Study of the economy. Classic economics concentrates on how the forces of supply and demand allocate scarce product and service resources. Macroeconomics studies a nation or the world's economy as a whole, using data about inflation, unemployment and industrial production to understand the past and predict the future. Microeconomics studies the behavior of specific sectors of the economy, such as companies, industries, or households. Over the years, various schools of economic thought have gained prominence, including Keynesian Economics, Monetarism and Supply-Side Economics.
| Business Encyclopedia:Economics |
Every person is involved with making economic decisions every day of his or her life. This occurs when one decides whether to cook a meal at home or go to a restaurant to eat, or when one decides between purchasing a new luxury car or a low-priced pickup truck. People make economic decisions when they decide whether to rent or purchase housing or where they should attend college.
Wants, Needs, and Scarcity
As a society, and in economic terms, people have unlimited wants; however, resources are scarce. Don't confuse wants and needs. Individuals often want what they don't need. In the automobile example used above, someone might want to drive a large luxury car, but a small pickup truck may be more suited to the purchaser's needs if he or she must have a vehicle for hauling furniture. Economic decisions must be made.A resource is scarce when there is not enough of it to satisfy human wants. And human wants are endless. Because of unlimited wants and limited resources to satisfy those wants, economic decisions must be made. This problem of scarcity (limited resources) must be addressed, which leads to economics and economic problems.
Figure 1 illustrates the relationships that exist relative to wants and scarcity. Many elements influence economic decisions. To better understand economics, it is critical to understand what is shown in this Figure.
Resources
Economic resources, often called factors of production, are divided into four general categories. They are land, labor (sometimes referred to as human resources), capital, and entrepreneurship.Land.Land describes the ground that might be used to build a structure such as a factory, school, home, or church, but it means much more than that. Land is also the term used for the resources that come from the land. Trees are produced by the land and are used for lumber, firewood, paper, and numerous other products, so they are referred to as land. Minerals that come from the ground, such as oil that is used to make gasoline or to lubricate automobile engines, or gold that is used to make jewelry, or wheat that is grown on the land and is used in the production of bread and other products, or sheep that are raised for the wool they produce that is used to make sweaters are all described as land.
Labor (Human Resources). Labor is the general category of the human effort that is used for the production of goods and services. This includes physical labor, such as harvesting trees for lumber, drilling for oil or mining for gold, growing wheat for bread, or raising the sheep that produce wool for a sweater. In addition to physical labor, there is mental labor, which is necessary for such activities as planning the best ways to harvest trees and making decisions about which trees to harvest. Labor is also involved when a doctor or surgeon analyzes and diagnoses (mental labor) before performing a medical procedure, then performs the procedure (physical labor).
Capital. Capital is input that is often viewed in two ways, much as is labor. Capital might be viewed as human capital—the knowledge, skills, and attitudes that humans possess that allow them to produce. The other type of capital is physical capital, which includes buildings, machinery, tools, and other items that are used to produce goods and service. Traditionally, physical capital has been a prerequisite for human capital; however, because of rapid changes in technology, today human capital is less dependent on physical capital.
Entrepreneurship. One special form of human capital that is important in an economic setting is entrepreneurship (often thought of as the fourth factor of production). Entrepreneurial abilities are needed to improve what we have and to create newgoods and services. An entrepreneur is one who brings together all the resources of land, labor, and capital that are needed to produce a better product or service. In the process of doing this, the entrepreneur is willing to assume the risk of success and failure.
Many people associate entrepreneurship with creating or owning a new business. That is one definition of entrepreneurship but not the only one. An entrepreneur might create a newmarket for something that already exists or push the use of a natural resource to newlimits in order to maximize efficiency and minimize consumption. See "entrepreneurship" for a more general discussion as it relates to business ownership.
Goods and Services
It takes land, labor, and capital that are used by an entrepreneur to produce goods and services that will ultimately be used to satisfy our wants. Goods are tangible, meaning they are something that can be seen or touched. The production of goods requires using limited resources to produce in order to satisfy wants. An example might be a farmer who grows grain. The farmer uses farm equipment manufactured from resources; ground is a natural resource that is used to grow the grain; and because the growth of grain depletes the nutrients in the soil, the farmer must use fertilizers to restore the nutrients. Limited resources are used to produce natural or chemical fertilizers, but they are necessary for crop production. Water might be used to irrigate the crop and enhance production. When the crop is ready for harvest, the farmer uses additional resources to complete the process—equipment, gasoline, labor, and so on—which results in a good that can be used or sold for use by others.Services are provided in numerous ways and are an intangible activity. There is no doubt that one can often see someone providing a service, but the service is not something that someone can pick up and take home to use. An example of a service is a ride in a taxi through a crowded city. It takes resources for the owner or driver to provide the service, and a passenger is consciously aware of riding in a taxi. When the ride is completed and the provider has been paid, the passenger doesn't have anything tangible to hold except the receipt. However, resources have been used to provide the service. The automobile used as the cab, the fuel used to operate the cab, and the labor of the driver are all examples of resources being used to provide a service that will satisfy a want.
It is important to understand that because goods and services utilize resources that are limited, goods and services are also scarce. Scarcity results when the demand for a good or service is greater than its supply. Remember that society has unlimited wants but scarce resources. It is scarcity, then, that causes consumers to have to make choices. If individuals can't have everything they want, they must decide which of the goods and services are most important and which they can do without.
Economic Choice
Opportunity Cost. When one makes economic decisions, it is because of limited resources. Alternatives must be considered. People make such decisions based on expecting greater benefits from one alternative than another. There is an opportunity cost involved in the choice. Opportunity cost is the benefit forgone from the best alternative that is not selected: Individuals give up an opportunity to use or enjoy something in order to select something else.Opportunity costs can't always be measured, because it might be satisfaction that is lost. At other times, however, opportunity cost can be measured. Here are examples of each. Perhaps a student is studying hard for a final examination in a difficult course because a good exam score is critical to achieve the desired grade. Friends call to invite the student out for the evening. The alternatives are to study or to have fun. Being wise, the student selects studying instead of going out. It is difficult to measure the opportunity cost of having fun with friends. In the second example, the same studying student is asked to help someone clean a garage. If the person offers to pay the student $50 to clean the garage and the student chooses to study, the opportunity cost is easily measured at $50. In both these examples, opportunity cost is directly related to what was given up, not any other benefits that might result from the decision.
Circumstances also play a role in opportunity cost. Sometimes people are forced into a decision because of circumstances and the results may not always be optimal. For example, if someone is planning to relocate to a newcity to start a new job and wants to sell a house before the move in order to be able to purchase a newhouse in the newlocation, the person may sell the house for less than the market price in order to complete the process. The opportunity cost is the value of what was given up in order to be able to purchase a newhome. Every time a choice is made, opportunity costs are assumed.
Production. Another economic choice that must be made is related to production. This is illustrated in Figure 1. All four of the decisions must be made: What goods will be produced? How will production occur? Howmuch should be produced? Who will be the recipients? All are decisions that influence production efficiency.
Efficiency is the primary element in deciding what to produce and how to go about the production process. Efficiency is producing with the least amount of expense, effort, and waste, but not without cost. If you take something away from a person to satisfy another person, one will be less happy and the other will be more happy. If a way can be found to make one person more happy without making the other person less happy, this would be efficient.
An example of economic efficiency might be the following. Assume someone owns a car and a friend doesn't own a car but does drive. The friend needs transportation regularly for a week. It happens to be a time when the car owner will be away on a business trip and therefore won't be using the car. It makes no sense for the friend to buy a car to use for such a short period of time, so the owner loans the friend the car for that week. The car owner is no worse off and the friend is better off. Economic efficiency has occurred in this situation. If the car owner had not loaned the car to the friend, there would have been waste because the friend would have had to buy or rent a car. It is wasteful to fail to take advantage of opportunities in which there is no loss of satisfaction to either party.
Production efficiency is a situation in which it is not possible to produce any more units of a good without giving up the opportunity to produce another good unless a change occurs in available productive resources. If a farmer is growing wheat to be sold for the production of bread, there is a point at which adding additional fertilizer to the soil would do no good. If the fertilizer were used on an oat crop in a different field, production could be increased for that crop. The way to increase the wheat production is to find different resources to make the crop better, such as irrigating the land to provide more moisture.
In the above example, it was suggested that different or additional resources might be used to increase production. This is necessary only after efficiency has been achieved. Additional resources would have to come from land, labor, capital, or entrepreneurship. It is most common that capital will be used most often to increase production. Capital is productive input that is increased by people. This is known as investment. Investment involves giving up what might presently be consumed in favor of producing something to consume in the future. If the farmer wants to increase wheat production in the future, something will have to be given up now in order to increase the resources available for future production.
Increasing human capital is critical to increasing production. This does not mean that more people must be produced, but rather that the knowledge and skills of humans must be increased. This can happen because of improvements in technology and newways of satisfying wants. This involves the entrepreneurial factor that was described previously—the human element that figures out ways to improve and expand the resources that already exist.
Product Distribution. Getting goods into the hands of those who want them involves many choices. The economic system must decide how to divide the products that are produced among the potential recipients. Sometimes products can be divided equally among recipients, but normally this is not the situation. It must then be determined how the division will take place. In a capitalistic economic system, distribution is often determined by wealth. If two people have the same wants, the person who can most afford something will be able to acquire it.
The Laws of Supply and Demand
Production decisions are made based on demand for goods and services. Supply of goods and services is dependent upon demand for the same. Why do movies that are much more popular stay at theaters longer than those that aren't as popular? Demand for the movie causes the theater operators to supply the showings that the consumer wants. Why does the room rate in a convention hotel go down on weekends? There is less demand on weekends because most convention-goers leave on Friday or Saturday and others don't arrive until Monday, so the supply of available rooms goes up. Hotel operators try to create more demand for their vacant weekend rooms by lowering prices and offering attractive amenities.The law of demand states that during a specific time period the quantity of a product that is demanded is inversely related to its price, as long as other things remain constant. The higher the price, the lower the demand; the lower the price, the higher the demand. Don't confuse demand with wants. Consumers have unlimited wants, as was established at the beginning of this discussion. Nor are demands and wants the same as needs. A consumer may need to have a crown put on a tooth but may not want to have it done because of the high cost. At some point, the suffering patient may demand the services be provided regardless of the price.
Often when prices are too high and demand for a product or service lessens, it is because consumers have found a suitable substitute. Substitution happens all the time as a result of economic decisions that are made by consumers. For example, if someone needs a winter coat and likes one with a designer name and a price that reflects that name, the purchase may not be made. Instead, the person finds a similar coat that does not have a designer label and purchases it instead at a much lower cost.
Demand for goods or services determines the amount that will be supplied. The law of supply states that the greater the demand, the more that will be supplied; the lower the demand, the less that will be supplied. The amount that will be supplied by a producer of the good or service is based on capacity and willingness to supply the product at a specific price. A producer will not supply goods and services just because there is demand for them—price for the good or service is an important consideration.
If consumers are willing to pay more for a good or service, the producer will likely be willing to shift more resources in order to increase the supply of the demanded product. If a rancher is raising prime beef cattle and there is high demand for this good and consumers are willing to pay more for high-quality beef, then the rancher might be willing to supply more even if it is necessary to shift resources or acquire additional resources to be able to do so.
Demands change, supplies change, and prices change. So how does a producer knowhow much is enough and what price to charge for the goods and services? Very simply, the demand for and supply of goods and services can be plotted on graphs using different prices. The supply and demand for a good or service intersect on the graph at what is called the equilibrium price, or the price where all of what is supplied will be demanded. If the price is belowe quilibrium, there will be a shortage of the good or service, and if the price is above equilibrium, there will be a surplus of the good or service. For a more detailed explanation on this aspect of economics, see the discussion of supply and demand.
Summary
Economics is a complex topic that is studied constantly and thoroughly. This article has given an overview of some of the main tenets of economics; however, there is much that was not even introduced. There are other topics throughout this encyclopedia, such as macroeconomics and microeconomics, that will further define and expand the topic of economics.Bibliography
Dolan, Edwin G., and Lindsey, David E. (1991). Economics. Chicago: Dryden.Heilbroner, Robert L., and Thurow, Lester C. (1987). Economics Explained. New York: Simon & Schuster.
Lipsey, Richard G., Steiner, Peter O., Purvis, Douglas D., and Courant, Paul N. (1990). Economics. New York: Harper & Row.
McEachern, William A. (1991). Economics: A Contemporary Introduction. Cincinnati, OH: South-Western Publishing.
[Article by: ROGER L. LUFT]
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