Economics This article is about the social science. For other uses, see Economics (disambiguation). Economics studies trade, production and consumption decisions, such as those that occur in a traditional marketplace. Economics



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Economics

This article is about the social science. For other uses, see Economics (disambiguation).



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a vegetable vendor in a marketplace.
Economics studies trade, production and consumption decisions, such as those that occur in a traditional marketplace.

Economics is the social science that studies the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek οκονομία (oikonomia, "management of a household, administration") from οκος (oikos, "house") + νόμος (nomos, "custom" or "law"), hence "rules of the house(hold)". [1] Current economic models developed out of the broader field of political economy in the late 19th century, owing to a desire to use an empirical approach more akin to the physical sciences. [2]

A definition that captures much of modern economics is that of Lionel Robbins in a 1932 essay:

"... the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses." [3]

Scarcity means that available resources are insufficient to satisfy all wants and needs. Absent of scarcity and alternative uses of available resources there is no economic problem. The subject thus defined involves the study of choices as they are affected by incentives and resources.

Economics aims to explain how economies work and how economic agents interact. Economic analysis is applied throughout society, in business, finance and government, but also in crime,[4] education,[5] the family, health, law, politics, religion,[6] social institutions, war,[7] and science.[8] The expanding domain of economics in the social sciences has been described as economic imperialism.[9][10]

Common distinctions are drawn between various dimensions of economics: between positive economics (describing "what is") and normative economics (advocating "what ought to be") or between economic theory and applied economics or between mainstream economics (more "orthodox" dealing with the "rationality-individualism-equilibrium nexus") and heterodox economics (more "radical" dealing with the "institutions-history-social structure nexus"[11]). However the primary textbook distinction is between microeconomics ("small" economics), which examines the economic behavior of agents (including individuals and firms) and macroeconomics ("big" economics), addressing issues of unemployment, inflation, monetary and fiscal policy for an entire economy.


History of economic thought

a stele depicting a man sitting down
The upper part of the stele of Hammurabi's code of laws

The city states of Sumer developed a trade and market economy based originally on the commodity money of the Shekel which was a certain weight measure of barley, while the Babylonians and their city state neighbors later developed the earliest system of economics using a metric of various commodities, that was fixed in a legal code.[12] The early law codes from Sumer could be considered the first (written) economic formula, and had many attributes still in use in the current price system today... such as codified amounts of money for business deals (interest rates), fines in money for 'wrong doing', inheritance rules, laws concerning how private property is to be taxed or divided, etc.[13][14] For a summary of the laws, see Babylonian law and Ancient economic thought.

Economic thought dates from earlier Mesopotamian, Greek, Roman, Indian, Chinese, Persian and Arab civilizations. Notable writers include Aristotle, Chanakya (also known as Kautilya), Qin Shi Huang, Thomas Aquinas and Ibn Khaldun through to the 14th century. Joseph Schumpeter initially considered the late scholastics of the 14th to 17th centuries as "coming nearer than any other group to being the 'founders' of scientific economics" as to monetary, interest, and value theory within a natural-law perspective.[15] After discovering Ibn Khaldun's Muqaddimah, however, Schumpeter later viewed Ibn Khaldun as being the closest forerunner of modern economics,[16] as many of his economic theories were not known in Europe until relatively modern times.[17]

Nonetheless, recent research indicates that the Indian scholar-philosopher Chanakya (c. 340-293 BCE) predates Ibn Khaldun by a millennium and a half as the forerunner of modern economics,[18][19][20][21] and has written more expansively on this subject, particularly on political economy. His magnum opus, the Arthashastra (The Science of Wealth and Welfare),[22] is the genesis of economic concepts that include the opportunity cost, the demand-supply framework, diminishing returns, marginal analysis, public goods, the distinction between the short run and the long run, asymmetric information and the producer surplus.[23] In his capacity as an advisor to the throne of the Maurya Empire of ancient India, he has also advised on the sources and prerequisites of economic growth, obstacles to it and on tax incentives to encourage economic growth.[24]



a seaport with a ship arriving
1638 painting of a French seaport during the heyday of mercantilism

Two other groups, later called 'mercantilists' and 'physiocrats', more directly influenced the subsequent development of the subject. Both groups were associated with the rise of economic nationalism and modern capitalism in Europe. Mercantilism was an economic doctrine that flourished from the 16th to 18th century in a prolific pamphlet literature, whether of merchants or statesmen. It held that a nation's wealth depended on its accumulation of gold and silver. Nations without access to mines could obtain gold and silver from trade only by selling goods abroad and restricting imports other than of gold and silver. The doctrine called for importing cheap raw materials to be used in manufacturing goods, which could be exported, and for state regulation to impose protective tariffs on foreign manufactured goods and prohibit manufacturing in the colonies.[25][26]

Physiocrats, a group of 18th century French thinkers and writers, developed the idea of the economy as a circular flow of income and output. Adam Smith described their system "with all its imperfections" as "perhaps the purest approximation to the truth that has yet been published" on the subject. Physiocrats believed that only agricultural production generated a clear surplus over cost, so that agriculture was the basis of all wealth.

Thus, they opposed the mercantilist policy of promoting manufacturing and trade at the expense of agriculture, including import tariffs. Physiocrats advocated replacing administratively costly tax collections with a single tax on income of land owners. Variations on such a land tax were taken up by subsequent economists (including Henry George a century later) as a relatively non-distortionary source of tax revenue. In reaction against copious mercantilist trade regulations, the physiocrats advocated a policy of laissez-faire, which called for minimal government intervention in the economy.[27][28]



Classical political economy

Publication of Adam Smith's The Wealth of Nations in 1776, has been described as "the effective birth of economics as a separate discipline."[29] The book identified land, labor, and capital as the three factors of production and the major contributors to a nation's wealth.



a man facing the right
Adam Smith wrote The Wealth of Nations

In Smith's view, the ideal economy is a self-regulating market system that automatically satisfies the economic needs of the populace. He described the market mechanism as an "invisible hand" that leads all individuals, in pursuit of their own self-interests, to produce the greatest benefit for society as a whole. Smith incorporated some of the Physiocrats' ideas, including laissez-faire, into his own economic theories, but rejected the idea that only agriculture was productive.

In his famous invisible-hand analogy, Smith argued for the seemingly paradoxical notion that competitive markets tended to advance broader social interests, although driven by narrower self-interest. The general approach that Smith helped initiate was called political economy and later classical economics. It included such notables as Thomas Malthus, David Ricardo, and John Stuart Mill writing from about 1770 to 1870.[30]

While Adam Smith emphasized the production of income, David Ricardo focused on the distribution of income among landowners, workers, and capitalists. Ricardo saw an inherent conflict between landowners on the one hand and labor and capital on the other. He posited that the growth of population and capital, pressing against a fixed supply of land, pushes up rents and holds down wages and profits.



a man facing the viewer
Malthus cautioned law makers on the effects of poverty reduction policies

Thomas Robert Malthus used the idea of diminishing returns to explain low living standards. Population, he argued, tended to increase geometrically, outstripping the production of food, which increased arithmetically. The force of a rapidly growing population against a limited amount of land meant diminishing returns to labor. The result, he claimed, was chronically low wages, which prevented the standard of living for most of the population from rising above the subsistence level.

Malthus also questioned the automatic tendency of a market economy to produce full employment. He blamed unemployment upon the economy's tendency to limit its spending by saving too much, a theme that lay forgotten until John Maynard Keynes revived it in the 1930s.

Coming at the end of the Classical tradition, John Stuart Mill parted company with the earlier classical economists on the inevitability of the distribution of income produced by the market system. Mill pointed to a distinct difference between the market's two roles: allocation of resources and distribution of income. The market might be efficient in allocating resources but not in distributing income, he wrote, making it necessary for society to intervene.

Value theory was important in classical theory. Smith wrote that the "real price of every thing ... is the toil and trouble of acquiring it" as influenced by its scarcity. Smith maintained that, with rent and profit, other costs besides wages also enter the price of a commodity.[31] Other classical economists presented variations on Smith, termed the 'labour theory of value'. Classical economics focused on the tendency of markets to move to long-run equilibrium.

Marxism

a man facing the viewer
The Marxist school of economic thought comes from the work of German economist Karl Marx.

Marxist (later, Marxian) economics descends from classical economics. It derives from the work of Karl Marx. The first volume of Marx's major work, Das Kapital, was published in German in 1867. In it, Marx focused on the labour theory of value and what he considered to be the exploitation of labour by capital.[32][33] The labour theory of value held that the value of a thing was determined by the labor that went into its production. This contrasts with the modern understanding that the value of a thing is determined by what one is willing to give up to obtain the thing.



Neoclassical economics

A body of theory later termed 'neoclassical economics' or 'marginalism' formed from about 1870 to 1910. The term 'economics' was popularized by such neoclassical economists as Alfred Marshall as a concise synonym for 'economic science' and a substitute for the earlier, broader term 'political economy'.[34][35] This corresponded to the influence on the subject of mathematical methods used in the natural sciences.[2]

Neoclassical economics systematized supply and demand as joint determinants of price and quantity in market equilibrium, affecting both the allocation of output and the distribution of income. It dispensed with the labour theory of value inherited from classical economics in favor of a marginal utility theory of value on the demand side and a more general theory of costs on the supply side.[36]

In microeconomics, neoclassical economics represents incentives and costs as playing a pervasive role in shaping decision making. An immediate example of this is the consumer theory of individual demand, which isolates how prices (as costs) and income affect quantity demanded. In macroeconomics it is reflected in an early and lasting neoclassical synthesis with Keynesian macroeconomics.[37][38]

Neoclassical economics is occasionally referred as orthodox economics whether by its critics or sympathizers. Modern mainstream economics builds on neoclassical economics but with many refinements that either supplement or generalize earlier analysis, such as econometrics, game theory, analysis of market failure and imperfect competition, and the neoclassical model of economic growth for analyzing long-run variables affecting national income.

Keynesian economics

two men in suits converse with each other
John Maynard Keynes (above, right), widely considered a key theorist in economics.

Keynesian economics derives from John Maynard Keynes, in particular his book The General Theory of Employment, Interest and Money (1936), which ushered in contemporary macroeconomics as a distinct field.[39][40] The book focused on determinants of national income in the short run when prices are relatively inflexible. Keynes attempted to explain in broad theoretical detail why high labour-market unemployment might not be self-correcting due to low "effective demand" and why even price flexibility and monetary policy might be unavailing. Such terms as "revolutionary" have been applied to the book in its impact on economic analysis.[41][42][43]

Keynesian economics has two successors. Post-Keynesian economics also concentrates on macroeconomic rigidities and adjustment processes. Research on micro foundations for their models is represented as based on real-life practices rather than simple optimizing models. It is generally associated with the University of Cambridge and the work of Joan Robinson.[44]

New-Keynesian economics is also associated with developments in the Keynesian fashion. Within this group researchers tend to share with other economists the emphasis on models employing micro foundations and optimizing behavior but with a narrower focus on standard Keynesian themes such as price and wage rigidity. These are usually made to be endogenous features of the models, rather than simply assumed as in older Keynesian-style ones.



Chicago School of economics

The Chicago School of economics is best known for its free market advocacy and monetarist ideas. According to Milton Friedman and monetarists, market economies are inherently stable if left to themselves and depressions result only from government intervention.[45] Friedman, for example, argued that the Great Depression was result of a contraction of the money supply, controlled by the Federal Reserve, and not by the lack of investment as Keynes had argued. Ben Bernanke, current Chairman of the Federal Reserve, is among the economists today generally accepting Friedman's analysis of the causes of the Great Depression.[46]

Milton Friedman effectively took many of the basic principles set forth by Adam Smith and the classical economists and modernized them. One example of this is his article in the September 1970 issue of The New York Times Magazine, where he claims that the social responsibility of business should be “to use its resources and engage in activities designed to increase its profits...(through) open and free competition without deception or fraud.” [47]

Other schools and approaches

Other well-known schools or trends of thought referring to a particular style of economics practiced at and disseminated from well-defined groups of academicians that have become known worldwide, include the Austrian School, the Freiburg School, the School of Lausanne, post-Keynesian economics and the Stockholm school. Contemporary mainstream economics is sometimes separated into the Saltwater approach of those universities along the Eastern and Western coasts of the US, and the Freshwater, or Chicago-school approach.

Within macroeconomics there is, in general order of their appearance in the literature; classical economics, Keynesian economics, the neoclassical synthesis, post-Keynesian economics, monetarism, new classical economics, and supply-side economics. Alternative developments include ecological economics, institutional economics, evolutionary economics, dependency theory, structuralist economics, world systems theory, econophysics, and biophysical economics.[48]

Microeconomics

Microeconomics looks at interactions through individual markets, given scarcity and government regulation. A given market might be for a product, say fresh corn, or the services of a factor of production, say bricklaying. The theory considers aggregates of quantity demanded by buyers and quantity supplied by sellers at each possible price per unit. It weaves these together to describe how the market may reach equilibrium as to price and quantity or respond to market changes over time.

This is broadly termed supply and demand analysis. Market structures, such as perfect competition and monopoly, are examined as to implications for behavior and economic efficiency. Analysis of change in a single market often proceeds from the simplifying assumption that behavioral relations in other markets remain unchanged, that is, partial-equilibrium analysis. General-equilibrium theory allows for changes in different markets and aggregates across all markets, including their movements and interactions toward equilibrium.[49][50]

Markets

In microeconomics, production is the conversion of inputs into outputs. It is an economic process that uses resources to create a commodity that is suitable for exchange. This can include manufacturing, warehousing, shipping, and packaging. Some economists define production broadly as all economic activity other than consumption. They see every commercial activity other than the final purchase as some form of production. Production is a process, and as such it occurs through time and space. Because it is a flow concept, production is measured as a "rate of output per period of time".

There are three aspects to production processes, including the quantity of the commodity produced, the form of the good created and the temporal and spatial distribution of the commodity produced. Opportunity cost expresses the idea that for every choice, the true economic cost is the next best opportunity. Choices must be made between desirable yet mutually exclusive actions. It has been described as expressing "the basic relationship between scarcity and choice.".[51] The notion of opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently.[52] Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, pleasure or any other benefit that provides utility should also be considered.

The inputs or resources used in the production process are called factors of production. Possible inputs are typically grouped into six categories. These factors are raw materials, machinery, labour services, capital goods, land, and enterprise. In the short-run, as opposed to the long-run, at least one of these factors of production is fixed. Examples include major pieces of equipment, suitable factory space, and key personnel.

A variable factor of production is one whose usage rate can be changed easily. Examples include electrical power consumption, transportation services, and most raw material inputs. In the "long-run", all of these factors of production can be adjusted by management. In the short run, a firm's "scale of operations" determines the maximum number of outputs that can be produced, but in the long run, there are no scale limitations. Long-run and short-run changes play an important part in economic models.

Economic efficiency describes how well a system generates the maximum desired output a with a given set of inputs and available technology. Efficiency is improved if more output is generated without changing inputs, or in other words, the amount of "friction" or "waste" is reduced. Economists look for Pareto efficiency, which is reached when a change cannot make someone better off without making someone else worse off.

Economic efficiency is used to refer to a number of related concepts. A system can be called economically efficient if: No one can be made better off without making someone else worse off, more output cannot be obtained without increasing the amount of inputs, and production ensures the lowest possible per unit cost. These definitions of efficiency are not exactly equivalent. However, they are all encompassed by the idea that nothing more can be achieved given the resources available.

Specialization

Specialization is considered key to economic efficiency because different individuals or countries have different comparative advantages. While one country may have an absolute advantage in every area over other countries, it could nonetheless specialize in the area which it has a relative comparative advantage, and thereby gain from trading with countries which have no absolute advantages. For example, a country may specialize in the production of high-tech knowledge products, as developed countries do, and trade with developing nations for goods produced in factories, where labor is cheap and plentiful.

According to theory, in this way more total products and utility can be achieved than if countries produced their own high-tech and low-tech products. The theory of comparative advantage is largely the basis for the typical economist's belief in the benefits of free trade. This concept applies to individuals, farms, manufacturers, service providers, and economies. Among each of these production systems, there may be a corresponding division of labour with each worker having a distinct occupation or doing a specialized task as part of the production effort, or correspondingly different types of capital equipment and differentiated land uses.[53][54][55]

Adam Smith's Wealth of Nations (1776) discusses the benefits of the division of labour. Smith noted that an individual should invest a resource, for example, land or labour, so as to earn the highest possible return on it. Consequently, all uses of the resource should yield an equal rate of return (adjusted for the relative riskiness of each enterprise). Otherwise reallocation would result. This idea, wrote George Stigler, is the central proposition of economic theory, and is today called the marginal productivity theory of income distribution. French economist Turgot had made the same point in 1766.[56]

In more general terms, it is theorized that market incentives, including prices of outputs and productive inputs, select the allocation of factors of production by comparative advantage, that is, so that (relatively) low-cost inputs are employed to keep down the opportunity cost of a given type of output. In the process, aggregate output increases as a by product or by design.[57] Such specialization of production creates opportunities for gains from trade whereby resource owners benefit from trade in the sale of one type of output for other, more highly-valued goods. A measure of gains from trade is the increased output (formally, the sum of increased consumer surplus and producer profits) from specialization in production and resulting trade.[58][59][60]

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