What is Economics?

Economics is like a traffic report…

It can give you a sense of how efficiently goods and services (vehicles) are moving to their desired locations. It can pinpoint specific problems in the market (broken-down cars) that are causing traffic to slow down. And it can predict when traffic will resume its normal pace (economic forecast).

Economics is the study of how people and groups decide to use their scarce resources to produce, distribute, and consume the goods and services they enjoy. It is a social science that dates back to the writings of 18th-century Scottish philosopher Adam Smith, sometimes called the “Father of Economics.”

Economics can turn a microscopic focus on the activities of individuals or companies, or it can use a telescopic approach to bring large markets and international trade into view. For example, economics can analyze why a local T-shirt business is succeeding, why the global oil market is reeling, or why a nation is facing high unemployment.

This social science is useful for understanding the complicated actions of a vast number of independent players in a free market. But it can also shed light on the decision-making process of a central authority that oversees an economy dominated by the government.

Economists are frequently in the news when the stock market or overall economy are trending downward. People turn to economists and economic analysis to understand how we got here and how we can get out.

Economics is often divided into two subcategories: macroeconomics and microeconomics. They are closely intertwined — It’s difficult to study one without encountering the other.

Macroeconomics is the type commonly featured on newscasts. It deals with the overall state of the economy at the scale of regions, nations, and even the entire world. For example, macroeconomics would concern itself with a country’s employment and inflation rates.

Microeconomics focuses on the smaller picture — the behavior of individuals, groups, and firms. For instance, microeconomics would look at how a company determines what to produce, how much to charge, and how many workers to hire. Microeconomics can also examine what’s going on in a specific industry, such as telecommunications.

Before the Great Depression in the 1930s, what we now call microeconomics was the framework for all economic discussion. But the traditional approach of looking at narrow sectors of the economy failed to explain what had happened to damage the world’s largest markets. Macroeconomics emerged in response as a way to explain large-scale economic activity.

There are four primary economic systems: traditional, market, command, and mixed.

In a traditional economy, people are typically hunters, farmers, fishers, and gatherers. What to produce and how to distribute is based on custom. Bartering is more common than the exchange of money. In a traditional economy, a surplus of goods is rare — People tend to make full use of their resources.

Historical examples of traditional economies include those of indigenous people in North America before the arrival of Europeans. Traditional economies still exist in remote regions today, such as among the Inuit in the Arctic.

A market economy, also called a free market economy, is most often associated with capitalism. Citizens and businesses in a capitalist society can own private property, including major assets such as airlines and automobile factories.

Free market economies receive minimum intervention by the government. Authorities may regulate things like pollution control and worker safety, but don’t interfere with companies’ decisions about everyday operations. Taxes, tariffs, and other interventions are nonexistent or minimal. Businesses can distribute goods and services as they see fit in response to the laws of supply and demand. Thanks to competition, market economies are more likely to produce innovative consumer products than are command economies.

For example, in a free market economy, the owner of a car company usually owns both the factory and each automobile that it produces. He or she can choose what kind of vehicle to build. The company pays employees wages to build cars, which it then sells at a price determined by supply and demand. The owner keeps the profits from the sale.

In a command economy, the government owns and controls most industries, especially vital enterprises like transportation systems and factories. The aim isn’t personal profit, but rather advancing the interests of the state. The government allocates resources and carefully direct the activities of enterprises, controlling what and how much they produce, prices, and wages. Basically, a central authority, rather than the market, makes all economic decisions. Old-line communist regimes of the 20th century, such as those of the Soviet Union, were command economies.

Neither the free market nor a command economy is perfect, which has led many countries, including the US, to combine features of the two. In a mixed economy, capitalism still prevails, but the government takes a more hands-on approach. This can happen when a free market economy introduces regulations, taxes, or public provision of health and education. For example, in the US, private companies can own automobile factories, but both the facility and the cars must meet government standards for pollution.

Some economies that were strictly command economies for much of the 20th century now look more like mixed economies. Their governments still maintain tight reins on much of the market but also allow a degree of capitalist profit-making. This is the case with modern-day China, a country that’s now home to an impressive number of millionaires and even billionaires.

Here are some of the main schools of economic thought:

Followers of the classical school adhere to the thinking of Adam Smith, an 18th-century Scottish philosopher and economist. Smith maintained that free markets could generally handle the ups and downs of capitalism without government intervention.

Smith explained that buyers and sellers predictably act selfishly. Inadvertently, their actions improve the market’s efficiency as sellers choose to only stock products that will produce profits, and buyers purchase only the items they want. Smith argued that it is as if an “invisible hand” subtly moves people to behave in a way that stabilizes the overall economy.

One of the best-known schools of economic theory is Keynesian economics. It’s named after British economist John Maynard Keynes, whose ideas emerged as a way to explain what caused the Great Depression.

Before Keynes, economists generally believed that free markets eventually balanced themselves without organized intervention. Keynes popularized the idea that markets can’t always right themselves in deep recessions, because wages and prices can’t adjust quickly enough. Instead, Keynes prescribed government spending as a way to stimulate demand and restore economic equilibrium. His ideas inspired President Franklin D. Roosevelt to launch public works programs, Social Security, and other government spending initiatives to help the US recover from the Great Depression.

Keynesian thinking was most dominant during the middle of the 20th century. It lost some appeal during the 1970s, when its economic model failed to explain how some countries were experiencing seemingly contradictory market conditions —slow growth plus inflation (known as “stagflation”).

Monetarism, a school of economic theory linked to American economist Milton Friedman, argues that the US government’s failure to implement good monetary policy (control of the money supply) in the 1930s was the chief reason for the Great Depression.

Monetarism focuses on making sure that the correct amount of money is circulating through the economy. Friedman thought that the government should make the growth of the money supply match the expansion of the economy. In other words, if the US economy grows by 3 percent, the government should increase the amount of money in circulation by 3 percent.

The US government used some aspects of monetarism in the 1970s to curb runaway inflation. Keynesian theory couldn’t explain why the US was experiencing slow economic growth, high unemployment, and high inflation at the same time. Keynes’s prescription of increasing government spending to boost growth wouldn’t work, since that would also hike inflation. The government turned to the monetarist approach, which led to policies that restricted the money supply⁠ to curb inflation. The strategy worked, although it also led to recession.

Monetarism faded into the background starting in the 1980s, but it’s tenet that a primary goal of the central bank should be controlling inflation through the money supply remains relevant.

Neoclassical economics, which has roots in the 19th century, is the mainstream school of thought taught at most universities today. The neoclassical movement views value differently from the classical theory. Classical thinking sees value as equivalent to the cost of producing an item, while neoclassical models see value as the interaction of the buyer’s demand for the product with the seller’s supply of the item. Neoclassical economics assumes that people are rational agents armed with relevant information and aim to maximize utility and profits.

Austrian economic theory, named for its country of origin, takes a hardline view against government intervention in the free market. Born at the end of the 19th century, it promotes the idea that capitalism should be allowed to function freely without government influence.

The policies of Austrian economics are revered by some modern politicians, such as former US Congressman and three-time presidential candidate Ron Paul. Austrian economics differs from other schools of thought in its steadfast rejection of governments rescuing troubled economies even in the worst of times.

The Marxian school of economics is based on the work of 19th-century German economist Karl Marx. Marx disagreed with classical economists’ idea that a free market would maximize benefits for all of society. He argued that capitalism necessarily benefits only the ruling class, which exploits labor. He asserted that only a centralized authority with control over the market could prevent abuse of the working class and look out for everyone’s interests.

Behavioral economics is one of the newer schools of thought, emerging in the late 20th century. University of Chicago professor and economist Richard Thaler is routinely referred to as the founder of behavioral economics. However, the school owes a great debt to the work of psychologists Amos Tversky and Nobel Prize-winner Daniel Kahneman starting in the 1970s.

Behaviorists try to understand human decision-making in the marketplace. For example, they want to know why investors sometimes make irrational choices when given overwhelming evidence that a different decision would be to their advantage.

The study of economics is broad, but here are three basic ideas:

Scarcity is the idea that demand is virtually infinite while resources are limited. Everything from raw materials to time to labor to money are far from endless. This fundamental concept means that people, companies, and nations have to make choices about how to allocate resources in the best way. Scarcity also means every choice has an opportunity cost — Every decision should be weighed relative to the next best alternative.

Supply refers to the amount of a product or service for sale in the marketplace, while demand reflects how much consumers want to buy it. The law of supply and demand is one of the primary theories in economics. It argues that the availability of a product relative to how much customers desire it determines its price.

A cost-benefit analysis weighs whether an expected positive outcome justifies the costs. Individuals and companies alike evaluate costs and benefits when making decisions.

Imagine that a shoe company releases a limited edition of a hot new sneaker. The fact that the item is scarce means that demand far outpaces supply. As a result, sneaker fans will likely be willing to pay far more for these shoes than for regular sneakers.

Why would sneaker lovers fork over so much money? Because they believe the benefits — a great addition to their collections or looking cool in new kicks — outweigh the cost.