What is an Economy?

An economy is kind of like a school cafeteria at lunchtime…

Each day, many schoolchildren get a mixture of items for their lunch. Some of them are served whatever the cafeteria offers. Others bring a collection of foods from home. Now, let’s say that one child prefers milk over juice, which is what they currently have. But another student has the opposite taste, and is currently stuck with milk. If they find each other, they can exchange the drink they don't want for the one they do. That's similar to how an economy works. Individuals trade what they have for the things they want to consume.

An economy is a network of trade occurring among interdependent individuals and groups, usually within a geographical area. Let’s break this down a bit further.

Participants in an economic system produce goods and services with their labor and capital. Those same participants also consume goods and services created by other people or organizations in that economy. They directly or indirectly exchange the things they produce for the things they consume. In the past, most people directly traded their products for other goods through a process called bartering. Today, fiat money tends to serve as the medium to facilitate trades.

Typically, when people talk about the economy, they are referring to the amount of economic activity happening, such as the wages, rents, and profits being generated. One common measure for economic activity is gross domestic product (GDP), which is the total value of goods and services that a country produces in a set period of time.

People generally classify economies based on the amount of government control that is involved. At one end of the spectrum, the government doesn’t interfere with the economy at all. Instead, the individuals own the factors of production (land, labor, and capital) and decide how to use them. The laws of supply and demand (which determine how buyers and sellers react to changing prices) dictate what gets produced and how much things cost. This system of letting the market decide on production and consumption is called a free-market economy – It is commonly known as capitalism.

At the other end of the spectrum, the government fully controls the production and distribution of goods and services. Political leaders decide what gets produced and how it gets allocated to its citizens. This system of central planning is called a command economy. Because the government decides what gets made, individuals don't have control over the means of production. That typically means that the society collectively — rather than individually — owns the land and resources within its borders.

There are many types of command economies, each with its own nuances. For example, socialism distributes profits according to how much you contribute, rather than how much of a business you own. In communism, everyone provides their labor to the nation and gets back from the government only what they need. Lastly, fascism is designed with the idea that everyone should work for the good of the nation – It usually has a military focus.

Countries that operate somewhere between an entirely free-market economy and a complete command economy are considered to be mixed economies. A mixed economy features some combination of market pricing (driven by the laws of supply and demand) and government intervention. In reality, almost every economy in the modern world is a mixed economic system that falls somewhere along the continuum. Countries like the United States are much closer to a market economy whereas countries like China are much closer to a command economy.

Economics is the academic field that comprises the study of the economy. Economics is a far-reaching field of study and examines how individuals and groups use their limited resources to produce, distribute, and consume goods and services.

Macroeconomics focuses on the big picture of an economy. It is a zoomed-out look at how people and products move around. When people talk about the economy, this is usually what they mean. Key topics in macroeconomics include the unemployment rate, gross domestic product, and balance of trade.

However, the big picture consists of numerous small decisions that add up to the economy. Microeconomics is a zoomed-in view that focuses on the individual choices that people and firms make with their time and money. Key topics in microeconomics include profit maximization, diminishing marginal utility, and consumer choice theory.

The origin of the English word economy comes from ancient Greece – The literal translation roughly means "to manage one's household." The Greeks viewed the economy as sacrificing one thing to gain something else. Using this definition, economies existed far before humans began studying them. The concept of bartering (aka trading one good for another) likely predates any recorded history of humankind.

However, the concept of an economy as we know it today — exchanging goods or time for currency that we later trade for other products — probably started about 5,000 years ago. That is the age of the oldest known coin, a Mesopotamian shekel. Countless examples of minted coinage appear after that. The creation and exchange of goods are what make an economy, and it's safe to assume that people have been using shiny objects to trade for thousands of years.

Meanwhile, modern economic theory began in the 18th century. Before then, philosophers mainly observed the morality and ethics of decision-making. These moral philosophers opined on interactions between people, social contracts, and justice in the face of conflict.

It wasn't until Adam Smith, a moral philosopher, wrote The Theory of Moral Sentiments in 1759 that the idea of an economic system was properly put into words. He later expanded on his ideas – Smith’s 1776 masterpiece, The Wealth of Nations, is today considered the foundational work for the concept of an economy as we know it.

Many intellectuals built from Smith's work and expanded the study of the economy into what we know today. For example, John Maynard Keynes revolutionized the field of macroeconomics, and was influenced by World War II and the Great Depression. Keynesian economics is now one of the preeminent lines of thought that inform the use of fiscal policy (changing government spending and tax level), which helps guide and stabilize an economy.

The United States technically has a mixed economy, but it is closer to a free-market economy than many other countries. The laws of supply and demand set the price for most goods in the US, and individuals have ownership over the means of production. Those are characteristics of a market-based, capitalist system.

However, the US government does provide some goods and services that are not allocated by market forces. Public education and highway infrastructure are prime examples of this. This government intervention means that the US doesn't have a pure market economy, but it's close.

Most countries, including the US, have mixed economies. However, the US economy is much closer to a free-market economy (aka one with individual ownership and prices set by supply and demand) than many other countries.

Other developed nations – like members of the European Union, Canada, and Britain – have mixed economies that include slightly more government control than the US. Notably, they all offer government healthcare, while the US has a mostly market-based health system. Some countries also extend public education to include university studies, provide childcare, and include more robust social support systems. In general, the more services that a government provides, the less that economy is based on free-market fundamentals.

Some countries have systems that are very close to complete command economies. For example, China's economy was centrally planned before the economic reforms that began in 1978. Since then, the Chinese economy adopted some market-oriented practices, making it a mixed economy – But it is still closer to a command economy than most other countries today.