Economics (Encyclopedia of Business and Finance)
Economics is often described as a body of knowledge or study that discusses how a society tries to solve the human problems of unlimited wants and scarce resources. Because economics is associated with human behavior, the study of economics is classified as a social science. Because economics deals with human problems, it cannot be an exact science and one can easily find differing views and descriptions of economics. In this discussion, the focus is an overview of the elements that constitute the study of economics, that is, wants, needs, scarcity, resources, goods and services, economic choice, and the laws of supply and demand.
Every person is involved with making economic decisions every day of his or her life. This occurs when one decides whether to cook a meal at home or go to a restaurant to eat, or when one decides between purchasing a new luxury car or a low-priced pickup truck. People make economic decisions when they decide whether to rent or purchase housing or where they should attend college.
WANTS, NEEDS, AND SCARCITY
As a society, and in economic terms, people have unlimited wants; however, resources are scarce. Don't confuse wants and needs. Individuals often want what they don't need. In the automobile example used above, someone might want to drive a large luxury car, but a small pickup truck may be more suited to the purchaser's needs if he or she must have a vehicle for hauling furniture. Economic decisions must be made.
A resource is scarce when there is not enough of it to satisfy human wants. And human wants are endless. Because of unlimited wants and limited resources to satisfy those wants, economic decisions must be made. This problem of scarcity (limited resources) must be addressed, which leads to economics and economic problems.
Figure 1 illustrates the relationships that exist relative to wants and scarcity. Many elements influence economic decisions. To better understand economics, it is critical to understand what is shown in this Figure.
Economic resources, often called factors of production, are divided into four general categories. They are land, labor (sometimes referred to as human resources), capital, and entrepreneurship.
Land. Land describes the ground that might be used to build a structure such as a factory, school, home, or church, but it means much more than that. Land is also the term used for the
resources that come from the land. Trees are produced by the land and are used for lumber, firewood, paper, and numerous other products, so they are referred to as land. Minerals that come from the ground, such as oil that is used to make gasoline or to lubricate automobile engines, or gold that is used to make jewelry, or wheat that is grown on the land and is used in the production of bread and other products, or sheep that are raised for the wool they produce that is used to make sweaters are all described as land.
Labor (Human Resources). Labor is the general category of the human effort that is used for the production of goods and services. This includes physical labor, such as harvesting trees for lumber, drilling for oil or mining for gold, growing wheat for bread, or raising the sheep that produce wool for a sweater. In addition to physical labor, there is mental labor, which is necessary for such activities as planning the best ways to harvest trees and making decisions about which trees to harvest. Labor is also involved when a doctor or surgeon analyzes and diagnoses (mental labor) before performing a medical procedure, then performs the procedure (physical labor).
Capital. Capital is input that is often viewed in two ways, much as is labor. Capital might be viewed as human capitalhe knowledge, skills, and attitudes that humans possess that allow them to produce. The other type of capital is physical capital, which includes buildings, machinery, tools, and other items that are used to produce goods and service. Traditionally, physical capital has been a prerequisite for human capital; however, because of rapid changes in technology, today human capital is less dependent on physical capital.
Entrepreneurship. One special form of human capital that is important in an economic setting is entrepreneurship (often thought of as the fourth factor of production). Entrepreneurial abilities are needed to improve what we have and to create newgoods and services. An entrepreneur is one who brings together all the resources of land, labor, and capital that are needed to produce a better product or service. In the process of doing this, the entrepreneur is willing to assume the risk of success and failure.
Many people associate entrepreneurship with creating or owning a new business. That is one definition of entrepreneurship but not the only one. An entrepreneur might create a newmarket for something that already exists or push the use of a natural resource to newlimits in order to maximize efficiency and minimize consumption. See "entrepreneurship" for a more general discussion as it relates to business ownership.
GOODS AND SERVICES
It takes land, labor, and capital that are used by an entrepreneur to produce goods and services that will ultimately be used to satisfy our wants. Goods are tangible, meaning they are something that can be seen or touched. The production of goods requires using limited resources to produce in order to satisfy wants. An example might be a farmer who grows grain. The farmer uses farm equipment manufactured from resources; ground is a natural resource that is used to grow the grain; and because the growth of grain depletes the nutrients in the soil, the farmer must use fertilizers to restore the nutrients. Limited resources are used to produce natural or chemical fertilizers, but they are necessary for crop production. Water might be used to irrigate the crop and enhance production. When the crop is ready for harvest, the farmer uses additional resources to complete the processquipment, gasoline, labor, and so onhich results in a good that can be used or sold for use by others.
Services are provided in numerous ways and are an intangible activity. There is no doubt that one can often see someone providing a service, but the service is not something that someone can pick up and take home to use. An example of a service is a ride in a taxi through a crowded city. It takes resources for the owner or driver to provide the service, and a passenger is consciously aware of riding in a taxi. When the ride is completed and the provider has been paid, the passenger doesn't have anything tangible to hold except the receipt. However, resources have been used to provide the service. The automobile used as the cab, the fuel used to operate the cab, and the labor of the driver are all examples of resources being used to provide a service that will satisfy a want.
It is important to understand that because goods and services utilize resources that are limited, goods and services are also scarce. Scarcity results when the demand for a good or service is greater than its supply. Remember that society has unlimited wants but scarce resources. It is scarcity, then, that causes consumers to have to make choices. If individuals can't have everything they want, they must decide which of the goods and services are most important and which they can do without.
Opportunity Cost. When one makes economic decisions, it is because of limited resources. Alternatives must be considered. People make such decisions based on expecting greater benefits from one alternative than another. There is an opportunity cost involved in the choice. Opportunity cost is the benefit forgone from the best alternative that is not selected: Individuals give up an opportunity to use or enjoy something in order to select something else.
Opportunity costs can't always be measured, because it might be satisfaction that is lost. At other times, however, opportunity cost can be measured. Here are examples of each. Perhaps a student is studying hard for a final examination in a difficult course because a good exam score is critical to achieve the desired grade. Friends call to invite the student out for the evening. The alternatives are to study or to have fun. Being wise, the student selects studying instead of going out. It is difficult to measure the opportunity cost of having fun with friends. In the second example, the same studying student is asked to help someone clean a garage. If the person offers to pay the student $50 to clean the garage and the student chooses to study, the opportunity cost is easily measured at $50. In both these examples, opportunity cost is directly related to what was given up, not any other benefits that might result from the decision.
Circumstances also play a role in opportunity cost. Sometimes people are forced into a decision because of circumstances and the results may not always be optimal. For example, if someone is planning to relocate to a newcity to start a new job and wants to sell a house before the move in order to be able to purchase a newhouse in the newlocation, the person may sell the house for less than the market price in order to complete the process. The opportunity cost is the value of what was given up in order to be able to purchase a newhome. Every time a choice is made, opportunity costs are assumed.
Production. Another economic choice that must be made is related to production. This is illustrated in Figure 1. All four of the decisions must be made: What goods will be produced? How will production occur? Howmuch should be produced? Who will be the recipients? All are decisions that influence production efficiency.
Efficiency is the primary element in deciding what to produce and how to go about the production process. Efficiency is producing with the least amount of expense, effort, and waste, but not without cost. If you take something away from a person to satisfy another person, one will be less happy and the other will be more happy. If a way can be found to make one person more happy without making the other person less happy, this would be efficient.
An example of economic efficiency might be the following. Assume someone owns a car and a friend doesn't own a car but does drive. The friend needs transportation regularly for a week. It happens to be a time when the car owner will be away on a business trip and therefore won't be using the car. It makes no sense for the friend to buy a car to use for such a short period of time, so the owner loans the friend the car for that week. The car owner is no worse off and the friend is better off. Economic efficiency has occurred in this situation. If the car owner had not loaned the car to the friend, there would have been waste because the friend would have had to buy or rent a car. It is wasteful to fail to take advantage of opportunities in which there is no loss of satisfaction to either party.
Production efficiency is a situation in which it is not possible to produce any more units of a good without giving up the opportunity to produce another good unless a change occurs in available productive resources. If a farmer is growing wheat to be sold for the production of bread, there is a point at which adding additional fertilizer to the soil would do no good. If the fertilizer were used on an oat crop in a different field, production could be increased for that crop. The way to increase the wheat production is to find different resources to make the crop better, such as irrigating the land to provide more moisture.
In the above example, it was suggested that different or additional resources might be used to increase production. This is necessary only after efficiency has been achieved. Additional resources would have to come from land, labor, capital, or entrepreneurship. It is most common that capital will be used most often to increase production. Capital is productive input that is increased by people. This is known as investment. Investment involves giving up what might presently be consumed in favor of producing something to consume in the future. If the farmer wants to increase wheat production in the future, something will have to be given up now in order to increase the resources available for future production.
Increasing human capital is critical to increasing production. This does not mean that more people must be produced, but rather that the knowledge and skills of humans must be increased. This can happen because of improvements in technology and newways of satisfying wants. This involves the entrepreneurial factor that was described previouslyhe human element that figures out ways to improve and expand the resources that already exist.
Product Distribution. Getting goods into the hands of those who want them involves many choices. The economic system must decide how to divide the products that are produced among the potential recipients. Sometimes products can be divided equally among recipients, but normally this is not the situation. It must then be determined how the division will take place. In a capitalistic economic system, distribution is often determined by wealth. If two people have the same wants, the person who can most afford something will be able to acquire it.
THE LAWS OF SUPPLY AND DEMAND
Production decisions are made based on demand for goods and services. Supply of goods and services is dependent upon demand for the same. Why do movies that are much more popular stay at theaters longer than those that aren't as popular? Demand for the movie causes the theater operators to supply the showings that the consumer wants. Why does the room rate in a convention hotel go down on weekends? There is less demand on weekends because most convention-goers leave on Friday or Saturday and others don't arrive until Monday, so the supply of available rooms goes up. Hotel operators try to create more demand for their vacant weekend rooms by lowering prices and offering attractive amenities.
The law of demand states that during a specific time period the quantity of a product that is demanded is inversely related to its price, as long as other things remain constant. The higher the price, the lower the demand; the lower the price, the higher the demand. Don't confuse demand with wants. Consumers have unlimited wants, as was established at the beginning of this discussion. Nor are demands and wants the same as needs. A consumer may need to have a crown put on a tooth but may not want to have it done because of the high cost. At some point, the suffering patient may demand the services be provided regardless of the price.
Often when prices are too high and demand for a product or service lessens, it is because consumers have found a suitable substitute. Substitution happens all the time as a result of economic decisions that are made by consumers. For example, if someone needs a winter coat and likes one with a designer name and a price that reflects that name, the purchase may not be made. Instead, the person finds a similar coat that does not have a designer label and purchases it instead at a much lower cost.
Demand for goods or services determines the amount that will be supplied. The law of supply states that the greater the demand, the more that will be supplied; the lower the demand, the less that will be supplied. The amount that will be supplied by a producer of the good or service is based on capacity and willingness to supply the product at a specific price. A producer will not supply goods and services just because there is demand for themrice for the good or service is an important consideration.
If consumers are willing to pay more for a good or service, the producer will likely be willing to shift more resources in order to increase the supply of the demanded product. If a rancher is raising prime beef cattle and there is high demand for this good and consumers are willing to pay more for high-quality beef, then the rancher might be willing to supply more even if it is necessary to shift resources or acquire additional resources to be able to do so.
Demands change, supplies change, and prices change. So how does a producer knowhow much is enough and what price to charge for the goods and services? Very simply, the demand for and supply of goods and services can be plotted on graphs using different prices. The supply and demand for a good or service intersect on the graph at what is called the equilibrium price, or the price where all of what is supplied will be demanded. If the price is belowe quilibrium, there will be a shortage of the good or service, and if the price is above equilibrium, there will be a surplus of the good or service. For a more detailed explanation on this aspect of economics, see the discussion of supply and demand.
Economics is a complex topic that is studied constantly and thoroughly. This article has given an overview of some of the main tenets of economics; however, there is much that was not even introduced. There are other topics throughout this encyclopedia, such as macroeconomics and microeconomics, that will further define and expand the topic of economics.
Dolan, Edwin G., and Lindsey, David E. (1991). Economics. Chicago: Dryden.
Heilbroner, Robert L., and Thurow, Lester C. (1987). Economics Explained. New York: Simon & Schuster.
Lipsey, Richard G., Steiner, Peter O., Purvis, Douglas D., and Courant, Paul N. (1990). Economics. New York: Harper & Row.
McEachern, William A. (1991). Economics: A Contemporary Introduction. Cincinnati, OH: South-Western Publishing.
Economics (Encyclopedia of Management)
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.
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 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 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 timell 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).
Movement along the demand curveeferred to as a change in quantity demandedeans 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.
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.
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 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.
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:
- 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)uch as a Japanese auto plant in the United Statess 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.
- 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 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.
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 beennd continue to beiffering theories about some areas of economic behavior. Following is a brief overview of the three most influential theoretical perspectives.
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.
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.
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.
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