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Fundamentals of economics

Looking at some early work on the subject, Adam Smith (the man with the invisible hand fetish … ‘it wasn’t me, it was my invisible hand…’) famously defined economics as “an inquiry into the nature and causes of the wealth of nations” (1776), whilst Alfred Marshall painted an attractively casual picture of the “study of mankind in the ordinary business of life” (1890).  Robbins (1932) is credited with a classic definition:

“Economics is the science which studies human behavior as a relationship between given ends and scarce means which have alternative uses.”

This does seem to capture the fundamental economic preoccupations of ideas of wants, choice, and scarcity quite well, but leaves me feeling a bit depressed about everything. Nevermind … on to the fundamentals bit:

Economists place a fundamental assumption about human nature at the heart of their discipline: that human wants are unlimited, and that people are driven by the satisfaction of these wants. The fact that the world in which we live is characterised by a limited amount of resources on which humans can draw means that humanity must compete for resources in conditions of scarcity. Scarcity is defined as “the excess of human wants over what can actually be produced to fulfil these wants” (Sloman, 2009:5). The resources for which we can compete are termed the factors of production, and are divided into three forms: labour; land and raw materials; and capital.

Economics, then, is concerned with the distribution of goods and services in these circumstances. The level of wealth among individuals or groups inevitably varies, so economics may examine how or why wealth is distributed in certain ways, or even look at methods in which different distributions of wealth might be achieved.

The interplay of the forces of supply and demand play a major role in economic analyses, to the extent that they “lie at the very centre of economics” (Sloman, 2009:5). The constant tension between these forces is expressed (in free or market economies) via the price mechanism, which responds to changes in the relationship of supply and demand (as a result of choices made by individuals and groups in an economy). If shortages occur, prices tend to rise, whereas surpluses allow prices to fall.  In an idealised model of a market, an ‘equilibrium price’ can be reached in which the forces are balanced. Various signals and incentives help the operation of the price mechanism within and between markets.

The influence of shortages and surpluses on price affects consumers and producers in various ways, as the economic model of the circular flow of goods and incomes demonstrates. In this model, households (consumers of goods and services) buy goods and services from firms (producers), whilst firms buy labour, land or capital (the factors of production) from households, who might be compensated with wages, rent, or interest, for example. This ensures that incomes and goods continue to flow in the economy in the different markets which operate within it.

An important distinction in economics is between analysis of the overall processes and levels of activity of an entire economy on the one hand, and analysis of particular aspects of the economy on the other. The former is known as macroeconomics, whilst the latter is called microeconomics.  Macroeconomics focuses on overall or aggregate levels of supply (output), demand (spending), and levels of growth (whether positive or negative) in an economy.

Macroeconomics examines overall supply and demand levels in order to explain or predict changes in levels of inflation, balance of trade (relationships of imports/exports), or recessions (periods of negative growth). In contrast microeconomics might focus on specific areas of economic activity (the production of particular goods or services), production methods, and the characteristics of particular markets. Microeconomics also examines the relationships between particular choices and the costs associated with them. Important concepts in this respect include opportunity cost, and marginal costs and benefits. When a decision is made, the opportunity cost is viewed as the best alternative to the actual course of action taken – “the opportunity cost of any activity is the sacrifice made to do it” (Sloman, 2009:8). This is an important consideration as it helps to determine the implications of economic decisions which need to be made. Economists assume that individuals make choices according to rational self-interest – making a decision based on an evaluation of the costs and benefits. This involves attention to the marginal costs or benefits of a decision  – the advantages or disadvantages of increasing or decreasing levels of certain activities  (rather than just deciding to do or not do something – the total costs/benefits).

As human understanding of the complex nature of the world and our activities within it has increased, economists have been forced to broaden the scope of their analysis to include certain social and environmental consequences of economic decision-making. Decisions which satisfy rational self-interest for individuals, groups or firms may nevertheless lead to outcomes such as pollution or extreme inequality which themselves have wider consequences for society and the economy as a whole (whether nationally or globally). Indeed, Sloman (2009:24) states that “[u]nbridled market forces can result in severe problems for individuals, society and the environment”. Growing recognition of these potential problems may help explain contemporary concern with sustainability, the role of government regulation of industry, and the creation of the concept of ‘corporate social responsibility’. As such, economists are asked to take account of economic and social goals of a society (as expressed through their government), and therefore contribute to their knowledge to help policy makers work toward these goals.

References

Library of Economics and Liberty (2012) What is economics? Available from: http://www.econlib.org/library/Topics/College/whatiseconomics.html [Accessed 10th November, 2013]

Sloman, J. (2009)  Economics. 7th ed. Harlow: Pearson

Sloman, J. (2007) Essentials of Economics. 4th ed. Harlow: Pearson

Whitehead, G. (1992) Economics. Oxford: Heinemann