Economics is the study of how people choose to use their scarce resources to meet their competing desires. Resources include money, property, and time. A resource is considered scarce when people cannot obtain as much of it as they would choose if the resource were free. Scarcity forces people to make choices about how best to use their resources. A consumer chooses whether to use his or her income to buy food or a book. A parent chooses how to allocate (distribute) his or her time between working for income and caring for children. A factory owner chooses whether to expand production by hiring more workers or purchasing more machinery. A government may collect trillions of dollars in tax revenue, but it still has to choose whether to devote these funds to improving highways or building new schools. All of these are examples of the kinds of choices that might be made concerning the allocation of resources.
Scarcity also implies that people have to compete for resources and for the goods and services that they desire. In economics, goods are items that people value—for example, food, clothes, and books. Services are activities performed that have value, such as a haircut, legal advice, or police protection. The form that the competition might take is determined by the nature of the economy. An economy is made up of a broad mix of participants—buyers and sellers; workers and employers; and businesses, governments, and other organizations—all involved in the production and exchange of goods and services.
The rules of the economy determine the nature of competition. In a market economy, people compete for goods and services by offering and setting prices. In nonmarket settings, the forms of the competition might include lobbying government officials or waiting in line to obtain goods. Within the rules of the economy, people determine how many and what types of goods and services they want, how to go about producing these goods and services, and how to distribute them among all the people who are competing to obtain them. The choices made also determine what jobs are available, how much people earn, and how people live. Economists seek to examine these choices, to observe their causes and effects, and to understand how the various forces of an economy interact.
The organization of economies
Typically, the organization of an economy lies between two extreme models—capitalism and central planning. Under the capitalist model, households and privately owned businesses trade goods and services in markets. Households may be made up of individuals living alone, families, or unrelated groups of people living together. Businesses are made up of (1) individuals who own their business, (2) owners working together in a business partnership, or (3) corporations in which owners hold stock in a business.
Under a capitalist model, households and businesses own their own property. This property can include goods—such as factories, land, houses, and televisions and other consumer goods—as well as ideas, such as inventions and brand names. Businesses in capitalist economies choose what goods to produce and at what price to sell those goods. Consumers in these economies choose whether or not to purchase goods at the prices they find. In the late 1800’s, the United States and Canada were considered to be mostly capitalist nations, although their governments still played important roles in their economies.
At the other extreme, under the model of central planning, the government controls the economy, and it has a much larger role in choosing which goods and services to produce and how they will be distributed. For much of the 1900’s, both the Union of Soviet Socialist Republics, or Soviet Union, and the People’s Republic of China centrally planned their economies.
The economies of all nations combine elements of capitalism and central planning. The economic mixture within a nation may change over time. For example, the governments of the United States and Canada have expanded economic regulation, spending, and welfare programs since 1900. Further, in response to World War I (1914-1918) and World War II (1939-1945), the central government in both nations practiced extensive central planning. There are also examples of nations moving in the opposite direction. In the late 1980’s, the Soviet Union began increasing the role of markets in its economy. That trend continued as the country broke up into independent states in 1991. China also began moving toward a less centrally planned economy in the 1980’s.
The free market.
Capitalist economies rely on free markets, which permit people to engage in economic activities largely free from government control. The Scottish economist Adam Smith, in his classic work The Wealth of Nations (1776), set forth the principles of a free-market system. According to Smith, society benefits if individuals are allowed to pursue their own self-interest in markets where competition sets the prices that allocate goods among buyers and sellers. Smith believed that competition would, without control or direction, act “as if by an invisible hand” to determine market prices.
A number of factors go into making the “invisible hand” work in a free market. Sellers prefer to sell their goods for higher prices to make more profit. Buyers prefer to pay lower prices so that they can buy more items with their income. If the sellers of a good ask too high a price, the quantity demanded of that good will be less than the quantity supplied. Sellers with lower costs who are having trouble finding buyers will compete by asking a lower price. Buyers will then be willing to buy more of the good. On the other hand, when sellers ask too low a price, quantity demanded exceeds quantity supplied. Buyers who want the item but are having trouble buying it will then compete by raising the prices they offer. Sellers will then be willing to sell more of the good. The competition on both sides of the market ultimately leads to a set of market prices where the quantity supplied is equal to the quantity demanded. When this occurs, the market is said to be in equilibrium.
In a capitalist economy, there are numerous types of markets. The wages employers pay to workers are set in labor markets. Real estate markets determine the rents and selling prices for houses and factories. Interest rates, which in loans represent the price of obtaining goods sooner rather than later, are set in capital markets for lending and investing.
Government intervention.
The role played by governments in an economy depends on the degree to which the system favors capitalism or central planning. Even in capitalist systems, however, governments play an important role. Governments are different from households and businesses, because governments can force people to pay taxes or to take actions. As a result, governments provide a number of services that businesses and households typically do not.
Governments establish the property-rights structure for the economy. To enforce property rights, governments establish police forces and provide for courts of law. The courts settle disputes between buyers and sellers and order people who harm others or damage the property of others to pay compensation (payment to make up for a loss). Governments also provide national defense against attempts by other countries to take or damage the nation’s resources.
In many economies, governments play more expanded roles. Many governments seek to reduce unemployment and keep prices low using fiscal and monetary policies. Fiscal policy is devoted to managing the amounts of tax revenue and government spending. Monetary policy involves managing the money supply and the value of a nation’s currency. Monetary policy is typically conducted by the nation’s central bank, which is a government agency in many countries. In the United States, the central bank is the Federal Reserve System. Although established by the federal government, the Federal Reserve is mostly an independent agency. It adjusts the money supply by buying and selling bonds, setting requirements that banks hold money in reserve, and setting the interest rate at which the Federal Reserve makes loans to national banks. Currently, the Federal Reserve uses monetary policy to influence the federal funds rate, the interest rate at which national banks make loans to each other. The Federal Reserve does not, however, have direct control over this rate.
Governments in many countries regulate or own public utilities that provide electric power, natural gas, sewers, and water treatment. They provide schools and build roads. Many governments regulate economic activity. For example, they may use antitrust laws to promote competition. Governments may also set standards for working conditions and wages; ban harmful or misleading marketing practices; require certain goods to be inspected before they can be sold; set policies to limit pollution; and prohibit businesses from discriminating against people on the basis of race, sex, or age.
Nearly all government decisions affect the distribution of income and wealth. Many governments collect taxes and redistribute them to the poor, unemployed, retired, and disabled. Many nations regulate or provide health care. Government policies also influence the distribution of income indirectly. For example, regulations that limit the number of sellers can raise the sellers’ income at the expense of consumers. In some nations, leaders set policies that favor the few and leave many of the nation’s people in poverty.
The world economy.
Throughout history, people and organizations from different nations have exchanged goods and services in the world economy. During the late 1800’s, national economies became more integrated, meaning that increasing numbers of goods were exchanged across national boundaries, the number of people migrating to new countries rose, and there was increased investment in foreign countries. As a result, differences across countries in prices, wages, and interest rates narrowed. This process of integration was halted by World War I; the Great Depression, a worldwide economic slump that occurred during the 1930’s; and World War II. Since the end of World War II, national economies have again become more integrated with one another. The process, renamed globalization in the modern era, has been encouraged by many factors, including developments in transportation, communications, and computer technology.
When people voluntarily choose to trade with each other, both sides gain from the trade. The potential for gains from trade across national boundaries has led governments and international organizations to become more interested in promoting free trade—trade without limits or restrictions. The United States has worked to develop freer trade with Canada and Mexico under the North American Free Trade Agreement (NAFTA). Similarly, the European Union (EU) has reduced many trade barriers between its member countries. In addition, many nations have joined the World Trade Organization (WTO) to work toward increasing free trade worldwide.
Nearly all countries, however, adopt some policies that restrict international trade to protect domestic businesses from foreign competition. The restrictions often force consumers to pay higher prices for goods from the protected businesses. Such restrictions include import tariffs and import quotas. Import tariffs are taxes on goods purchased from other countries. Import quotas limit the quantity of goods that people can import from foreign countries. Some nations also pay subsidies to aid their own nation’s businesses. The practice of establishing trade barriers to help certain national businesses is commonly called protectionism.
International trade involves the exchange of goods and services across national boundaries. Since countries often have different types of money, known as currencies, markets have developed to trade them. The price of one currency in terms of another is the exchange rate. The value of a nation’s currency rises when there is greater demand for products sold by people of that nation. For example, if Americans want to buy more Japanese products, Americans demand more yen, Japan’s currency. The yen therefore increases in value because it takes more dollars to get each yen. Exchange rates that are allowed to rise and fall on world currency markets are called floating exchange rates. Many governments intervene in currency markets if the exchange rate for their currency rises or falls too much.
Economics and society
The standard of living.
The economic activities of households, businesses, governments, and organizations have a powerful impact on the lifestyles and living conditions of the general population. The standard of living is a measure of the general well-being of an individual, family, or group of people.
Economists use gross domestic product per person as the most common measure of the average standard of living in a nation’s economy. The gross domestic product (GDP) is the market value of all final goods and services produced within an economy during a particular time. To obtain the GDP per person, the value of a nation’s goods and services is divided by the nation’s population. When making comparisons over time, economists focus on real GDP per person, which adjusts GDP for general changes in prices. When making comparisons between countries, GDP per person is adjusted for differences in currency values in each country. The adjustments are made to make sure that the differences reflect differences in actual goods and services and not differences in prices.
The countries with the highest GDP per person include Australia, Canada, many of the European Union countries, Japan, and the United States. People in these countries typically have more food, more consumer goods, better housing, greater educational opportunities, and better medical care than the rest of the world’s people.
GDP per person does not measure all of the dimensions of economic welfare. For example, it does not give a full picture of the income distribution in a nation. People are thought to have a higher standard of living if they spend a smaller share of their income on basic food, they live longer and healthier lives, their environment is less polluted, they have more freedom, they are better educated, or they have more leisure (time spent not working). Therefore, economists use a variety of measures to compare standards of living.
Economic growth.
Improvement in the standard of living typically occurs when an economy increases its output of goods and services during an expansion, a period of economic growth. A period of decreased economic activity is called a recession, contraction, or, in severe cases, a depression. The pattern of fluctuations between expansions and recessions is known as the business cycle.
At the most basic level, the output in a nation’s economy is determined by the amount of labor, capital, and natural resources a nation has. Labor is the amount of effort people devote to an activity. Capital refers to goods, such as buildings and machinery, which can be used to produce other goods. Natural resources include such things as land, minerals, water, and petroleum.
To achieve economic growth, a nation’s economy must add to its inputs (items required for production) of labor, capital, or natural resources, or improve the way that it uses them. Advances in technology, knowledge, and organization allow people to get more out of each input and to combine inputs more effectively. Such advances increase productivity, which is the amount of goods or services produced using a given set of inputs in production.
Savings and investments play an important role in economic growth. People save when they use less than the full amount of the income they have earned. Many people in developed countries put their savings in banks, where the money can earn interest. The banks, in turn, lend the money to others in the economy. Some people invest their savings in stocks and bonds sold by corporations, which in turn use the funds to expand production. Many people also invest their time and money in obtaining education and job training that improves their skills, also known as human capital. As people save and invest more, economies tend to grow faster.
The economic organization of the country also plays an important role in economic growth. Many studies show that countries with governments that protect the freedoms of individuals and property rights, and that offer impartial courts, tend to lead the list of countries with the highest GDP per person. Countries with unstable governments that are troubled by such problems as civil wars or high levels of corruption tend to grow more slowly.
Distribution of income.
People receive income in a variety of ways. Most people earn wages or salaries in exchange for their work. Business owners receive income in the form of profits, which is the revenue left over after subtracting the costs of all the inputs. People who own shares of stock in a corporation may receive income in the form of payments called dividends. Owners of land and buildings receive payment called rent. Many people receive transfer payments from government programs, such as unemployment insurance or social security. People who sell land or stocks at prices higher than the original prices they paid receive income in the form of capital gains.
The distribution of income varies by country. In a country with highly unequal distribution of income, the highest-earning 10 percent of the households might receive nearly 50 percent of the nation’s income. In many of the countries with the highest GDP per person, the share of income held by the top 10 percent in the early 2020’s was between 20 and 30 percent.
Income distributions are determined in part by the mixture of markets and central planning in an economy. In market economies, people tend to rank higher in the income distribution when they are older, have more education, work more hours, or have more inherited wealth. Sometimes, people become wealthy because they are lucky. A household’s position in the income distribution often changes from year to year. College students rank low in the distribution while in school and move much higher after they graduate. People employed in industries that experience booms and busts also move up in the distribution when they are employed and down when they are unemployed. Some people remain low in the income distribution because they are discriminated against. In many economies, particularly centrally planned economies, people gain more income as they gain more influence over government policies.
One of the world’s major economic problems is poverty—that is, when people lack the income and resources to live adequately by the standards of their community. The percentage of a population that lives in poverty is called the poverty rate. In the early 2020’s, roughly 10 percent of the world population was living on less than $2.15 per day, the amount per person that the World Bank has set as the international poverty line. The factors that determine economic growth and the income distribution strongly influence the poverty rate. Some nations and many charities and individuals offer aid to people in less developed countries to help relieve the suffering from poverty.
History of economic thought
Early theories.
The ancient Greek historian and author Xenophon wrote about how best to organize households and public affairs in Oeconomicus. The title, made up of the Greek words for house and management, is the source for the English word economics. The Greek philosopher Aristotle discussed exchanges between individuals and the role of money and interest in society. Philosophers in the Middle Ages, from about the A.D. 400’s through the 1400’s, wrote a great deal about how to define economic value.
Between the 1500’s and the 1700’s, the economic policies of nations were strongly influenced by mercantilism. Leaders of mercantilist nations sought to maintain their political and military power and to increase their share of the world’s wealth. To achieve these goals, they increased their supplies of gold and silver by exporting more goods than they imported. In addition, mercantilist leaders often strictly regulated agriculture, industry, and trade within their own nations.
During the mid-1700’s, a group of French economists known as the physiocrats argued that the key to creating additional wealth was through increases in agricultural productivity. To stimulate such production, they argued that governments should reduce taxation and allow freer trade. The physiocrats described their recommended policy as laissez faire << `lehs` ay FAIR >> , a French term that means allow to do. The term is still in use in economics today.
The classical economists.
Most economists today consider Adam Smith to be the father of modern economics. Smith greatly expanded on the laissez faire ideas of the physiocrats. He believed that the government could best promote the general well-being by protecting individual freedoms, providing a “regular administration of justice,” and promoting competition and free trade. Smith also warned against allowing sellers to make agreements that reduced competition. Smith’s ideas have become central features of the policies toward markets followed by many developed economies.
Three British economists of the late 1700’s and the 1800’s were particularly influential in expanding on Smith’s theories and challenging them. David Ricardo developed the concept of comparative advantage and demonstrated the benefits of free trade among nations. Thomas Robert Malthus warned that rapid population growth would surpass the world’s resources and lead to food shortages, disease, and wars. John Stuart Mill made popular the notion of an economic equilibrium and described how the equilibrium changed when factors in the economy changed. Although Mill supported the idea of a free-market economy, he favored some government interventions to promote a more even distribution of wealth.
Karl Marx and Communism.
Some writers disagreed with the classical economists’ belief that competition under a capitalist system would lead to economic progress. Karl Marx, a German philosopher of the 1800’s, viewed human history as a struggle between classes over ownership of the means of production. Marx argued that technological change under capitalism would lead to a series of depressions. The depressions—each more severe than the last—would leave workers in a worse condition and put more resources into the hands of a small ruling class. Eventually workers would revolt and gain control of economic resources and the government. Marx’s theories influenced the development of a number of socialist and Communist governments during the 1900’s.
Modern economics.
During the late 1800’s and the early 1900’s, economists began to use scientific methods to study economic problems. Alfred Marshall of England developed the theory of how prices and quantities traded are affected by changes in supply and demand. The French economist Leon Walras applied mathematical analysis to show how changes in one market lead to changes in all other markets until the economy reaches a general equilibrium. Wesley Clair Mitchell of the United States studied increases and decreases in economic activity during the course of a business cycle.
The Great Depression of the 1930’s caused a number of economists to seek new explanations for economic depressions. John Maynard Keynes, a British economist, argued that wages and prices did not always adjust in the ways that the classical economists had predicted. The economy could, therefore, reach a stable position with high unemployment. Keynes suggested that governments could help end depressions by creating budget deficits, in which government spending exceeded tax revenues. Extra spending and lower taxes would create employment and provide people with more income that they would then use to buy goods and services or invest in new projects.
Joseph A. Schumpeter of Austria emphasized the role of entrepreneurs (people who organize and manage a business or industrial undertaking) in developing innovations that drive economic growth. His theories of the business cycle described how waves of innovation, or new ways of doing things, stimulated growth but could eventually lead to overexpansion by businesses and then the next recession. Schumpeter predicted that the growth of big business would ultimately cause expansions in government regulation that would work against big business. Friedrich von Hayek, another Austrian economist, argued that markets promoted economic welfare because prices provided large amounts of information at low cost. He thought that protecting the economic freedom of individuals was central to the success of economies.
During the last half of the 1900’s, many economists made significant contributions. The American economist Simon Kuznets developed new methods for measuring output, income, and productivity. Milton Friedman, another American economist, argued that changes in the money supply led to business-cycle fluctuations. He recommended that central banks increase the money supply at a constant rate to stabilize prices and promote economic growth. Economists who support these ideas are known as monetarists, and Friedman was a leading spokesman of this school of thought.
The American economist Robert E. Lucas, Jr., is a leader among rational expectations theorists. Economists in this school argue that when people correctly predict changes in government fiscal and monetary policies, the policies become less effective at stimulating production. For example, a government could try to stimulate demand for goods by increasing the money supply. Suppliers with rational expectations, however, might recognize that the rise in demand for their products is due only to a rise in the amount of money available in the economy and not to an increase in the amount of products that consumers want to buy. In such an instance, suppliers would raise their prices but would not increase the amount of goods produced. Then the result of the government policy would be inflation (a decline in the value of money), and no change in real GDP. The insights from rational expectations theory have led economists and policymakers to pay closer attention to the availability of information in determining the effectiveness of monetary and fiscal policies.
The American economists Paul A. Samuelson and Kenneth Arrow and the French-born American economist Gérard Debreu were among the leaders in using mathematics to describe and extend economic theories. The Hungarian-born American mathematician John von Neumann and the Austrian economist Oskar Morgenstern paved the way for the widespread use of game theory, a method based upon formal logic used for studying strategies when people interact with others. The American mathematician John Forbes Nash, Jr., contributed to the development of game theory with important insights on how to predict behavior in settings where people might get more benefit by not cooperating with one another. 
Research today generally seeks to understand the relationships between various parts of the economy. Many economists—such as Daniel L. McFadden and James J. Heckman of the United States—have greatly expanded the use of statistical methods to identify the relationship between economic variables. In addition, the methods of economic analysis have increasingly been applied to areas outside the field’s traditional boundaries. The American economist Gary Becker, for instance, established that economic methods could be used to study such issues as discrimination, crime, marriage, families, and addiction.
Careers in economics
Many economists find career opportunities in the business world as market analysts, consultants, and business managers. They help businesses understand production costs, markets, investment options, and other issues. Economists also help governments evaluate economic conditions and develop economic policies. Many economists teach and conduct research at colleges and universities. In addition to professional economists, thousands of other workers carry out statistical and clerical duties that are associated with economics.
A college degree in economics, business administration, or mathematics is essential for a person considering a career in economics. College students who major in economics are expected to take courses in calculus and statistics. The courses for someone pursuing a degree in economics frequently include basic and advanced classes in microeconomics and macroeconomics, as well as courses in some of the individual fields of economics.
People who wish to teach economics at a college or university usually must have a doctor’s degree in economics. However, some schools, especially two-year institutions, may hire instructors with master’s degrees. Many companies and government agencies require economic analysts to have graduate training.
