ECONOMICS

The study of economics leads to the formulation of the principles upon which the economy is based. History, politics, and the social sciences cannot be understood without the basic understanding of economic principles. The science of economics is concerned with the scientific laws that relate to business administration, and attempts to formulate the principles that relate to the satisfaction of wants.

The term "economics" covers such a broad range of meaning that any brief definition is likely to leave out some important aspect of the subject. It is a social science concerned with the study of economies and the relationships between them. Economics is the study of how people and society choose to employ scarce productive resources, which could have alternative uses, to produce various commodities and distribute them for consumption. Economics generally studies problems from society's point of view rather than from the individual's. Finally, economics studies the allocation of scarce resources among competing ends.

OBJECTIVES

As a science, economics must first develop an understanding of the processes by which human desires are fulfilled. Second, economics must show how causes that affect production and consumption lead to various results. Furthermore, it must draw conclusions that will serve to guide those who conduct and, in part, control economic activity.

MICRO AND MACRO VIEWS
OF THE ECONOMY

While there are numerous specialties within the academic field, at its most basic level economics is commonly divided into two broad areas of focus: microeconomics and macroeconomics. Microeconomics is the study of smaller levels of the economy, such as how an individual firm or a small group of firms operate. Macroeconomics is the study of whole economies or large sectors of economies.

MICROECONOMICS.

Microeconomics is the social science dealing in the satisfaction of human wants using limited resources. It focuses on individual units that make up the whole of the economy. It examines how households and businesses behave as individual units, not as parts of a larger whole. For instance, microeconomics studies how a household spends its money. It also studies the way in which a business determines how much of a product to produce, how to make the best use of production factors, and what pricing strategy to use. Microeconomics also studies how individual markets and industries are organized, what patterns of competition they follow, and how these patterns affect economic efficiency and welfare.

MACROECONOMICS.

Macroeconomics studies an economy at the aggregate level. It is concerned with the workings of the whole economy or large sectors of it. These sectors include government, business, and households. Macroeconomics deals with such issues as national economic output and growth, unemployment, recession, inflation, foreign trade, and monetary and fiscal policy.

BASIC ECONOMIC PRINCIPLES

Basic economic principles include the law of demand, demand determinants, the law of supply, supply determinants, market equilibrium, factors of production, the firm, gross product, as well as inflation and unemployment.

THE LAW OF DEMAND.

When an individual want is expressed as an intention to buy, it becomes a demand. The law of demand is a theory about the relationship between the amount of a good that a buyer both desires and is able to purchase per unit of time, and the price charged for it. The ability to pay is as important as the desire for the good, because economics is interested in explaining and predicting actual behavior in the marketplace, not just intentions. At a given price for a good, economics is interested in the buyer's demand that can effectively be backed by a purchase. Thus, it is implied with demand that a consumer not only has the desire and need for a product, but also has the money to purchase it. The law of demand states that the lower the price charged for a product, resource, or service, the larger will be the quantity demanded per unit of time. Conversely, the higher the price charged, the smaller will be the quantity demanded per unit of time—all other things being constant. For example, the lower the purchase price for a six-pack of Coca-Cola, the more a consumer will demand (up to some saturation point, of course).

DEMAND DETERMINANTS.

Movement along the demand curve—referred to as a change in quantity demanded—means that only the price of the good and the quantity demanded change. All other things are assumed to be constant or unchanged. These things include the prices of all other goods, the individual's income, the individual's expectations about the future, and the individual's tastes. A change in one or more of these things is called a change in demand. The entire demand curve will move as a result of a change in demand.

LAW OF SUPPLY.

The law of supply is a statement about the relationship between the amount of a good that a supplier is willing and able to supply and offer for sale, per unit of time, and each of the different possible prices at which that good might be sold. This law further states that suppliers will supply larger quantities of a good at higher prices than at lower prices. In other words, supply generally is governed by profit-maximizing behaviors. The supply curve indicates what prices are necessary in order to give a supplier the incentive to provide various quantities of a good per unit of time. Just as with the demand curve, movement along the supply curve always assumes that all other things are constant.

SUPPLY DETERMINANTS.

At the opportunity for sale at a certain price, a part of total supply becomes realized market supply. Economics emphasizes movement along the supply curve in which the price of the good determines the quantity supplied. As with the demand curve, the price of the good is singled out as the determining factor with all other things being constant. On the supply side, these things are the prices of resources and other production factors, technology, the prices of other goods, the number of suppliers, and the suppliers' expectations.

MARKET EQUILIBRIUM.

Supply and demand interact to determine the terms of trade between buyers and sellers. In theory, supply and demand mutually determine the price at which sellers are willing to supply just the amount of a good that buyers want to buy. The market for every good has a demand curve and a supply curve that determine this price and quantity. When this price and quantity are established, the market is said to be in equilibrium. The price and quantity at which this occurs are called the equilibrium price and equilibrium quantity. In equilibrium, price and quantity have the tendency to remain unchanged.

FACTORS OF PRODUCTION

Factors of production are economic resources used in the production of goods, including natural, man-made, and human resources. They may be broken down into two broad categories: (1) property resources, specifically capital and land; and (2) human resources, specifically labor and entrepreneurial ability.

Managers often speak of capital when referring to money, especially when they are talking about the purchase of equipment, machinery, and other productive facilities. Financial capital is the more accurate term for the money used to make such purchases. An economist would refer to these purchases as investments. The economist uses the term capital to mean all the man-made aids used in production. It is sometimes referred to as investment goods. Capital consists of machinery, tools, buildings, transportation and distribution facilities, and inventories of unfinished goods. A basic characteristic of capital goods is that they are used to produce other goods. Capital goods satisfy wants indirectly by facilitating the production of consumable goods, while consumer goods satisfy wants directly.

To an economist, land is the fundamental natural resource that is used in production. This resource includes water, forests, oil, gas, and mineral deposits. These resources are rapidly becoming scarce. Land resources, which include natural resources above, on, and below the soil, are distinguished by the fact that man cannot make them.

Labor is a broad term that covers all the different capabilities and skills possessed by human beings. While this often this means direct production labor, it includes management labor as well. The term manager embraces a host of skills related to the planning, administration, and coordination of the production process.

Entrepreneurial ability also is known as enterprise. Entrepreneurs have four basic functions. First, they take initiative in using the resources of land, capital, and labor to produce goods and services. Second, entrepreneurs make basic business policy decisions. Third, they develop innovative new products, productive techniques, and forms of business organization. Finally, entrepreneurs bear the risk. In addition to time, effort, and business reputation, they risk their own personal funds, as well as those of associates and stockholders.

THE FIRM

The economic resources of land, capital, and labor are brought together in a production unit that is referred to as a business or a firm. The firm uses these resources to produce goods that are then sold. The money obtained from the sale of these goods is used to pay the economic resources. Payments to those providing labor services are called wages. Payments to those providing buildings, land, and equipment leased to the firm are called rent. Payments to those providing financial capital, such as loans, stocks, and bonds, are called dividends and interest. In other words, capital goods tend to increase the productivity of labor through being man-made and reproducible.

GROSS PRODUCT

The total dollar value of all the final goods produced by all the firms in an economy is called the gross product. This commonly is measured by one or both of the following:

1. Gross national product (GNP) includes the value of all goods and services produced by firms originating in a single nation. This means that foreign direct investment (FDI)—such as a Japanese auto plant in the United States—is not included in GNP, even though the plant might employ U.S. workers and sell its output exclusively to U.S. consumers. Conversely, the value of production by U.S.-based firms abroad would be considered part of the U.S. GNP.
2. Gross domestic product (GDP) includes the value of all goods and services produced within a nation, regardless of where the owners of production are based. In this case, FDI into the United States would contribute to U.S. GDP, while U.S. investment in other countries would contribute to those countries' GDP, not that of the United States.

GDP is the preferred measure of gross product for many kinds of economic analyses. This is because foreign investment has grown rapidly around the world, and because foreign-owned assets, such as a manufacturing facility, tend to have a greater net influence on the domestic economy in which they are situated. Both measures of gross product calculate the value of products and services on a value-added basis so that output is not double-counted, such as when products are resold through different phases of the supply and distribution chain.

In order to make comparisons, economists often use "real" GNP or GDP, which means the figure has been adjusted to hide the effects of inflation, or the general rise of prices relative to the quantity or quality of goods produced. Therefore, real gross product is commonly taken as an indictor of overall economic health. A rise at a moderate, sustainable pace is considered healthiest. However, if gross product is declining or rising at an unsustainably fast pace, it usually is interpreted as a negative signal.

INFLATION AND UNEMPLOYMENT

The economic health of a nation, of which gross product is one measure, is directly affected by two other important factors: inflation and unemployment.

INFLATION.

Inflation is an ongoing general rise in prices without a corresponding rise in the quantity or quality of the underlying merchandise or services (i.e., getting "less for more"). Ultimately, inflation represents an economic imbalance and diminishes a currency's real and nominal purchasing power. The steeper the rise, the faster the decline of the currency's purchasing power. Rapid economic expansion is one factor that can lead to price inflation, as can lax or inconsistent control of the money supply (such as through central bank monetary policy). Leading measures of inflation in the United States are the Consumer Price Index (CPI) and the Producer Price Index (PPI). When inflation data are used to adjust the estimate of GDP, it is known as the GDP deflator.

UNEMPLOYMENT.

The unemployment rate measures the percentage of the total number of workers in the labor force who are actively seeking employment but are unable to find jobs. While this seems straightforward, there are some measurement issues to consider, such as what constitutes looking for a job, how part-time labor is interpreted (i.e., being underemployed rather than unemployed), and what happens when an individual is technically employable but not actively seeking employment for whatever reason.

Measurement difficulties aside, in general the higher the unemployment rate, the more the economy is wasting labor resources by allowing people to sit idle. Still, when unemployment rates are low there is a tendency toward wage inflation because new employees are harder to find and workers often require additional incentives in order to take or keep a job. Because having a moderate pool of unemployed workers serves as a buffer to rising labor costs, most economists view full employment (zero or negligible unemployment) as impractical and even undesirable. Structural unemployment seemingly allows human capital to flow more freely (and cheaply) when there are changes in demand for labor in various parts of the economy. Of course, this does not mean that high unemployment is viewed as positive.

SCHOOLS OF ECONOMIC THOUGHT

While many of the aforementioned basic economic principles and ideas are widely accepted by economists, there have been—and continue to be—differing theories about some areas of economic behavior. Following is a brief overview of the three most influential theoretical perspectives.

CLASSICAL ECONOMICS.

Dating back to eighteenth-century Europe, classical economics posited the market system would ensure full employment of the economy's resources. Classical economists acknowledged that abnormal circumstances such as wars, political upheavals, droughts, speculative crises, and gold rushes would occasionally deflect the economy from the path of full employment. However, when these deviations occurred, automatic adjustments in prices, wages, and interest rates within the market would soon restore the economy to the full-employment level. A decrease in employment would reduce prices, wages, and interest rates. Lower prices would increase consumer spending, lower wages would increase employment, and lower interest rates would boost investment spending. Classical economists believed in Say's Law, which states that supply creates its own demand. Although more recent economic philosophies differ in some of the specifics, particularly on the role of governments, central banks, and international trade, many tenets of classical economics are still accepted today.

KEYNESIAN ECONOMICS.

As a consequence of the 1936 publication of British economist John Maynard Keynes's General Theory of Employment, Interest, and Money, mainstream economists came to give less importance to the role of money in the economy than had classical economists. Keynes sought to explain why there was cyclical employment in capitalistic economies. It was Keynes's analysis of how total demand determines total income, output, and employment, and the potentially key role for fiscal policy in the process, that captured the attention of most economists.

Moreover, the General Theory seemed to make compelling arguments for the use of government fiscal policy to avoid such problems and to smooth out economic instability. Keynesian followers believe that savings must be offset by investment. They termed propensity to consume as a person's decision on how much of total income will be allocated to savings and how much will be spent. The Keynesian view sees the causes of unemployment and inflation as the failure of certain fundamental economic decisions, particularly saving and investment decisions. In short, the Keynesian view is one of a demand-based economy.

MONETARISM.

More recently, the monetarists, led by Nobel laureate economist Milton Friedman, argued that money plays a much more important role in determining the level of economic activity than is granted to it by the Keynesians. Monetarism holds that markets are highly competitive and that a competitive market system gives the economy a high degree of macroeconomic stability. Monetarists argue that price and wage flexibility provided by competitive markets cause fluctuations in total demand rather than output and employment. Monetarism is thus concerned with controlling the money supply and not injecting excess liquidity into markets. This view is somewhat compatible with, but not identical to, the supply-side school of economics.