Table of Contents
Table of Contents

How Is an Economy Formed and Why Does It Grow?

Broadly speaking, an economy is an interrelated system of human labor, exchange, and consumption. An economy forms naturally from aggregated human action–a spontaneous order, much like language. Individuals trade with each other to improve their standards of living. Improved standards of living are made possible when labor is more productive. Productivity is driven by specialization, technological innovation, and working capital. The only sustainable way for an economy to grow is through increased productivity.

Key Takeaways

  • An economy is a connected system of labor, exchange, and consumption, formed from human action, and driven by increased productivity.
  • Economies stand distinct from one another as a result of regional boundaries; they develop distinctly from one another based on government actions, policies, labor and productivity growth.
  • Economic growth results when groups of people, so-called economic actors, are able to produce goods and services with increasing efficiency.
  • To produce real productivity, an economy must have better tools and equipment, namely capital goods, and greater specialization of laborers.

What Is an Economy?

Most economies are distinguished from one another by regional boundaries (the U.S. economy, the Chinese economy, the economy of Colorado), although that distinction has become less accurate with the rise of globalization. It doesn't take a planned government effort to create an economy, but it does take one to restrict and artificially mold it.

The fundamental nature of economic activity only differs from place to place based on the restrictions placed on economic actors. All human beings are faced with resource scarcity and imperfect information. The economy of North Korea is very different from South Korea, despite a similar heritage, people, and set of resources. It's public policy that makes their economies so distinct.

Economic Formation

An economy forms when groups of people leverage their unique skills, interests, and desires to trade with each other voluntarily. People trade because they believe it makes them better off. Historically, a form of intermediation (money) is introduced to make trade easier.

People are financially rewarded based on the value others place on their productive outputs. They tend to specialize in that which will deems them most valuable. Then they trade the portable representation of their productive value –money– for other goods and services. The total sum of these productive efforts is referred to as an economy.

Growing an Economy

An individual laborer is more productive (and worth more) when they can more efficiently turn resources into valuable goods and services. This could be everything from a farmer improving crop yields to a hockey player selling more tickets and jerseys. When a whole group of economic actors can produce goods and services more efficiently, it's known as economic growth.

Growing economies turn less into more, faster. This surplus of goods and services makes it easier to achieve a certain standard of living. This is why economists are so concerned about productivity and efficiency. It's also why markets reward those who produce the most value in the eyes of consumers.

There are only a handful of ways to increase real (marginal) productivity. The most obvious is to have better tools and equipment, which economists call capital goods–the farmer with a tractor is more productive than the farmer with just a small shovel.

It takes time to develop and build capital goods, which requires savings and investments. Savings and investment increase when present consumption is delayed for future consumption. The financial sector (banking and interest) provides this function in modern economies.

The other way to improve productivity is through specialization. Laborers improve the productivity of their skills and capital goods through education, training, practice, and new techniques. When the human mind better understands how to use human tools, more goods and services are produced and the economy grows. This raises the standard of living.

What Is Economics?

Economics is the study of how individuals and groups allocate limited resources to be used for production, distribution, and consumption. It is usually broken down into macroeconomics, which looks at the broad economy, and microeconomics, which looks at individual people and businesses.

What Are Economic Indicators?

Economic indicators are reports on how an economy is performing in key areas. These reports are released periodically and tend to impact stock performance, interest rate policy and governmental policy. Some examples include GDP, retail sales, and employment data.

What Are the Types of Economic Systems?

The main types of systems are primitivism, where individuals self-produce needs and wants; feudalism, where economic growth is driven by production by social class; capitalism, in which individuals and businesses own capital goods and production is driven by the supply and demand dynamics of the market economy; socialism, in which production decisions are made by a group and many economic functions are shared by all; and communism, a type of command economy in which production is centralized through the government.

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