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, trying to determine how these groups should organize and coordinate efforts to achieve maximum output.
One of the earliest recorded economic thinkers was the 8th-century BC 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 have unlimited wants and occupy a world of 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 Scottish historian Thomas Carlyle in 1849. He used it to criticize the liberal views on race and social equality of contemporary economists like John Stuart Mill, though some sources suggest Carlyle was actually describing the gloomy predictions by Thomas Robert Malthus that population growth would always outstrip the food supply.
Types of Economics
The study of economics is generally broken down into two disciplines.
- Microeconomics focuses on how individual consumers and firm make decisions; these individuals can be a single person, a household, a business/organization or a government agency. Analyzing certain aspects of human behavior, microeconomics tries to explain they respond to changes in price and why they demand what they do at particular price levels. Microeconomics tries to explain how and why different goods are valued differently, how individuals make financial decisions, and how individuals best trade, coordinate and cooperate with one another. Microeconomics' topics range from the dynamics of supply and demand to the efficiency and costs associated with producing goods and services; they also include how labor is divided and allocated, uncertainty, risk, and strategic game theory.
- Macroeconomics studies an overall economy on both a national and international level. Its focus can include a distinct geographical region, a country, a continent, or even the whole world. Topics studied include foreign trade, government fiscal and monetary policy, unemployment rates, the level of inflation and interest rates, the growth of total production output as reflected by changes in the Gross Domestic Product (GDP), and business cycles that result in expansions, booms, recessions, and depressions.
Micro- and macroeconomics are intertwined; as economists gain an understanding of certain phenomena, they can help us make more informed decisions when allocating resources. Many believe that microeconomics' foundations of individuals and firms acting in aggregate constitute macroeconomic phenomena.
- Economics is the study of how people allocate scarce resources for production, distribution, and consumption, both individually and collectively.
- Two major types of economics are microeconomics, which focuses on the behavior of individual consumers and producers, and macroeconomics, which examine overall economies on a regional, national, or international scale.
- Economics is especially concerned with efficiency in production and exchange and uses models and assumptions to understand how to create incentives and policies that will maximize efficiency.
- Economists formulate and publish numerous economic indicators, such as gross domestic product (GDP) and the Consumer Price Index (CPI).
- Capitalism, socialism, and communism are types of economic systems.
Schools of Economic Theory
There are also schools of economic thought. Two of the most common are monetarist and Keynesian. Monetarists have generally favorable views on free markets as the best way to allocate resources and argue that stable monetary policy is the best course for managing the economy. In contrast, the Keynesian approach believes that markets often don’t work well at allocating resources on their own and favors fiscal policy by an activist government in order to manage irrational market swings and recessions.
Economic analysis often progresses through deductive processes, including mathematical logic, where the implications of specific human activities are considered in a "means-ends" framework. Some branches of economic thought emphasize empiricism, 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.
The Economics of Labor, Trade, and Human Behavior
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.
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.
Economics focuses on the actions 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 just 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 stocks, fixed income, and forex markets when they are released. They can also be very useful for investors to judge how economic conditions will move markets and to guide investment decisions.
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 another period (the Bureau of Economic Analysis also issues a report monthly during the later part 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 report is very closely watched and measures the total receipts, or dollar value, of all merchandise sold in stores. The report estimates the total merchandise sold by taking sample data from retailers across the country—a figure that serves as a proxy of consumer spending levels. Because consumer spending represents more than two-thirds of GDP, this report is very useful to gauge 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 gauge 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 portion of productive capacity that is being used rather than standing idle 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 percent is considered "tight" and can increase the likelihood of price increases or supply shortages in the near term. Levels below 80 percent 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.
Types of Economic Systems
Economic systems are defined either by the way that stuff is produced or by how that stuff is allocated to people. For example, in primitive agrarian societies, people tend to self-produce all of their needs and wants at the level of the household or tribe. Family members would build their own dwellings, grow their own crops, hunt their own game, fashion their own clothes, bake their own bread, etc. This self-sufficient economic system is defined by very little division of labor and is also based on reciprocal exchange with other family or tribe members. In such a primitive society, the concept of private property didn’t typically exist as the needs of the community were produced by all for the sake of all.
Later, as civilizations developed, economies based on production by social class emerged, such as feudalism and slavery. Slavery involved production by enslaved individuals who lacked personal freedom or rights and existed as the property of their owner. Feudalism was a system where a class of nobility, known as lords, owned all of the lands and leased out small parcels to peasants to farm, with peasants handing over much of their production to the lord. In return, the lord offered the peasants relative safety and security, including a place to live and food to eat.
Capitalism emerged with the advent of industrialization. Capitalism is defined as a system of production whereby business owners (capitalists) produce goods for sale in order to make a profit and not for personal consumption. In capitalism, capitalists own the business including the tools used for production as well as the finished product. Workers are hired in return for wages, and the worker owns neither the tools he uses in the production process nor the finished product when it’s complete. If you work at a shoe factory and you take home a pair of shoes at the end of the day, that’s stealing even though you made them with your own hands. This is because capitalist economies rely on the concept of private property to distinguish who legally owns what.
Capitalist production relies on the market for the allocation and distribution of the goods that are produced for sale. A market is a venue that brings together buyers and sellers, and where prices are established that determine who gets what and how much of it. The United States and much of the developed world today can be described as capitalist market economies.
Alternatives to capitalist production exist. Two of the most significant ones developed in the 19th century as a response to what was seen as capitalism's abuses.
Socialism is a system of production whereby workers collectively own the business, the tools of production, the finished product, and share the profits – instead of having business owners who retain private ownership of all of the business and simply hire workers in return for wages. Socialist production often does produce for profits and utilizes the market to distribute goods and services. In the U.S., worker co-ops are an example of socialist production organized under a broader capitalist system.
Communism is a system of production where private property ceases to exist and the people of a society collectively own the tools of production. Communism does not use a market system, but instead relies on a central planner who organizes production (tells people who will work in what job) and distributes goods and services to consumers based on need. Sometimes this is called a command economy.