What Is an Economy?

An economy is the large set of inter-related production, consumption, and exchange activities that aid in determining how scarce resources are allocated. The production, consumption, and distribution of goods and services are used to fulfill the needs of those living and operating within the economy, which is also referred to as an economic system.

Key Takeaways

  • An economy is the large set of inter-related production and consumption activities that aid in determining how scarce resources are allocated.
  • In an economy, the production and consumption of goods and services are used to fulfill the needs of those living and operating within it.
  • Market-based economies tend to allow goods to flow freely through the market, according to supply and demand.

What's the Economy?

Understanding Economies

An economy encompasses all activity related to production, consumption, and trade of goods and services in an area. These decisions are made through some combination of market transactions and collective or hierarchical decision making. Everyone from individuals to entities such as families, corporations, and governments participate in this process. The economy of a particular region or country is governed by its culture, laws, history, and geography, among other factors, and it evolves due to the choices and actions of the participants. For this reason, no two economies are identical.

Types of Economies

Market-based economies allow individuals and businesses to freely exchange goods through the market, according to supply and demand. The United State is mostly a market economy where consumers and producers determine what’s sold and produced. Producers own what they make and decide their own prices, while consumers own what they buy and decide how much they’re willing to pay. 

Through these decisions, the laws of supply and demand determine prices and total production. If consumer demand for a specific good increases, prices tend to rise as consumers are willing to pay more for that good. In turn, production tends to increase to satisfy the demand since producers are driven by profit. As a result, a market economy has a tendency to naturally balance itself. As the prices in one sector for an industry rise due to demand, the money, and labor necessary to fill that demand shift to those places where they're needed.

Pure market economies rarely exist since there's usually some government intervention or central planning. Even the United States could be considered a mixed economy. Regulations, public education, social security benefits are provided by the government to fill in the gaps from a market economy and help to create balance. As a result, the term market economy refers to an economy that is more market-oriented in general.

Command-based economies are dependent on a central political agent, which controls the price and distribution of goods. Supply and demand cannot play out naturally in this system because it is centrally planned, so imbalances are common.

Studying Economies

The study of economies and the factors affecting economies is called economics. The discipline of economics can be broken into two major areas of focus, microeconomics, and macroeconomics.

Microeconomics studies the behavior of individuals and firms in order to understand why they make the economic decisions they do and how these decisions affect the larger economic system. Microeconomics studies why various goods have different values and how individuals coordinate and cooperate with each other. Microeconomics tends to focus on economic tendencies, such as how individual choices and actions impact changes in production.

Macroeconomics, on the other hand, studies the entire economy, focusing on large-scale decisions and issues. Macroeconomics includes the study of economy-wide factors such as the effect of rising prices or inflation on the economy. Macroeconomics also focuses on the rate of economic growth or gross domestic product (GDP), which represents the total amount of goods and services produced in an economy. Changes in unemployment and national income are also studied. In short, macroeconomics studies how the aggregate economy behaves.

History of the Concept of Economy

The word economy is Greek and means "household management." Economics as an area of study was touched on by philosophers in ancient Greece, notably Aristotle, but the modern study of economics began in 18th century Europe, particularly in Scotland and France.

The Scottish philosopher and economist Adam Smith, who in 1776 wrote the famous economic book called The Wealth of Nations, was thought of in his own time as a moral philosopher. He and his contemporaries believed that economies evolved from pre-historic bartering systems to money-driven and eventually credit-based economies. 

During the 19th century, technology and the growth of international trade created stronger ties among countries, a process that accelerated into the Great Depression and World War II. After 50 years of the Cold War, the late 20th and early 21st centuries have seen a renewed globalization of economies.