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 on allocating resources to satisfy their wants and needs, and tries to determine how these groups should organize and coordinate efforts to achieve maximum output.
Economic analysis often progresses through deductive processes, much like mathematical logic, where the implications of specific human activities are considered in a "means-ends" framework.
BREAKING DOWN 'Economics'
Unlimited Wants and Limited Means
One of the earliest recorded economic thinkers was the 8th century Greek farmer/poet Hesiod, who 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 occupy a world of unlimited wants and limited means. For this reason, the concepts of efficiency and productivity are held paramount by economists. Increased productivity and a 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 by Scottish historian Thomas Carlyle in 1849. He may have written it to describe the gloomy predictions by Thomas Robert Malthus that population growth would always outstrip the food supply, though some sources suggest Carlyle was actually targeting economist John Stuart Mill and his liberal views on race and social equality.
Types of Economics
Economics study is generally broken down into two categories.
- Microeconomics focuses on how individual consumers and producers make their decisions. This includes a single person, a household, a business or a governmental organization. Microeconomics ranges from how these individuals trade with one another to how prices are affected by the supply and demand of goods. Also studied are the efficiency and costs associated with producing goods and services, how labor is divided and allocated, uncertainty, risk, and strategic game theory.
- Macroeconomics studies the overall economy. This can include a distinct geographical region, a country, a continent or even the whole world. Topics studied include government fiscal and monetary policy, unemployment rates, growth as reflected by changes in the Gross Domestic Product (GDP) and business cycles that result in expansion, booms, recessions and depressions.
There are also schools of economic thought. Two of the most common are Classical and Keynesian. The Classical view believes that free markets are the best way to allocate resources and the government’s role should be limited to that of a fair, strict referee. In contrast, the Keynesian approach believes that markets don’t work well at allocating resources on their own, and that governments must step in from time to time and actively reallocate resources efficiently.
Some branches of economic thought emphasize empiricism in economics, rather than formal logic – specifically, macroeconomics or Marshallian microeconomics, which attempt to use the procedural observations and falsifiable tests associated with the natural sciences. Since true experiments cannot be created in economics, empirical economists 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.
Labor and Trade
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 difficult to determine which methods yield the best results in equilibrium.
Economics demonstrates, 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 trade is most efficient when coordinated through a medium of exchange, or money.
Incentives and Subjective Value
In focusing on labor, economics focuses on the action of human beings. Most economic models are based on assumptions that humans act with rational behavior, seeking the most optimal level of benefit or utility. But of course, human behavior can be unpredictable or inconsistent, and based on personal, subjective values (another reason why economic theories often are not well suited to empirical testing). This means that some economic models may be unattainable or impossible, or simply not work in real life.
Still, they do provide key insights for understanding the behavior of financial markets, governments, economies – and human decisions behind these entities. As it is, economic laws tend to be very general, and formulated by studying human incentives: Economics can say profits incentivize new competitors to enter a market, for example, or that taxes disincentivize spending.
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 stock , fixed income, and forex markets when they are released.
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 other period (the Bureau of Economic Analysis also issues a report monthly during the latter end of the 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 it can't 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.
Reported by the Department of Commerce during the middle of each month, the retail sales is a very closely watched report that measures the total receipts, or dollar value, of all merchandise sold stores. The report estimates the total merchandise sold by taking sample data from retailers across the country. This figure serves as a proxy of consumer spending levels. Because consumer spending represents more than two-thirds of the economy, this report is very useful to gage the economy's general direction. Also, because the report's data is based on the previous month sales, it is a timely indicator. The content in the retail sales report can cause above normal volatility in the market, and information in the report can also be used to gage inflationary pressures that affect Fed rates.
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 level of production activity in the economy. It is preferable for a country to see increasing values 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.
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.