomics, which examines an economy as a whole with a view to understanding the interaction between economic aggregates such as national income, employment and inflation. Note that this is different from general equilibrium theory, which deals with aggregate problems from a strictly constructed microeconomic viewpoint.
Economics can also be divided into numerious 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.
- The most significant example may be econometrics, which applies statistical techniques to the study of economic data. Computational economics relies on mathematical methods, including econometrics.
- Another trend which is more recent, and closer to microeconomics, is to use social psychology concepts (behavioral economics) and methods (experimental economics)
There has been an increasing trend for ideas and methods from economics to be applied in wider contexts. Since economics analysis focuses on decision making, it can be applied (with varying degrees of success) to any field where people are faced with alternatives – education, marriage, health, etc. Public Choice Theory studies how economic analysis can apply to those fields traditionally considered outside of economics. The areas of investigation in Economics therefore overlap with other social sciences, including political science and sociology. See political economy for the study of economics in the context of political science. The most prevalent political economy is loosely called capitalism.
Mainstream economics does not assume a priori that markets are preferable to other 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 that induces market participants to act in a manner consistent with optimal welfare, or by creating 'missing' markets to enable efficient 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 give price, and demand can be said to be the amount of a commodity that would be purchased 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 is then done to see what "trade offs" are made in the "market" which is the negotiation between sellers and buyers. Analysis is done as 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 some other activity.
Despite the extreme controversy surrounding larger economic issues, there is significant agreement among mainstream economists on the fundamentals of the subject, especially as reflected in microeconomics as opposed to macroeconomics. In particular the nature of money, supply and whether price reflects available information are areas of dispute. See below for further discussion.
Much contemporary theory assumes that economic agents act rationally to optimize well-being given available information. This may sometimes be an acceptable approximation - for instance, if a given individual's irrationality is canceled out in the aggregate) and tends to produce tractable results. However, this framework ("homo economicus" - has for decades been understood as a handy approximation (e.g., see Herbert Simon's model for "bounded rationality", which was awarded a Nobel Prize in 1978). More recently, irrational behavior and imperfect information have increasingly been the subject of formal modelling, often referred to as behavioral economics, for which Daniel Kahneman won a Nobel Prize in 2002. An example is the growing field of behavioral finance which combines previous theory with cognitive psychology.
Economic language and reasoning
Economics relies on rigorous styles of argument more than other social sciences. This is at least, the purported ideal of professionals in the field. Economic methodology has several interacting parts;
- Collection of economic data. This data consists of collecting measurable values of price, and changes in price, for measurable commodities. For example the cost to hire a worker for a week, or the cost of a particular commodity, and how much is typically used.
- Formulation of models of economic relationships, for example, the relationship between the general level of prices and the general level of employment. This includes observable forms of economic activity: money, consumption, preferences, buying, selling, prices etc. Some of the models are simple accounting models, while others postulate specific kinds of economic behavior, such as utility or profit maximization. An example of a model which illustrates both of these aspects, is the classical mathematical formulation of the Keynesian system involving the consumption function and the national income identity. In this article we will refer to such models as formal models although they are not formal in the sense of formal logic.
- Production of Economic statistics. Taking the data collected, and applying the model being used to produce a representation of economic activity. For example the "general price level" is 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 gasoline costs 1 euro a liter, to calculate the price level would require a model of how much gasoline 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 gasoline, and what other goods they might substitute for it, which requires a model.
- Reasoning within economic models. This process of reasoning (see the articles on informal logic, logical argument, fallacy) may or may not involve advanced mathematics. For instance, an established (though possibly unexamined) tradition among economists is to reason about economic variables in two-dimensional graphs in which curves representing relations between the axis variables are parametrized by various indices. A good example of this type of reasoning is exhibited by Paul Krugman's online essay, There's something about macro. See also the article IS/LM model. One critical analysis of economic reasoning is studied in Paul Samuelson's thesis, Foundations of Economic Analysis: he identifies a class of assertions called operationally meaningful theorems which are those that can be meaningfully formulated within an economic model. As usual in science, the conclusions obtained by reasoning have a predictive as well as confirmative (or dismissive) value. An example of the predictive value of economic theory is a prediction as to the effect of current deficits on interest rates 10 years into the future; An example of the confirmative value of economic theory would be confirmation (or dismissal) of theories concerning the relation between marginal tax rates and the deficit.
Formal modelling has been adopted to some extent by all branches of economics. It is not the identical to what is often referred to as mathematical economics; this includes, but is not limited to, an attempt to set microeconomics, in particular general equilibrium on solid mathematical foundation. Some reject mathematical economics: The Austrian School of economics believes that anything beyond simple logic is often unnecessary and inappropriate for economic analysis. In fact, the entire empirical-deductive framework sketched in this section may be rejected outright by this school. However, we believe the framework sketched here represents accurately the current predominant view of economics.
Development of economic thought
Modern economic thought is usually said 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 of schools that have developed later, see history of economic thought. Modern mainstream economics can be said to begin with Mills focusing of what was then called "political economy" 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 the foundation of micro-economics.
The central idea promoted by Smith was that the competition between various suppliers and buyers would produce the best possible distribution of goods and services, because it would encourage individuals to specialize and improve their capital, so as 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 in particular.
In the 19th century, Karl Marx synthesized a variety of schools of thought involving the social distribution of resources, including the work of Adam Smith, as well as socialism and egalitarianism, and used the systematic approach to logic taken from philosopher Hegel to produce "Das Kapital". His work was the most widely adhered-to critique of market economics during much of the 19th and 20th centuries. The Marxist paradigm of economics is not generally held in high regard by market 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 used to describe work which accepts concepts from his work but does not necessarily subscribe to the political thrust of Marxist thought.
In the early 20th century, economics became increasingly statistical, and the study of econometrics became increasingly important. Statistical treatment of price, unemployment, money supply and other variables, as well as the compiling of these statistics, became more and more central to economic writing and disputes within the field of economics.
Macroeconomics diverged from microeconomics with Keynes in the 1920s, and was codified in the 1930s by Keynes and others, particularly John Hicks. It grew in popularity as a reaction to the Great Depression. Keynes had been an influential exponent of the importance of central banking and government involvement in economic affairs, as well as a critic of the political economy of the post World War I period. His "General Theory" encapsulated both criticisms of classical theory that had been levelled by Thorstein Veblen and others, as well a method for economic management of aggregate demand. For an overview of a number of competing schools, see macroeconomics.
Many economists use a combination of Neoclassical microeconomics and Keynesian macroeconomics. This combination, sometimes known 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.
In principle, economics can be applied to any type of economic organization. However. the majority of economic theory centers around systems where goods are exchanged in the market - where buyers and sellers seek to maximize their results by trading. The dominant form of market economics focuses on societies where property is owned by individuals, money has a rational basis, and profit comes from utilizing labor and capital to produce goods to be sold in the market - or capitalism. However, economic theory 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 to societies where the allocation of resources is not through the market, but through political mechanisms, generally referred to as command 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 has vehement 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 factor of production and trading, hence its most detailed and precise work has dealt with the institutions belonging to market societies, and most specifically to capitalist and socialist societies. To what extent economics must be adjusted to be applied to earlier forms of social organization has been the source of discussion. Generally, mainstream economists mostly feel that the basic framework of economics is relevant and flexible enough to be applied to virtually any form of society. Marxist economics asserts that history is divided into eras which are determined by which two classes, which are struggling to control the means of production - that is slaves and masters, peasants and royalty, wage workers and capitalists - and that mainstream economics only applies to those societies which are "objectively" industrial, that is to say, societies which are capable of industrial production 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 rather than price based models, imperfect economic actors, and treating economics as a biological science, based on evolutionary norms rather than abstract exchange.
The study of risk has been influential, which viewed variations in price over time as more important than actual price. This particularly applies to financial economics where risk-return tradeoffs are the crucial decisions to be made.
The most important area of growth has been in the study of information and decision. Examples of this school include the work of Joseph Stiglitz. Problems of asymmetric information and moral hazard, 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 idea that energy relationships rather than price relationships determine economic structure, and the use of fractal geometry to create economic 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 to market analysis, particularly arbitrage. (See Complexity in Economics)
Another infant branch of economics is neuroeconomics. This combines neuroscience, economics, and psychology to study how we make choices.
Economics in the context of Western thought
Basic Scarcity in Economic Theory
Because scarcity and decision are central to economic theory, the question of what is the basic trade-off in economics is of central importance. In every economic theory, there is a basic exchange of two or more ultimately scarce commodities. For Adam Smith, it was defined as the trading of time, or convenience, for money. For example, a person could live near town, and pay more for 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 these bases its view of scarcity on a different fundamental trade-off. A small number of economists prefer to define economics as the study 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. 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. The marginal cost of a commodity is the cost to produce the last unit of it, the marginal utility is the happiness gained from buying the last unit. Economic theory uses marginalism to describe the "diminishing returns" from consumption - the 10th candy bar doesn't taste as good as the first, and so brings less "marginal utility". 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, plus the percentage of fixed costs. Marginalism states that when the profit from the next unit will be zero, that unit will not be produced.
Information theory has been applied to economics since the work of Ronald Coase in the 1930's. However, with Herbert Simon and John von Neumann in the 1950's, it gathered a more specific formalism as part of game theory. This emphasises that the decision-making process itself is costly.
Marxist economics generally denies the trade-off of time for money. In the Marxist view, concentrated control over the means of production is the basis for the allocation of resources among classes. Scarcity of any particular physical resource is subsidiary to the central question of power relationships embedded in the means of production.
The question of the environment is viewed, in the traditional economic framework, as being related to the externalization of costs. That is, market economics assumes that a good which is underpriced, is overconsumed. Externalization of cost, in this view, 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 old tradition of viewing economic relationships as being based on the scarcity of energy, rather than price, as the central feature of economics.
It could be argued that beneath an economic theory is a theory of value. Value can be defined as the underlying activity which economics describes and measures. It is what is "really" happening.
Adam Smith defined "labor" as the underlying source of value, and "the labor theory of value" underlies the work of Karl Marx, Ricardo and many other "classical" economists. The "labor theory of value" argues that a good or service is worth the labor that it takes to produce, and the abundance or scarcity of labor determines the price of a commodity. The labor theory of value and the closely related cost-of-production theory of value dominates the work of most classical economists, but they are far from the only accepted basis for "value". For example neoclassical economists and Austrian School economists prefer the marginal theory of value.
"Market theory" argues that there is no "value" separate from price, that the market incorporates all available information into price, and that so long as markets are open, that price and value are one and the same. This theory rests on the idea of the "rational economic actor". This was orginally asserted by Mill.
Another set of theories rest on the idea that there is a basic external scarcity, and that "value" represents the relationship to that basic scarcity. 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.
Price is the measurable quantities involved in an exchange. Price theory, therefore, charts the movement of measurable quantities over time, and the relationship between price and other measurable variables. In Adam Smith's Wealth of Nations this was the trade-off between price and convenience. A great deal of economic theory is based around prices and the theory of supply and demand.
Supply and demand assume that the factors affecting the agents who supply a particular commodity can be separated from those who wish to sell it. Sellers have a quantity they would wish to sell at every given price and a price for any quantity the wish to sell; buyers have a quantity they will demand at any given price and a price that is acceptable to them if they have to buy a particular quantity.
The market 'clears' at the point where all the supply and demand at a given price balance. That is, the amount of a commodity available at a given price equals the amount that buyers are willing to purchase at that price. It is assumed that there is a process that will result in the market reaching this point, but exactly what the process is in a real situation is an ongoing subject 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-quantity combinations acceptable to buyers, or the demand curve, one showing the combinations acceptable to sellers, or the supply curve. The market clears where 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 be described entirely in terms of tradeoffs with other goods. For a century the Say's Law was believed in economic theory, which said that markets, as a whole, would always clear.
In many practical economic models, some form of "price stickiness" is incorporated to model the observed fact that in many markets prices do not move fluidly. Economic policy often revolves around arguments as to what is causing "economic friction", or price 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 there are significant scarcities not factored into price, there is said to be an externalization of cost. Market economics predicts that scarce goods which are under-priced are over-consumed (See social cost). This leads into public goods theory.
Economics and other disciplines
There is some degree of tension between economics and ethics, another of the most basic social sciences, which tends to avoid quantification and emphasize balances of rights. Modern economics deals with this tension explicitly – according to some thinkers a theory of economics is also, or implies also, a theory of moral reasoning. One way economists deal with this is to qualify discussions of economic choice by noting that "all else being equal..." referring to moral or social factors that are supposedly held equivalent for all choices that one might make. For exploration of this issue, see the moral purchasing article.
Another premise is that economics fits within a finite ecosystem where there are at least some abundant resources – for instance, when fueling a fire one is usually concerned with finding the wood, and not so much with finding the air to burn it with. Economics explicitly does not deal with free abundant inputs – one criticism is that it often conflicts with ecology's view of what affects what. Human beings are, according to ecologists, merely one species participating in a vast energy system on this planet – economy is a subset of ecology that deals with just one species' habits and wants. See nature's services for the economic view of ecology and green economics for the view wherein economics is a subset of ecology.
A third premise is that economics suggests market forms and other means of distribution of scarce goods that do not just affect "desires and wants" but also "needs" and "habits". Much of so-called economic "choice" is involuntary, certainly given the conditioning that people have to expect certain quality of life. This leads to one of the most hotly debated areas in economic policy: namely the effect and efficacy of welfare policies. This is viewed as a failure to respect economics reasoning by libertarians, who argue that redistribution 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 the first 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 the subject 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 assumptions of "mainstream" technical and quantitative economics. Use of this term often signals an a basic disagreement with the terminology or paradigm of market economics. Political economy explicitly brings political considerations into economic analysis and therefore tends 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 economics department.
- Microeconomics — Supply and Demand — Consumer Theory — Production theory — Experimental economics — Behavioral economics — General equilibrium — Industrial organization — Financial economics — Managerial economics — International trade — Labor economics — Development economics — Environmental economics — Welfare economics — Public choice theory — Public goods — Transport economics — Health economics — Marginal demand
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