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I’ve been reading Samuelson’s Economics, a classic introductory textbook. So far I’ve got a better understanding of what economics is about. The essential definition according to Samuelson is that it is ‘the study of how societies use scarce resources to produce valuable commodities and distribute them among different people’. This includes, but is not limited to, the following questions:

• How the prices of labour, capital and land are set, and how they are used to allocate resources
• How the financial markets behave and how they allocate capital to the rest of the economy
• Distribution of income and how the poor might be helped without reducing growth
• Impact of government activities on growth
• Studying swings in production and unemployment and how policies can encourage growth
• International trade
• Growth in developing countries and how to encourage efficient use of resources

Returning to the above definition, we can see that without scarcity – i.e. if there were always enough goods to satisfy every person’s every desire – there would be no need for economics, because everybody could just take what they want and need without depriving anyone else. The desire for efficiency is also essential to economics; if we didn’t care about satisfying as many needs and desires as possible, then we wouldn’t need economics to tell us how to most efficiently distribute scarce resources. The economy is producing efficiently ‘when it cannot increase the economic welfare of one person without making someone else worse off’.

A QUESTION/ DIGRESSION

As an aside, I disagree with / don’t understand this definition. Imagine an economy where most of the resources are in the hands of one person (call him Bill). Imagine, reasonably, that in such an economy no-one’s economic welfare could be increased without making Bill worse off. According to Samuelson’s definition, then, this society is efficient. But surely, you want a notion of efficiency which allows decreases in welfare of one person so long as they result in proportionally greater increases in the welfare of others. If Bill’s income tax for the year is £1 million, and that revenue allows government spending, which stimulates GDP, perhaps it could make 10,000 people £20 richer – a net gain for society. Wouldn’t this be a more efficient use of resources?

From a Google search, I think the notion of ‘pareto-optimal’ captures my pre-theoretical intuition about efficiency – where a pareto-optimal situation is one in which no individual’s welfare can be improved without making another individual’s welfare proportionally even worse off. Imagine that taxing Bill £1 million makes 9,999 other people £10 richer. But this would not count as pareto-optimal, because Bill would have lost more than the combined gains of others (£1 million vs £99,990). That’s what I had imagined an economist’s notion of efficiency referred to, before reading Samuelson. But perhaps I’m jumping the gun here!

…back on topic:

Microeconomics is the study of individual entities such as markets, firms and households. It considers how individual prices are set, the determination of prices of land, labour and capital, and market efficiency.

Macroeconomics came around in the 1930’s when John Maynard Keynes decided to look at the overall performance of the economy. He analysed what causes unemployment and downturns, investment and consumption, the management of money and interest rates by central banks, and why some economies thrive and others fail. These days the distinction between the two is less important, with microeconomics being applied to studying unemployment and inflation.

Economists observe current economic phenomena as well as historic data and make theoretical predictions and broad generalisations on that basis. They also use econometrics, which is the application of statistical analysis to economic data, allowing them to identify the relationships between different factors.

The kind of economy one has depends on three things:
• What goods should be produced
• How should they be produced
• For whom will they be produced

Factors of production are things that are used to create goods and services, and come in three categories:
• Land (and other natural resources)
• Labour – human time
• Capital – goods which can be used to create new goods