1.

introduction to Economics
Economics is a social science concerned with the production, distribution, and
consumption of goods and services. It studies how individuals, businesses,
governments, and nations make choices about how to allocate resources.
Economics focuses on the actions of human beings, based on assumptions
that humans act with rational behavior, seeking the most optimal level of
benefit or utility. The building blocks of economics are the studies of labor and
trade. Since there are many possible applications of human labor and many
different ways to acquire resources, it is the task of economics to determine
which methods yield the best results.

Economics can generally be broken down into macroeconomics, which

concentrates on the behavior of the economy as a whole, and
microeconomics, which focuses on individual people and businesses.

KEY TAKEAWAYS
● Economics is the study of how people allocate scarce resources for
production, distribution, and consumption, both individually and
collectively.
● Two major types of economics are microeconomics, which focuses on
the behavior of individual consumers and producers, and
macroeconomics, which examine overall economies on a regional,
national, or international scale.
● Economics is especially concerned with efficiency in production and
exchange and uses models and assumptions to understand how to
create incentives and policies that will maximize efficiency.
● Economists formulate and publish numerous economic indicators, such
as gross domestic product (GDP) and the Consumer Price Index (CPI).
● Capitalism, socialism, and communism are types of economic systems.
Understanding Economics
One of the earliest recorded economic thinkers was the 8th-century B.C.
Greek farmer/poet Hesiod, who wrote that labor, materials, and time needed
to be allocated efficiently to overcome scarcity. But the founding of modern
Western economics occurred much later, generally credited to the publication
of Scottish philosopher Adam Smith's 1776 book, An Inquiry Into the Nature
and Causes of the Wealth of Nations.1
The principle (and problem) of economics is that human beings have unlimited
wants and occupy a world of limited means. For this reason, the concepts of
efficiency and productivity are held paramount by economists. Increased
productivity and a more efficient use of resources, they argue, could lead to a
higher standard of living.

Despite this view, economics has been pejoratively known as the "dismal
science," a term coined by Scottish historian Thomas Carlyle in 1849.2He
used it to criticize the liberal views on race and social equality of contemporary
economists like John Stuart Mill, though some commentators suggest Carlyle
was actually describing the gloomy predictions by Thomas Robert Malthus
that population growth would always outstrip the food supply.

Types of Economics
The study of economics is generally broken down into two disciplines.

Microeconomics focuses on how individual consumers and firms make

decisions; these individual decision making units can be a single person, a
household, a business/organization, or a government agency. Analyzing
certain aspects of human behavior, microeconomics tries to explain how they
respond to changes in price and why they demand what they do at particular
price levels. Microeconomics tries to explain how and why different goods are
valued differently, how individuals make financial decisions, and how
individuals best trade, coordinate, and cooperate with one another.
Microeconomics' topics range from the dynamics of supply and demand to the
efficiency and costs associated with producing goods and services; they also
include how labor is divided and allocated; how business firms are organized
and function; and how people approach uncertainty, risk, and strategic game
theory.

Macroeconomics studies an overall economy on both a national and

international level, using highly aggregated economic data and variables to
model the economy. Its focus can include a distinct geographical region, a
country, a continent, or even the whole world. Its primary areas of study are
recurrent economic cycles and broad economic growth and development.
Topics studied include foreign trade, government fiscal and monetary policy,
unemployment rates, the level of inflation and interest rates, the growth of total
production output as reflected by changes in the Gross Domestic Product
(GDP), and business cycles that result in expansions, booms, recessions, and
depressions.

Micro- and macroeconomics are intertwined. Aggregate macroeconomic

phenomena are obviously and literally just the sum total of microeconomic
phenomena. However these two branches of economics use very different
theories, models, and research methods, which sometimes appear to conflict
with each other. Integrating the microeconomics foundations into
macroeconomic theory and research is a major area of study in itself for many
economists.

Schools of Economic Theory

There are many competing, conflicting, or sometimes complementary theories
and schools of thought within economics.

Economists employ many different methods of research from logical deduction

to pure data mining. Economic theory often progresses through deductive
processes, including mathematical logic, where the implications of specific
human activities are considered in a "means-ends" framework. This type of
economics deduces, for example, that it is more efficient for individuals or
companies to specialize in specific types of labor and then trade for their other
needs or wants, rather than trying to produce everything they need or want on
their own. It also demonstrates trade is most efficient when coordinated
through a medium of exchange, or money. Economic laws deduced in this way
tend to be very general and not give specific results: they can say profits
incentivize new competitors to enter a market, but not necessarily how many
will do so. Still, they do provide key insights for understanding the behavior of
financial markets, governments, economies—and human decisions behind
these entities.

Other branches of economic thought emphasize empiricism, rather than

formal logic—specifically, logical positivist methods, which attempt to use the
procedural observations and falsifiable tests associated with the natural
sciences. Some economists even use direct experimental methods in their
research, with subjects asked to make simulated economic decisions in a
controlled environment. Since true experiments may be difficult, impossible, or
unethical to use in economics, empirical economists mostly rely on simplifying
assumptions and retroactive data analysis. However, some economists argue
economics is not well suited to empirical testing, and that such methods often
generate incorrect or inconsistent answers.

Two of the most common in macroeconomics are monetarist and Keynesian.

Monetarists are a branch of Keynesian economics that argue that stable
monetary policy is the best course for managing the economy, and otherwise
often have generally favorable views on free markets as the best way to
allocate resources. In contrast, other Keynesian approaches favor fiscal policy
by an activist government in order to manage irrational market swings and
recessions and believe that markets often don’t work well at allocating
resources on their own.

Economic Indicators
Economic indicators are reports that detail a country's economic performance
in a specific area. These reports are usually published periodically by
governmental agencies or private organizations, and they often have a
considerable effect on stocks, fixed income, and forex markets when they are
released. They can also be very useful for investors to judge how economic
conditions will move markets and to guide investment decisions.

Below are some of the major U.S. economic reports and indicators used for
fundamental analysis.

Gross Domestic Product (GDP)

The Gross Domestic Product (GDP) is considered by many to be the broadest
measure of a country's economic performance. It represents the total market
value of all finished goods and services produced in a country in a given year
or another period (the Bureau of Economic Analysis issues a regular report
during the latter part of each month).3Many investors, analysts, and traders
don't actually focus on the final annual GDP report, but rather on the two
reports issued a few months before: the advance GDP report and the
preliminary report. This is because the final GDP figure is frequently
considered a lagging indicator, meaning it can confirm a trend but it can't
predict a trend. In comparison to the stock market, the GDP report is
somewhat similar to the income statement a public company reports at
year-end.

Retail Sales
Reported by the Department of Commerce during the middle of each month,
the retail sales report is very closely watched and measures the total receipts,
or dollar value, of all merchandise sold in stores.4The report estimates the
total merchandise sold by taking sample data from retailers across the
country—a figure that serves as a proxy of consumer spending levels.
Because consumer spending represents more than two-thirds of GDP, this
report is very useful to gauge the economy's general direction. Also, because
the report's data is based on the previous month sales, it is a timely indicator.
The content in the retail sales report can cause above normal volatility in the
market, and information in the report can also be used to gauge inflationary
pressures that affect Fed rates.

Industrial Production
The industrial production report, released monthly by the Federal Reserve,
reports on the changes in the production of factories, mines, and utilities in the
U.S. One of the closely watched measures included in this report is the
capacity utilization ratio, which estimates the portion of productive capacity
that is being used rather than standing idle in the economy.5It is preferable for
a country to see increasing values of production and capacity utilization at
high levels. Typically, capacity utilization in the range of 82–85% is considered
"tight" and can increase the likelihood of price increases or supply shortages
in the near term. Levels below 80% are usually interpreted as showing "slack"
in the economy, which might increase the likelihood of a recession.

Employment Data
The Bureau of Labor Statistics (BLS) releases employment data in a report
called the non-farm payrolls, on the first Friday of each month.6Generally,
sharp increases in employment indicate prosperous economic growth.
Likewise, potential contractions may be imminent if significant decreases
occur. While these are general trends, it is important to consider the current
position of the economy. For example, strong employment data could cause a
currency to appreciate if the country has recently been through economic
troubles because the growth could be a sign of economic health and recovery.
Conversely, in an overheated economy, high employment can also lead to
inflation, which in this situation could move the currency downward.

Consumer Price Index (CPI)

The Consumer Price Index (CPI), also issued by the BLS, measures the level
of retail price changes (the costs that consumers pay) and is the benchmark
for measuring inflation. Using a basket that is representative of the goods and
services in the economy, the CPI compares the price changes month after
month and year after year.7This report is one of the more important economic
indicators available, and its release can increase volatility in equity, fixed
income, and forex markets. Greater-than-expected price increases are
considered a sign of inflation, which will likely cause the underlying currency to
depreciate.

Types of Economic Systems

Societies have organized their resources in many different ways through
history, deciding how to use available means to achieve individual and
common ends.

Primitivism
In primitive agrarian societies, people tend to self-produce all of their needs
and wants at the level of the household or tribe. Families and tribes would
build their own dwellings, grow their own crops, hunt their own game, fashion
their own clothes, bake their own bread, etc. This economic system is defined
by very little division of labor and resulting low productivity, a high degree of
vertical integration of production processes within the household or village for
what goods are produced, and relationship based reciprocal exchange within
and between families or tribes rather than market transactions. In such a
primitive society, the concepts of private property and decision-making over
resources often apply at a more collective level of familial or tribal ownership
of productive resources and wealth in common.

Feudalism
Later, as civilizations developed, economies based on production by social
class emerged, such as feudalism and slavery. Slavery involved production by
enslaved individuals who lacked personal freedom or rights and were treated
as the property of their owner. Feudalism was a system where a class of
nobility, known as lords, owned all of the lands and leased out small parcels to
peasants to farm, with peasants handing over much of their production to the
lord. In return, the lord offered the peasants relative safety and security,
including a place to live and food to eat.
Capitalism
Capitalism emerged with the advent of industrialization. Capitalism is defined
as a system of production whereby business owners (entrepreneurs or
capitalists) organize productive resources including tools, workers, and raw
materials to produce goods for sale in order to make a profit and not for
personal consumption. In capitalism, workers are hired in return for wages,
owners of land and natural resources are paid rents or royalties for the use of
the resources, and the owners of previously created wealth are paid interest to
forgo the use of some of their wealth so that the entrepreneurs can borrow it
to pay wages and rents and purchase tools for hired workers to use.
Entrepreneurs apply their best judgement of future economic conditions to
decide what goods to produce, and are earn a profit if they decide well or
suffer losses if they judge poorly. This system of market prices, profit, and loss
as the selection mechanism as to who will decide how resources are allocated
for production is what defines a capitalist economy

These roles (workers, resource owners, capitalists, and entrepreneurs)

represent functions in the capitalist economy and not separate or mutually
exclusive classes of people. Individuals typically fulfill different roles with
respect to different economic transactions, relationships, organizations, and
contracts which they are a party to. This may even occur within a single
context, such as a employee-owned co-op where the workers are also the
entrepreneurs or a small business owner-operator who self-finances his firm
out of personal savings and operates out of a home office, and thus acts as
simultaneously as entrepreneur, capitalist, land owner, and worker.

The United States and much of the developed world today can be described
as broadly capitalist market economies.

Socialism
Socialism is a form of cooperative production economy. Economic socialism is
a system of production where there is limited or hybrid private ownership of
the means of production (or other types of productive property) and a system
of prices, profits, and losses is not the sole determinant used to establish who
engages in production, what to produce and how to produce it. Segments of
society band together to share these functions

Production decisions are made through a collective decision making process,

and within the economy some but not all economic functions are shared by all.
These might include any strategic economic functions that effect all citizens.
These would include Public Safety (police, fire, EMS), National Defense,
resource allocation (utilities. like water, and electric), education, and more.
These are often paid for through income or use taxes levied on the remaining
tactically independent economic functions (individual citizens, independent
businesses, foreign trade partners, etc).

Modern socialism contains certain elements of capitalism, such as a market

mechanism, and also some centralized control over some resources. If more
of the economic control is centralized in ever increasing ways, it may
eventually become more akin to communism. Note that socialism as an
economic system can and does occur under various forms of government,
from the Democratic Socialism of the Nordic countries to more authoritarian
strands found elsewhere.

Communism
Communism is a form of command economy, whereby nearly all economic
activity is centralized, and through the coordination of state-sponsored central
planners. A society's theoretical economic strength can be marshaled to the
benefit of the society at large. Executing this in reality is far more difficult than
in theory, in that it requires no conflicting or competing entities within the
society to challenge the allocation of resources. Note that instances of
economic communism in the modern era have also been coupled with an
authoritarian form of government, although this need not be the case in theory.
2.Scope & Nature of Economics
THE NATURE AND SCOPE OF ECONOMICS

1.1 What is Economics?

Economics is a very interesting subject because it analyses how human
beings make choices in an effort to maximize utility. It also analyses how a
society seeks to allocate their limited resources in other to achieve growth.
The term economics is derived from two words economy and science
meaning the science of the economy or the science of proper utilization of
resources. This chapter focuses on the nature and scope of economics. To
understand the subject matter of economics, we tried to look at its different
definitions by different scholars. The basic concepts of economics are
discussed in other to give a better understanding of the definitions. There is
also the need to understand the basic economic problems of any society
because other problems revolve around these problems. The various
definitions of economics is grouped under different headings as discussed
below:

1.1.1The Classical View of Economics

The Classical economists viewed economics as a science of wealth. Adam
Smith, the father of economics, in his book titled: ‘An Enquiry into the Nature
and Causes of Wealth of Nations’, defined economics as the science of
wealth. According to Adam Smith, economics makes inquiries into the factors
that determine the wealth and growth of a nation. So to Adam Smith what
forms the subject matter of economics is the production and expansion of
wealth. However, Ricardo shifted emphasis from wealth production to wealth
distribution. According to a French classical economist, J. B Say, economics is
the science of production, distribution and consumption of wealth. Other
classical economists such J.S. Mill, defines economics as the law that governs
mankind in the production of wealth. The wealth definition means that wealth
was considered to be an end in itself.
Critical Evaluation of the Classical Economists View
The classical economists narrowed the scope of economics by defining it as
the science that deals with only material wealth. They do not regard the
services of those who produce non-material goods because their services do
not relate to production of tangible goods. This view or conception by the
classical economists attracted a lot of criticisms. Critics pointed out that
economics studies not only material goods and wealth, but also includes
non-material goods such as services of teachers, doctors, lawyers. These
services provided by human resources fulfill human wants and should be
regarded as part of wealth.
Secondly, the classical economists emphasized the importance of wealth
rather than human beings in economic life. The critics observed that wealth
was given primary role while human life was given secondary role, but on the
contrary, human life should play a primary role and so cannot be sacrificed for
wealth.
According to the classical economists, wage to labour is the only source of
wealth to a nation, but the critics are of the view that there are other sources
of wealth such as natural resources, human resources and capital resources.
1.1.2 The Neo- Classical View of Economics
The neoclassical economists led by Alfred Marshal gave economics a
respectable place among social sciences. Marshall defined economics as the
study of mankind in the ordinary business of life; it examines that part of
individual and the social action which is most closely connected with the
attainment and use of material wellbeing Wealth was regarded not as an end
in itself but a means to an end because it was seen as the source of human
welfare.
Major propositions of Marshall’s welfare definition are economics is the
science of material welfare. Secondly, economics is a social science because
it is a study of men as they live and move and think in the ordinary business of
life and thirdly that economics is the study of rational behavior of people as
they maximize their material welfare This means that Economics is concerned
with economic activities that promote material welfare but excludes all
non-economic activities that are socially undesirable like stealing,
prostitutions, etc.
Critical Evaluation of the Neo-Classical Economists View
The neo-classical definition of economics was criticized by Lionel Robbins
because of the distinction between material and non-material activities.
According to Robbins, the use of the word ‘material’ narrows down the scope
of economics because there are many things in the world which are
immaterial, but are useful for promoting human welfare. Robbins regards all
goods and services which command a price as economic activity whether they
are material or non-material. To say services are non–material is misleading
because services have value. Their definition of Economics from the material
point of view is a misrepresentation of the science of Economics.
To the neoclassical economists, economics is concerned with material
welfare. According to Robbins, the word welfare should not be used along with
material activities because there are many activities which are regarded as
economic activities but they do not promote human welfare. For example, the
production and sale of tobacco, drugs and alcohol are economic activities but
harmful to human health.
Robbins has also objected to the word ‘welfare’ in the neo-classical definition.
Welfare is a subjective thing and varies from person to person, from age to
age. According to Robbins, it cannot be said in objective term which things will
promote welfare and the ones that will not. Robbins believes that economics is
not concerned with welfare rather he explains economics as the problem that
have arisen because of scarcity of resources.
1.1.3 Scarcity and Choice Definition by Lionel Robbins
Robbins criticized Marshall’s definition and provided his own definition in his
book, “An Essay on the Nature and Significance of Economic Science” in
1932. According to Robbins, economics is the science which studies human
behaviour as a relationship between ends and scarce means which have
alternative uses. This means that economics is a human science. It involves
maximizing satisfaction from scarce resource and the means available for
satisfying these ends (wants) are scarce or limited in supply. Also the scarce
means are capable of alternative uses, that is, the use of scarce resource for
one end prevents its use for any other purpose at that point in time. The ends
are of varying importance which necessarily leads to the problem of choice in
selecting the uses to which scarce resources can be put to. It is the various
alternative uses of the resources that we have to decide on the best allocation
of resources.
It should be noted that Robbins definition stands on three major facts namely:
Unlimited wants, scarcity of resources and alternative uses of the resources.
Robbins economics studies man’s activities in regards to all goods and
services, without distinguishing them as material and non-material; provided
they satisfy human wants. In other words, economic problem is one of
allocating scarce means in relation to numerous ends.
Critical Evaluation of Robbins Definition
Robbins definition is no doubt popular among economists because it points
out the basic economic problems confronting the society. But Robbins
definition has also been criticized on several grounds. According to the critics,
Robbins definition also talks about welfare which he formally criticized. In fact
in Robbins definition the idea of welfare is present because it involves the
allocation of resources to maximize satisfaction. But this maximum satisfaction
is nothing but welfare.
Also Robbins assumption fails to explain fully the nature of ‘end’ and the
difficulties associated with it. The idea of definite ends is also not acceptable
because immediate ends many act as intermediaries to further ends. It is
difficult to separate ends from means because immediate ends may be the
means to the achievement of further ends.
Robbins definition is also criticized for not analyzing the theory of economic
growth and development rather it talks about the theory of product and factor
pricing. The theory of economic growth and development studies how national
income and per capita income increase and what causes the increase.
Robbins takes the resources as given while the theory of economic growth is
concerned with reducing the scarcity of resources through accumulation of
capital and wealth. Therefore, Robbins definition though applicable to fully
employed economy is not realistic for analyzing the economic problems of the
real world. Economic problems arise not only due to scarcity but due to under,
miss or over utilization of resources.

1.1.4Samuelson’s Growth Oriented Definition

The present trend in the world is the establishment of welfare states and
improvement in the standard of living through reduction in poverty,
unemployment and income inequality. In line with this trend Samuelson has
given a definition of economics based on growth aspects. According to
Samuelson, “Economics is the study of how people and society end up
choosing with or without the use of money, to employ scarce productive
resources that could have alternative uses to produce various commodities
over time and distribute them for consumption, now or in the future, among
various person or groups in the society”. Samuelson’s definition is an
improvement over Robbins scarcity definition based on the following facts:
1. Samuelson regards economics as a social science which emphasized the
problem of scarce resources and the idea of alternative uses of resources.
2. He emphasized on the consumption and distribution of various commodities
for the present and future economic growth thereby highlighting the study of
macroeconomics.
3. Samuelson lays emphasis on the use of modern technique of cost-benefit
analysis to evaluate the development programme for the use of limited
resources.
4. Samuelson’s definition of economics has superiority over that of Robbins
because of the inclusion of time element thereby making the scope of
economics dynamic.
From the above discussion, it is clear that economics cannot adequately be
defined in one sentence. No definition of economics has been generally
accepted as being satisfactory because every single definition has been
followed up with criticism. Even though there are different definitions as there
are different scholars, we will summarize economics as a social science
concerned with how human beings allocate their limited resources in order to
achieve a given end over time. That is, it analyses how households, firms,
and society as a whole try to maximize their gains from their limited resources
and opportunities now and in the future. A better understanding of the subject
matter of economics needs a probe into the scope.

1.2 The Scope of Economics

Economics as a subject is experiencing continuous growth. The frontier of the
subject has been widened after Alfred Marshall separated it from the term
Political Economy. A discussion on the scope of economics includes the
definition of economics, whether economics is an art or a science and whether
it is a positive or a normative science.

1.2.1 Economics as an Art and a Science

There have been numerous questions whether economics is an art or a
science. Economics is an art as well as a science. Economics is an art
because different theories and laws are explained with the help of graphs,
figures, tables, equations. Also economics make use of assumptions which
helps to define the conditions for the application of theories, laws and
relationship between economic variables.
Economics is a science because it is a systematized body of knowledge in
which economic facts are studied and analyzed. Economics just like science
have laws and theories which trace out a causal relationship between two or
more phenomena. For instance the law of demand tells us that, all things
being equal, a fall in price leads to an increase in demand and vice versa. A
rise or fall in price is the cause while the decrease or increase in demand is its
effect.
Economics is also a science because its laws possess universal validity such
as the law of demand, law of diminishing marginal utility, etc. Some people do
not regard economics as a science because there is no scope for
experimentation. Science involves collections of facts and testing them by
experimentation. Economic phenomena are complex because they relate to
man who acts irrationally as a result of tastes, habits, social and legal
institutions in the society. Although economics deal with statistical,
mathematical and econometric methods for testing, but they are not so
accurate to judge the true validity of economic laws and theories. As a result,
exact quantitative prediction becomes impossible. For instance, a rise in price
may not lead to a reduction in demand rather may increase demand because
people are scared of shortages in future.
But this does not mean that economics is not a science. It is rather classified
as a social science because it deals with human beings whose actions are so
filled with uncertainty.

1.2.2Economics as a Positive and Normative Science

According to J.N Keynes, a positive science may be defined as a body of
systematized knowledge concerning what it is; while a normative science is a
body of systematized knowledge relating to the criteria of what ought to be.
The objective of a positive science is the establishment of scientific laws; while
the objective of a normative science is the determination of the ideals. A
positive science is concerned with what is. According to Robbins, economics
is a science of what is which is not concerned with moral or ethical questions.
The positive science of economics makes it devoid of value or ethical
judgment, that is, it relates and describes facts without saying whether they
are good or bad. For instance, statements such as ‘Growth creates pollution’
or Growth gets rid of pollution’ are called positive statements –assertions of
facts that can be tested.
Normative economics involves value judgment or what are simply known as
value. It is concerned with the question of what ought to be. It makes
distinction between good and bad depending on ethics and beliefs of the
people rather than on scientific laws and principles. For instance, positive
economics is concerned with how aggregate consumption and investment,
how the national income and employment, and how the general price leves
are determined; it does not go into the question of what should the prices be,
what should be the savings rate, etc. these questions of what should be and
what ought to be, falls within normative economics.
Economics is both a positive and normative science because positive
economics sets about to discover what is true about the economy, while
normative economics evaluates whether the facts found are good or bad.

1.3 Basic Economic Concepts

Scarcity: - Scarcity means limited in supply. According to Thomas Sowell, the
first lesson of economics is scarcity. There are three categories of economic
resources: Land, labour and capital. Each of these resources exists in a finite,
limited quantity. People have unlimited wants and since we have a limited
amount of resources it means we can only produce a limited amount of goods
and services, that is, the limited resources cannot produce enough to satisfy
everyone’s unlimited wants. This gives rise to the study of economics for
better allocation of scare resources among competing and insatiable needs so
as to maximize welfare.
Choice: A choice is a comparison of alternatives. The problem of scarcity
leaves us in a situation in which we must constantly choose which of our
wants we will seek to satisfy. For instance, an individual consumer must
choose among the types of goods and services to consume because of his
limited income. He must also choose between spending on present
consumption and saving for future consumption.
The firm with its limited capital must decide what to produce and what not to
produce. A situation where the firm wants to produce two commodities, the
choice to produce more of one would mean a resolve to produce less of the
other.
The government is also forced to make a choice on the nature of public goods
to provide for the citizens. The government has the task of utilizing the scare
resources effectively in order to improve the welfare of the people. Scarcity
gives rise to choice and making a choice creates a sacrifice because
alternatives must be given up leading to the loss of the benefits which the
alternative would have provided.
Scale of Preference: - In economics, it is assumed that man is rational in his
choice making, that is, if a man has to choose between one thing and another,
it is expected that he will always choose the alternative that will yield the
greatest satisfaction. Similarly a firm faced with how to make a choice
between production of one product and another, will choose the product that
will yield the greatest profits. Scale of preference presents a list of wants
arranged in order of importance with the most pressing want listed first,
followed by the second most pressing need and so on.

Opportunity Cost: - Opportunity cost means forgone alternative. People must

make choices because of limited resources. Every choice has an opportunity
cost and so the satisfaction of one want involves forsaking the other.
Therefore the real cost of satisfying any want is the alternative forgone or the
opportunity cost. For instance, suppose a community uses a land and other
resources to build a school instead of a factory, the opportunity cost of
choosing the school is the loss of the factory and what could have been
produced by building the factory. Also if a student misses his lecture on
economics because he wants to go to the cinema, the cost to him is the
lectures that he decides to miss. Opportunity cost of any choice is the value of
the best alternative forgone in making it and not simply the amount spent on
that choice.
1.5 Central Economic Problems of any Economy
All modern economies have certain fundamental or basic economic problems
to deal with. The limited resources have led to the problem of how to assign
the scare resources in order to achieve maximum satisfaction. There is the
need to economize and utilize these resources in the most efficient manner in
order to satisfy the welfare of the society. These problems are called central
economic problems because other problems revolve around them. They are:
What to produce: - This has to do with the problem of allocation of resources
among different goods and services. It involves selection of what should be
produced and in what quantity in order to satisfy consumer wants as best as
possible using the available resources. The society has to choose among
different kinds of goods and decide on how to allocate resources among them,
for instance whether to produce capital goods or consumer goods. The
society also needs to determine the specific quantity of each type of good to
be produced. In a market economy, the choice of what to produce is made by
the buyers in other to fulfill their needs. Government can through its laws
determine what to produce in a given economy. But the production of one
good means a reduction in the production of another.
How to Produce: -This problem refers to selection of appropriate technique of
production, that is, how to combine resources in other to produce goods and
service in a more efficient way and at a minimum cost. A combination of
resources (factors) implies a technique of production. The technique of using
a combination which involves less capital and more labour is known as
labour-intensive mode of production while a combination of more capital and
less labour is capital-intensive mode of production. The decision on which
resource combination to use depends on availability of factors and their
relative prices. Therefore, it is in the interest of the society that factors should
be combined in a manner that maximum output can be produced at minimum
cost, using least possible scarce resources.
For whom to produce: - This economic problem focuses on how the national
product is to be distributed among the members of the society, that is, how the
consumer goods and capital goods will be distributed. The society has to
decide who receives the outputs produced in the economy because human
wants are unlimited. Should the economy produce goods for those with high
incomes or for those with low income? What demographic group should
production be targeted at? The money income of the people determines the
distribution of output in the society. The greater ones money income, the
greater the quantity of goods the person will purchase from the market.
Sometimes the supply of goods are in short supply leading to government
intervention through price legislation, rationing or through quotas.
What provision should be made for economic growth?
This problem deals with how to decide on how much saving and investment
should be made for future economic growth. No society or individual would
like to use all its scarce resources for only current consumption or else future
production will remain stagnant leading to a decline in the levels of living. The
society should devote a part of its resources for the production of capital
goods and for the promotion of research and development activities. Capital
and technological progress achieved in this way will lead to production of
consumer goods in the future and increase standard of living.
1.6 Microeconomics and Macroeconomics
Economics is divided into two major areas – Microeconomics and
Macroeconomics
Microeconomics: - The word micro is derived from the Greek word mikros
meaning small. Microeconomics is a branch of economics that is concerned
with the behavior of individual consumers, firms, industries, commodities and
prices. It studies how decisions made by individuals and businesses affect the
prices of goods and services. The main objective of microeconomics is to
maximize utility and minimize cost. It is also known as the price theory. The
major drawback of microeconomics is the unrealistic assumption of full
employment condition in an economy and it deals with the part of the
economy instead of the whole economy.
Macroeconomics: - The word macro is derived from the Greek word makros
meaning large. It is that branch of economics that focus on the impact of
choices on the total or aggregate level of economic activities.
Macroeconomics is the study of aggregates of individuals, firms, prices and
outputs. In other words, it studies the economy as a whole. It analyses issues
such as aggregate level of employment, the general price level, aggregate
savings and investment in the economy. The main objectives of
macroeconomics are full employment, economic growth, favourable balance
of payment and price stability. The major limitation of macroeconomics is that
it ignores the welfare of individuals in an economy and it takes into account
only aggregate variables which may not clearly explain economic conditions.
Microeconomics differs from macroeconomics in that while microeconomics
maps up close how individuals make decisions and how these decisions affect
the price and output of various goods and services, macroeconomics analyses
not individuals but aggregates of the economy. While microeconomics studies
how an individual firm employs its labours, macroeconomics studies the total
employment in a given economy. While microeconomics is particularly
concerned with the relative prices of goods and service; macroeconomics
studies total prices of all goods and services in the economy.
The division between microeconomics and macroeconomics is not rigid, they
are interrelated. What affects the part affects the whole while the whole is
made up of the parts. For instance, national income is the sum of the incomes
of individuals, households, firms and industries. Also aggregates that are
studied in macroeconomics are nothing but individual quantities which are
studied in microeconomics. Moreover, modern macroeconomics is based
upon the study of microeconomics. Therefore, microeconomics and
macroeconomics cannot be isolated from each other.

Books for Further Reading

Adebayo, A. (1994). Economics a Simplified Approach. Lagos: Harmony
Publishers
Ahuja, H. L. (2008). Modern Economics: Analytical Study. New Delhi: S.
Chand & Company, Ltd.
Iyoha, M. A; Oyefusi, S. A. & Oriakhi, D. E. (2003). An introduction to Modern
Microeconomics. Benin: Mindex Publishing.
Jhingan, M. L. (2010).Microeconomic Theory. Delhi:Vrinda Publications (P)
Ltd.
3. Scarcity & Choice
Where there is scarcity, choices must be made! Scarcity refers to the finite nature
and availability of resources while choice refers to people’s decisions about sharing
and using those resources. The problem of scarcity and choice lies at the very heart
of economics, which is the study of how individuals and society choose to allocate
scarce resources.

Some resources are plentiful while others are rare. We tend to think less about the air
that we breathe than about how we are going to spend our time on any given day.
That is because breathable air is in apparent abundance while the number of hours
in a day is clearly limited. Our decision to breathe is not a conscious one and is thus
somewhat uninteresting for an economist. On the other hand, a whole branch of
economics exists to understand and explain our choices of time allocation: how
many hours’ work and how many hours’ play are of fundamental importance to the
labour market. It is not just people’s time but also their skills that are in limited
supply. Economists are typically concerned with the efficiency of any allocation: how
can the most be made of such scarce resources?

While mainstream economics focuses on the preferences and decisions of

individuals in society, evaluating the allocation of scarce resources within a society
necessitates some aggregation of preferences in order to judge the utility of an
allocation to society as a whole (see the article on welfare economics). Thus, not
only the efficiency of an allocation but also its equity, or distributive fairness, is
relevant to the study of scarcity and choice. Indeed, the issue of equity is central to
the debate on free-market versus planned economies.

The scarcity of a resource in a particular context can be quantified and hence judged
objectively. Traditionally, economists have also studied people’s choices over scarce
resources as though they were taken through simple, objective and rational
calculation. Of course, people’s decision-making is not purely rational; it is affected
by emotion too. The fast-developing subfield of behavioural economics applies
insights from human psychology to enrich economists’ understanding of choice at a
more subjective level.

The basics of supply and demand tell us that the price of a rare item will be higher
than that of a common one. Marketing teams often apply the concepts of scarcity
and choice along with ideas from psychology to make money: if the impression can
be given that an item is in scarce supply then some people will be willing to pay more
for it, or to bring forward their purchases. Mind games about scarcity are played out
through campaign statements such as “Buy it while it lasts!”, “Last chance to order!”
or “Limited offer!” precisely in order to influence consumer choice.

Further reading
For an interesting discussion about the scarcity of a clear definition of economics
and how economists have chosen to present their discipline over the years, see
Backhouse and Medema's “Retrospectives: On the Definition of Economics” (Journal
of Economic Perspectives, 2009).

Good to know
Perhaps the most important and pressing issue of our time, that of climate change,
is essentially a problem of scarcity and choice. As the very air we breathe comes
under threat and our rivers begin to run dry there has never been a greater urgency to
consider economics in the search for practical solutions. The subfield of
environmental economics deals with emissions targets and permits, carbon taxes,
and subsidies for renewable sources of energy. It will surely be one of the most
in-demand areas for economists to work in the years to come.
4.Supply & Demand Theory
The law of supply and demand is a theory that explains the interaction
between the sellers of a resource and the buyers for that resource. The theory
defines the relationship between the price of a given good or product and the
willingness of people to either buy or sell it. Generally, as price increases,
people are willing to supply more and demand less and vice versa when the
price falls.

The theory is based on two separate "laws," the law of demand and the law of
supply. The two laws interact to determine the actual market price and volume
of goods on a market.

KEY TAKEAWAYS
● The law of demand says that at higher prices, buyers will demand less
of an economic good.
● The law of supply says that at higher prices, sellers will supply more of
an economic good.
● These two laws interact to determine the actual market prices and
volume of goods that are traded on a market.
● Several independent factors can affect the shape of market supply and
demand, influencing both the prices and quantities that we observe in
markets.
Understanding the Law of Supply and Demand
The law of supply and demand, one of the most basic economic laws, ties into
almost all economic principles in some way. In practice, people's willingness to
supply and demand a good determines the market equilibrium price, or the
price where the quantity of the good that people are willing to supply just
equals the quantity that people demand. However, multiple factors can affect
both supply and demand, causing them to increase or decrease in various
ways.

Volume 75%

Law of Supply and Demand

Law of Demand vs. Law of Supply
Demand
The law of demand states that, if all other factors remain equal, the higher the
price of a good, the less people will demand that good. In other words, the
higher the price, the lower the quantity demanded. The amount of a good that
buyers purchase at a higher price is less because as the price of a good goes
up, so does the opportunity cost of buying that good.

As a result, people will naturally avoid buying a product that will force them to
forgo the consumption of something else they value more. The chart below
shows that the curve is a downward slope.

Supply
Like the law of demand, the law of supply demonstrates the quantities that will
be sold at a certain price. But unlike the law of demand, the supply
relationship shows an upward slope. This means that the higher the price, the
higher the quantity supplied. From the seller's perspective, the opportunity
cost of each additional unit that they sell tends to be higher and higher.
Producers supply more at a higher price because the higher selling price
justifies the higher opportunity cost of each additional unit sold.

For both supply and demand, it is important to understand that time is always
a dimension on these charts. The quantity demanded or supplied, found along
the horizontal axis, is always measured in units of the good over a given time
interval. Longer or shorter time intervals can influence the shapes of both the
supply and demand curves.

Supply and Demand Curves

At any given point in time, the supply of a good brought to market is fixed. In
other words, the supply curve in this case is a vertical line, while the demand
curve is always downward sloping due to the law of diminishing marginal
utility. Sellers can charge no more than the market will bear based on
consumer demand at that point in time.

Over longer intervals of time, however, suppliers can increase or decrease the
quantity they supply to the market based on the price they expect to be able to
charge. So over time, the supply curve slopes upward; the more suppliers
expect to be able to charge, the more they will be willing to produce and bring
to market.
For all time periods, the demand curve slopes downward because of the law
of diminishing marginal utility. The first unit of a good that any buyer demands
will always be put to that buyer's highest valued use. For each additional unit,
the buyer will use it (or plan to use it) for a successively lower-valued use.

Shifts vs. Movement

For economics, the "movements" and "shifts" in relation to the supply and
demand curves represent very different market phenomena.

A movement refers to a change along a curve. On the demand curve, a

movement denotes a change in both price and quantity demanded from one
point to another on the curve. The movement implies that the demand
relationship remains consistent. Therefore, a movement along the demand
curve will occur when the price of the good changes and the quantity
demanded changes in accordance to the original demand relationship. In
other words, a movement occurs when a change in the quantity demanded is
caused only by a change in price, and vice versa.

Like a movement along the demand curve, a movement along the supply
curve means that the supply relationship remains consistent. Therefore, a
movement along the supply curve will occur when the price of the good
changes and the quantity supplied changes in accordance to the original
supply relationship. In other words, a movement occurs when a change in
quantity supplied is caused only by a change in price, and vice versa.

Shifts
Meanwhile, a shift in a demand or supply curve occurs when a good's quantity
demanded or supplied changes even though the price remains the same. For
instance, if the price for a bottle of beer was $2 and the quantity of beer
demanded increased from Q1 to Q2, then there would be a shift in the
demand for beer. Shifts in the demand curve imply that the original demand
relationship has changed, meaning that quantity demand is affected by a
factor other than price. A shift in the demand relationship would occur if, for
instance, beer suddenly became the only type of alcohol available for
consumption.

Conversely, if the price for a bottle of beer was $2 and the quantity supplied
decreased from Q1 to Q2, then there would be a shift in the supply of beer.
Like a shift in the demand curve, a shift in the supply curve implies that the
original supply curve has changed, meaning that the quantity supplied is
affected by a factor other than price. A shift in the supply curve would occur if,
for instance, a natural disaster caused a mass shortage of hops; beer
manufacturers would be forced to supply less beer for the same price.

How Do Supply and Demand Create an Equilibrium Price?

Also called a market-clearing price, the equilibrium price is the price at which
the producer can sell all the units he wants to produce and the buyer can buy
all the units he wants.

With an upward-sloping supply curve and a downward-sloping demand curve,

it is easy to visualize that at some point the two will intersect. At this point, the
market price is sufficient to induce suppliers to bring to market the same
quantity of goods that consumers will be willing to pay for at that price. Supply
and demand are balanced, or in equilibrium. The precise price and quantity
where this occurs depend on the shape and position of the respective supply
and demand curves, each of which can be influenced by a number of factors.

Factors Affecting Supply

Supply is largely a function of production costs such as labor and materials
(which reflect their opportunity costs of alternative uses to supply consumers
with other goods); the physical technology available to combine inputs; the
number of sellers and their total productive capacity over the given time frame;
and taxes, regulations, or other institutional costs of production.

Factors Affecting Demand

Consumer preferences among different goods are the most important
determinant of demand. The existence and prices of other consumer goods
that are substitutes or complementary products can modify demand. Changes
in conditions that influence consumer preferences can also be important, such
as seasonal changes or the effects of advertising. Changes in incomes can
also be important in either increasing or decreasing quantity demanded at any
given price.
Frequently Asked Questions
What is a simple explanation of the law of supply and demand?
In essence, the Law of Supply and Demand describes a phenomenon that is
familiar to all of us from our daily lives. It describes the way in which, all else
being equal, the price of a good tends to increase when the supply of that
good decreases (making it more rare) or when the demand for that good
increases (making the good more sought after). Conversely, it describes how
goods will decline in price when they become more widely available (less rare)
or less popular among consumers. This fundamental concept plays an
important role throughout modern economics.

Why is the law of supply and demand important?

The Law of Supply and Demand is important because it helps investors,
entrepreneurs, and economists to understand and predict conditions in the
market. For example, a company that is launching a new product might
deliberately try to raise the price of their product by increasing consumer
demand through advertising.

At the same time, they might try to further increase their price by deliberately
restricting the number of units they sell, in order to decrease supply. In this
scenario, supply would be minimized while demand would be maximized,
leading a higher price.

What is an example of the law of supply and demand?

To illustrate, let us continue with the above example of a company wishing to
market a new product at the highest possible price. In order to obtain the
highest profit margins possible, that same company would want to ensure that
its production costs are as low as possible.

To do so, it might secure bids from a large number of suppliers, asking each
supplier to compete against one-another to supply the lowest possible price
for manufacturing the new product. In that scenario, the supply of
manufacturers is being increased in a way that decreases the cost (or “price”)
of manufacturing the product. Here again, we see the Law of Supply and
Demand.
5.Cost & Benifits
A cost-benefit analysis is a systematic process that businesses use to analyze
which decisions to make and which to forgo. The cost-benefit analyst sums
the potential rewards expected from a situation or action and then subtracts
the total costs associated with taking that action. Some consultants or
analysts also build models to assign a dollar value on intangible items, such
as the benefits and costs associated with living in a certain town.

KEY TAKEAWAYS
● A cost-benefit analysis (CBA) is the process used to measure the
benefits of a decision or taking action minus the costs associated with
taking that action.
● A CBA involves measurable financial metrics such as revenue earned
or costs saved as a result of the decision to pursue a project.
● A CBA can also include intangible benefits and costs or effects from a
decision such as employees morale and customer satisfaction.
Volume 75%

Cost-Benefit Analysis (CBA)

Understanding Cost-Benefit Analysis (CBA)
Before building a new plant or taking on a new project, prudent managers
conduct a cost-benefit analysis to evaluate all the potential costs and
revenues that a company might generate from the project. The outcome of the
analysis will determine whether the project is financially feasible or if the
company should pursue another project.

In many models, a cost-benefit analysis will also factor the opportunity cost
into the decision-making process. Opportunity costs are alternative benefits
that could have been realized when choosing one alternative over another. In
other words, the opportunity cost is the forgone or missed opportunity as a
result of a choice or decision. Factoring in opportunity costs allows project
managers to weigh the benefits from alternative courses of action and not
merely the current path or choice being considered in the cost-benefit
analysis.
By considering all options and the potential missed opportunities, the
cost-benefit analysis is more thorough and allows for better decision-making.

The Cost-Benefit Analysis Process

A cost-benefit analysis should begin with compiling a comprehensive list of all
the costs and benefits associated with the project or decision.

The costs involved in a CBA might include the following:

● Direct costs would be direct labor involved in manufacturing, inventory,

raw materials, manufacturing expenses.
● Indirect costs might include electricity, overhead costs from
management, rent, utilities.
● Intangible costs of a decision, such as the impact on customers,
employees, or delivery times.
● Opportunity costs such as alternative investments, or buying a plant
versus building one.
● Cost of potential risks such as regulatory risks, competition, and
environmental impacts.

Benefits might include the following:

● Higher revenue and sales from increased production or new product.

● Intangible benefits, such as improved employee safety and morale, as
well as customer satisfaction due to enhanced product offerings or
faster delivery.
● Competitive advantage or market share gained as a result of the
decision.

An analyst or project manager should apply a monetary measurement to all of

the items on the cost-benefit list, taking special care not to underestimate
costs or overestimate benefits. A conservative approach with a conscious
effort to avoid any subjective tendencies when calculating estimates is best
suited when assigning a value to both costs and benefits for a cost-benefit
analysis.

Finally, the results of the aggregate costs and benefits should be compared
quantitatively to determine if the benefits outweigh the costs. If so, then the
rational decision is to go forward with the project. If not, the business should
review the project to see if it can make adjustments to either increase benefits
or decrease costs to make the project viable. Otherwise, the company should
likely avoid the project.

With cost-benefit analysis, there are a number of forecasts built into the
process, and if any of the forecasts are inaccurate, the results may be called
into question.
Limitations of the Cost-Benefit Analysis
For projects that involve small- to mid-level capital expenditures and are short
to intermediate in terms of time to completion, an in-depth cost-benefit
analysis may be sufficient enough to make a well-informed, rational decision.
For very large projects with a long-term time horizon, a cost-benefit analysis
might fail to account for important financial concerns such as inflation, interest
rates, varying cash flows, and the present value of money.

Alternative capital budgeting analysis methods, including net present value

(NPV), could be more appropriate for these situations. The concept of present
value states that an amount of money or cash in the present day is worth
more than receiving the amount in the future since today's money could be
invested and earn income.

One of the benefits of using the net present value for deciding on a project is
that it uses an alternative rate of return that could be earned if the project had
never been done. That return is discounted from the results. In other words,
the project needs to earn at least more than the rate of return that could be
earned elsewhere or the discount rate.

However, with any type of model used in performing a cost-benefit analysis,

there are a significant amount of forecasts built into the models. The forecasts
used in any CBA might include future revenue or sales, alternative rates of
return, expected costs, and expected future cash flows. If one or two of the
forecasts are off, the CBA results would likely be thrown into question, thus
highlighting the limitations in performing a cost-benefit analysis.

How Does one Weigh Costs vs. Benefits?

Cost-benefit analysis (CBA) is a systematic method for quantifying and then
comparing the total costs to the total expected rewards of undertaking a
project or making an investment. If the benefits greatly outweigh the costs, the
decision should go ahead; otherwise, it should probably not. CBAs,
importantly, will also include the opportunity costs of missed or skipped
projects.

What Are Some Tools or Methods Used in CBA?

Depending on the specific investment or project being evaluated, one may
need to discount the time value of cash flows using net present value
calculations. A benefit-cost ratio (BCR) may also be computed to summarize
the overall relationship between the relative costs and benefits of a proposed
project. Other tools may include regression modeling, valuation, and
forecasting techniques.

What Are the Costs and Benefits of Doing a

Cost-Benefit Analysis?
The process of doing a CBA itself has its own inherent costs and benefits. The
costs involve the time needed to carefully understand and estimate all of the
potential rewards and costs. This may also involve money paid to an analyst
or consultant to carry out the work. One other potential downside is that
various estimates and forecasts are required to build the CBA, and these
assumptions may prove to be wrong or even biased.

The benefits of a CBA, if done correctly and with accurate assumptions, are to
provide a good guide for decision-making that can be standardized and
quantified. If the CBA of doing a CBA is positive, you should do it!
6.All of Terminologies
In any technical subject, words commonly used in everyday life acquire very specific
technical meanings, and confusion can arise when someone is uncertain of the intended
meaning of a word. This article explains the differences in meaning between some technical
terms used in economics and the corresponding terms in everyday usage.

Contents

● 1
● "Recession"
●
● 2
● "Unemployed"
●
● 3
● "Money"
●
● 4
● "Investment" and "capital"
●
● 5
● "Government spending"
●
● 6
● "Welfare economics"
●
● 7
● "Efficient"
●
● 8
● "Cost" and "profit"
●
● 9
● "Demand"
●
● 10
● "Supply"
●
● 11
● "Marginal"
●
● 12
● "Significant"
●
● 13
● "Biased"
●
● 14
● "Dummy"
 ●
● 15
● "Elasticity"
●
● 16
● "Rational"
●
● 17
● "Rent"
●
● 18
● References
●

"Recession"[edit]
Economists commonly use the term "recession" to mean either a period of two successive

calendar quarters each having negative growth of real gross domestic product[1][2][3]—that is,

of the total amount of goods and services produced within a country—or that provided by the

National Bureau of Economic Research[4] (NBER): "...a significant decline in economic

activity spread across the country, lasting more than a few months, normally visible in real
GDP growth, real personal income, employment, industrial production, and wholesale-retail
sales." Almost all economists and policymakers refer to the NBER's determination for the

precise dates of a U.S. recession's beginning and end.[5]

In contrast, in non-expert, everyday usage, "recession" may refer to a period in which the
unemployment rate is substantially higher than normal.

"Unemployed"[edit]
Labor economists categorize people into three groups: "employed" – actually working at a
job, even if part-time; "unemployed" – not working, but looking for work or awaiting a
scheduled recall from a temporary layoff; and "not in the labor force" – neither working nor

looking for work.[3][6] People not in the labor force, even if they have given up looking for a

job despite wanting one, are not considered unemployed. For this reason it is often thought,
especially when a recession has persisted for a sustained period, that the unemployment
rate understates the true amount of unemployment because some unemployment is
disguised by discouraged workers having left the labor force.

The everyday usage of the word "unemployed" is usually broad enough to include disguised
unemployment, and may include people with no intention of finding a job. For example, a
dictionary definition is: "not engaged in a gainful occupation",[7] which is broader than the

economic definition.

"Money"
Economists use the word "money" to mean very liquid assets which are held at any moment

in time.[3][6] The units of measurement are dollars or another currency, with no time

dimension, so this is a stock variable. There are several technical definitions of what is
included in "money", depending on how liquid a particular type of asset has to be in order to
be included. Common measures include M1, M2, and M3.

In everyday usage, "money" can refer to the very liquid assets included in the technical
definition, but it usually refers to something much broader. When someone says "She has a
lot of money," the intended meaning is almost certainly that she has a lot of what economists
would call financial wealth, which includes not only the most liquid assets (which tend to pay
low or zero returns), but also stocks, bonds and other financial investments not included in
the technical definition. Non-financial assets, such as land and buildings, may also be
included. For example, dictionary definitions of money include "wealth reckoned in terms of

money" and "persons or interests possessing or controlling great wealth",[8] neither of which

correspond to the economic definition.

A related but different everyday usage occurs in the sentence "He makes a lot of money."
This refers to a variable that economists call income. Unlike the usages mentioned above,
this one has the units "dollars, or another currency, per unit of time", where the unit of time
might be a week, month, or year, making it a flow variable.

"Investment" and "capital"

While financial economists use the word "investment" to refer to the acquisition and holding
of potentially income-generating forms of wealth such as stocks and
bonds,macroeconomists usually use the word for the sum of fixed investment—the
purchasing of a certain amount of newly produced productive equipment, buildings or other
productive physical assets per unit of time—and inventory investment—the accumulation of
inventories over time. This is one of the major types of expenditure in an economy, the
others being consumption expenditure, government expenditure, and expenditure on a
country's export goods by people outside the country.
The everyday usage of "investment" coincides with the one used by financial
economists—the acquisition and holding of potentially income-generating forms of wealth
such as stocks and bonds.

Similarly, while financial economists use the word "capital" to refer to funds used by
entrepreneurs and businesses to buy what they need to make their products or to provide
their services, macroeconomists and microeconomists use the term capital to mean
productive equipment, buildings or other productive physical assets.

As with the term "investment", the everyday usage of "capital" coincides with its use by
financial economists.

"Government spending"
Economists distinguish between government spending on newly produced goods and
services, such as paying a company to build a new highway, and government spending on
transfer payments, which are payments such as welfare payments intended to redistribute
income. In economic models, transfer payments are normally treated as a negative
component of "taxes net of transfers", leaving "government spending on (newly produced)
goods and services" as a separate category, often referred to simply as "government
spending".

In everyday usage, "government spending" refers to the broader concept of government

spending on goods and services plus transfer payments.

"Welfare economics"
Welfare economics is a branch of economics that uses microeconomic techniques to
evaluate economic well-being, especially relative to competitive general equilibrium, with a
focus on economic efficiency and income distribution.

In general usage, including by economists outside the above context, welfare refers to a
form of transfer payment.

"Efficient"
Economists use the word efficient to mean any of several closely related things:[12]

● No one can be made better off without making someone else worse off (Pareto
efficiency).
 ● More output cannot be obtained without increasing the amount of inputs.
● Production proceeds at the lowest possible per-unit cost.
All of these definitions involve the idea that nothing more can be achieved given the
resources available.

In popular usage, efficient often has the similar but less precise meaning "functioning
effectively".

"Cost" and "profit"

The economics term cost, also known as economic cost or opportunity cost, refers to the
potential gain that is lost by foregoing one opportunity in order to take advantage of another.
The lost potential gain is the cost of the opportunity that is accepted. Sometimes this cost is
explicit: for example, if a firm pays $100 for a machine, its cost is $100. Other times,
however, the cost is implicit: for example, if a firm diverts resources from producing output
worth $200 into producing a different kind of output, then regardless of how much or how
little of the latter output is produced, the opportunity cost of doing so is $200.

In accounting, there is a different technical concept of cost, which excludes implicit

opportunity costs.

In common usage, as in accounting usage, "cost" typically does not refer to implicit costs
and instead only refers to direct monetary costs.

The economics term profit relies on the economic meaning of the term for "cost". While in
common usage, profit refers to earnings minus accounting cost, economists mean earnings
minus economic cost or opportunity cost.

"Demand"
In economics, demand refers to the strength of one or many consumers' willingness to
purchase a good or goods at a range of different prices. If, for example, a rise in income
causes a consumer to be willing to purchase more of a good than before contingent on each
possible price, economists say that the income rise has caused the consumer's demand for
the good to rise. In contrast, if a change in market conditions leads to a decline in the price
of a good resulting in a consumer's being willing to buy more of it, economists say that the
consumer's quantity demanded of the good has risen. A change in quantity demanded is
represented by a movement along the demand curve, while a change in demand is

represented by a shift of the demand curve.[12]

In popular usage a change in "demand" can refer to either what economists call a change in
demand or what economists call a change in quantity demanded.

"Supply"
In economics, supply refers to the strength of one or many producers' willingness to produce
and sell a good or goods at any in a range of prices. If, for example, a reduction in
production costs causes a producer to be willing to provide more of a good than before
contingent on each possible price, economists say that the drop in production costs has
caused supply to rise. In contrast, if a change in market conditions leads to a decline in the
price of a good resulting in a producer willing to sell less of it, economists say that the
consumer's quantity supplied of the good has fallen. A change in quantity supplied is
represented by a movement along the supply curve, while a change in supply is represented
by a shift of the supply curve.

"Marginal"
While "marginal" in common usage tends to mean "tangential", implying limited importance,
in economics "marginal" means "incremental". For example, the marginal propensity to
consume refers to the incremental tendency to spend income on consumer goods: the
fraction of any additional income which is spent on additional consumption (or conversely,
the fraction of any decrease in income which becomes a decrease in consumption).
Likewise, the marginal product of capital refers to the additional production of output that
results from using an additional unit of physical capital (machinery, etc.). If very small
increments are being considered, so that calculus is used, then this ratio of incremental
amounts is a derivative (for example, the marginal propensity to consume becomes the
derivative of consumption with respect to income).

"Significant"
In common usage, "significant" usually means "noteworthy" or "of substantial importance". In
econometrics — the use of statistical techniques in economics — "significant" means
"unlikely to have occurred by chance". For example, suppose one wishes to find if the
minimum wage rate affects firms' decisions on how much labor to hire. If the data show, on
the basis of statistical techniques, an effect of a particular non-zero magnitude, one wants to
know whether that non-zero magnitude could have arisen in the data by chance when in fact
the true effect is zero. If a statistical test shows that there is less than, say, a 5% chance that
one would have found this particular value if the true value were zero, then it is said that the
estimate is "significant at the 5% level". If not, then it is said that the estimate is "insignificant
at the 5% level".

Note, however, that the less precise phrase "economically significant" is sometimes used by
economists to mean something very similar to the common usage of "significant". If the
effect of the minimum wage on hiring decisions were found to be very small and yet the
numerical result is very unlikely to have occurred only by chance, then the estimated effect is
said to be statistically significant but not significant economically.

"Biased"
In common usage "biased" generally means "prejudiced". In econometrics, the estimate of
the effect of one thing on another (say, the estimate of the effect of the minimum wage upon
employment decisions) is said to be "biased" if the technique that was used to obtain the
estimate has the effect that, a priori, the expected value of the estimated effect differs from
the true effect, whatever the latter may be. In this case the technique, as well as the estimate
obtained with the technique, is called "biased". Researchers are likely to view a biased
estimate with suspicion.

"Dummy"
In common usage, dummy can offensively refer to someone who is silent or unintelligent, or
to a mannequin or puppet. In econometrics, "dummy" generally refers to a binary variable
that indicates whether a certain quality is present or absent. So, for example, a "male
dummy" would refer to a variable indicating that someone is male, rather than referring to an
unintelligent male or a male puppet.

"Elasticity"
In general usage "elasticity" refers to flexibility. In economics it refers to a quantitative
measurement of the degree of flexibility of something in response to something else. For
example, the "elasticity of demand with respect to income" or the "income elasticity of
demand" for a product refers to the percentage change in the quantity of the product
demanded in response to a 1% change in consumers' income, or more generally to the ratio
of the percentage change in quantity demanded to the percentage change in income. The
change in the denominator always causes the change in the numerator, so the elasticity can
be said to be the ratio of a percentage change that is caused to the percentage change of
something that is causative.

"Rational
In general usage, one is said to be rational if one is sane or lucid.[16] In economics,

rationality means that an economic agent specifies, or acts as if he implicitly specifies, a way
to characterize his or someone's well-being, and then takes into account all relevant
information in making choices so as to optimize that well-being. For example, an individual
consumer is assumed to be rational in the sense that he maximizes a utility function, which
expresses his subjective sense of well-being as a function of the amounts of various goods
he consumes; firms are assumed to maximize profit or some related goal. Economists
assume that in the presence of uncertainty, an agent is rational in the sense of specifying a
way of evaluating sets of possible outcomes (and associated probabilities) with some
function: A consumer is assumed to choose his consumption levels of various goods so as
to pick the set of possible outcomes, and associated probabilities, that maximizes this
function, which is often assumed to be the expected value of a von Neumann–Morgenstern
utility function; a firm is often assumed to maximize the expected value of profit.

"Rent"
In general usage, rent refers to a payment made in exchange for temporary use of property,
for example paying rent to stay in an apartment. In economics, rent is any payment to an
owner or factor of production in excess of the costs needed to bring that factor into
production. Effectively, it is payment made to a producer above and beyond what would have
been necessary to incentivize them to produce. It can roughly be understood as unearned
revenue.

In many cases,common-usage "rent" is an example of economic-usage "rent", making the

distinction between the two confusing.
7. Factor of production
Factors of production are the inputs needed for the creation of a good or
service. The factors of production include land, labor, entrepreneurship, and
capital.1

KEY TAKEAWAYS
● Factors of production is an economic term that describes the inputs
used in the production of goods or services to make an economic profit.
● These include any resource needed for the creation of a good or
service.
● The factors of production are land, labor, capital, and entrepreneurship.
● The state of technological progress can influence the total factors of
production and account for any efficiencies not related to the four typical
factors.
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Factors Of Production
How Factors of Production Works
The modern definition of factors of production is primarily derived from a
neoclassical view of economics. It amalgamates past approaches to economic
theory, such as the concept of labor as a factor of production from socialism,
into a single definition.

Land, labor, and capital as factors of production were originally identified by

early political economists such as Adam Smith, David Ricardo, and Karl Marx.
Today, capital and labor remain the two primary inputs for processes and
profits. Production, such as in manufacturing, can be tracked by certain
indexes, including the ISM manufacturing index.

Four Factors of Production

There are four factors of production—land, labor, capital, and
entrepreneurship.
Image by Sabrina Jiang © Investopedia 2020
Land as a factor
Land has a broad definition as a factor of production and can take on various
forms, from agricultural land to commercial real estate to the resources
available from a particular piece of land. Natural resources, such as oil and
gold, can be extracted and refined for human consumption from the land.

Cultivation of crops on land by farmers increases its value and utility. For a
group of early French economists called “the physiocrats,” who predated the
classical political economists, land was responsible for generating economic
value.

While land is an essential component of most ventures, its importance can

diminish or increase based on industry. For example, a technology company
can easily begin operations with zero investment in land. On the other hand,
land is the most significant investment for a real estate venture.

Labor as a factor
Labor refers to the effort expended by an individual to bring a product or
service to the market. Again, it can take on various forms. For example, the
construction worker at a hotel site is part of labor, as is the waiter who serves
guests or the receptionist who enrolls them into the hotel.

Within the software industry, labor refers to the work done by project
managers and developers in building the final product. Even an artist involved
in making art, whether it is a painting or a symphony, is considered labor.

For the early political economists, labor was the primary driver of economic
value. Production workers are paid for their time and effort in wages that
depend on their skill and training. Labor by an uneducated and untrained
worker is typically paid at low prices.

Skilled and trained workers are referred to as “human capital” and are paid
higher wages because they bring more than their physical capacity to the task.
For example, an accountant’s job requires the analysis of financial data for a
company. Countries that are rich in human capital experience increase
productivity and efficiency.

The difference in skill levels and terminology also helps companies and
entrepreneurs create corresponding disparities in pay scales. This can result
in a transformation of factors of production for entire industries. An example of
this is the change in production processes in the information technology (IT)
industry after jobs were outsourced to countries with lower salaries.

Capital as a factor
In economics, capital typically refers to money. However, money is not a factor
of production because it is not directly involved in producing a good or service.
Instead, it facilitates the processes used in production by enabling
entrepreneurs and company owners to purchase capital goods or land or to
pay wages. For modern mainstream (neoclassical) economists, capital is the
primary driver of value.1

As a factor of production, capital refers to the purchase of goods made with

money in production. For example, a tractor purchased for farming is capital.
Along the same lines, desks and chairs used in an office are also capital.

It is important to distinguish personal and private capital in factors of

production. A personal vehicle used to transport family is not considered a
capital good, but a commercial vehicle used expressly for official purposes is.
During an economic contraction or when they suffer losses, companies cut
back on capital expenditure to ensure profits. During periods of economic
expansion, however, they invest in new machinery and equipment to bring
new products to market.

An illustration of the above is the difference in markets for robots in China

compared to the United States after the 2008 financial crisis. China
experienced a multi-year growth cycle after the crisis, and its manufacturers
invested in robots to improve productivity at their facilities and meet growing
market demands.

As a result, the country became the biggest market for robots. Manufacturers
within the United States, which had been in the throes of an economic
recession after the financial crisis, cut back on their investments related to
production due to tepid demand.

Entrepreneurship as a factor
Entrepreneurship is the secret sauce that combines all the other factors of
production into a product or service for the consumer market. An example of
entrepreneurship is the evolution of the social media behemoth Facebook Inc.
(FB).

Mark Zuckerberg assumed the risk for the success or failure of his social
media network when he began allocating time from his daily schedule toward
that activity. When he coded the minimum viable product himself,
Zuckerberg’s labor was the only factor of production.

After Facebook became popular and spread across campuses, it realized it

needed to recruit additional employees. He hired two people, an engineer
(Dustin Moskovitz) and a spokesperson (Chris Hughes), who both allocated
hours to the project, meaning that their invested time became a factor of
production.2

The continued popularity of the product meant that Zuckerberg also had to
scale technology and operations. He raised venture capital money to rent
office space, hire more employees, and purchase additional server space for
development. At first, there was no need for land. However, as business
continued to grow, Facebook built its own office space and data centers.3
Each of these requires significant real estate and capital investments.

Another example of entrepreneurship is Starbucks Corporation (SBUX). The

retail coffee chain needs land (prime real estate in big cities for its coffee
chain), capital (large machinery to produce and dispense coffee), and labor
(employees at its retail outposts for service). Entrepreneur Howard Schultz,
the company’s founder, provided the fourth factor of production by being the
first person to realize that a market for such a chain existed and figuring out
the connections among the other three factors of production.4

While large companies make for excellent examples, a majority of companies

within the United States are small businesses started by entrepreneurs.
Because entrepreneurs are vital for economic growth, countries are creating
the necessary framework and policies to make it easier for them to start
companies.

Ownership of Factors of Production

The definition of factors of production in economic systems presumes that
ownership lies with households, who lend or lease them to entrepreneurs and
organizations. But that is a theoretical construct and rarely the case in
practice. Except for labor, ownership for factors of production varies based on
industry and economic system.

For example, a firm operating in the real estate industry typically owns
significant parcels of land, while retail corporations and shops lease land for
extended periods of time. Capital also follows a similar model in that it can be
owned or leased from another party. Under no circumstances, however, is
labor owned by firms. Labor’s transaction with firms is based on wages.

Ownership of the factors of production also differs based on the economic

system. For example, private enterprises and individuals own most of the
factors of production in capitalism. However, collective good is the
predominating principle in socialism. As such, factors of production, such as
land and capital, are owned and regulated by the community as a whole under
socialism.5

Special Considerations
While not directly listed as a factor, technology plays an important role in
influencing production. In this context, technology has a fairly broad definition
and can be used to refer to software, hardware, or a combination of both used
to streamline organizational or manufacturing processes.

Increasingly, technology is responsible for the difference in efficiency among

firms. To that end, technology—like money—is a facilitator of the factors of
production. The introduction of technology into a labor or capital process
makes it more efficient. For example, the use of robots in manufacturing has
the potential to improve productivity and output. Similarly, the use of kiosks in
self-serve restaurants can help firms cut back on their labor costs.

Typically, the Solow residual, also known as “total factor productivity (TFP),”
which measures the residual output that remains unaccounted for from the
four factors of production, increases when technological processes or
equipment are applied to production. Economists consider TFP to be the main
factor driving economic growth for a country. The greater a firm’s or country’s
TFP, the greater its growth.

What are the factors of production?

The factors of production are an important economic concept outlining the
elements needed to produce a good or service for sale. They are commonly
broken down into four elements: land, labor, capital, and entrepreneurship.
However, commentators sometimes refer to labor and capital as the two
primary factors of production. Depending on the specific circumstances, one
or more factors of production might be more important than the others.

What are examples of the factors of production?

Land refers to physical land, such as the acres used for a farm or the city
block on which a building is constructed. Labor refers to all wage-earning
activities, such as the work of professionals, retail workers, and so on.
Entrepreneurship refers to the initiatives taken by entrepreneurs, who typically
begin as the first workers in their firms and then gradually employ other factors
of production to grow their businesses. Finally, capital refers to the cash,
equipment, and other assets needed to start or grow a business.

Are all factors of production equally important?

Depending on the context, some factors of production might be more
important than others. For example, a software company that relies primarily
on the labor of skilled software engineers might see labor as its most valuable
factor of production. Meanwhile, a company that makes its money from
building and renting out office space might see land and capital as its most
valuable factors. As the demands of a business change over time, the relative
importance of the factors of production will also change accordingly.
8. Social Economic System
(a) Market structure

Market structure, in economics, refers to how different industries are

classified and differentiated based on their degree and nature of
competition for goods and services. It is based on the characteristics that
influence the behavior and outcomes of companies working in a specific
market.

Some of the factors that determine a market structure include the number
of buyers and sellers, ability to negotiate, degree of concentration, degree
of differentiation of products, and the ease or difficulty of entering and
exiting the market.

Summary
● Market structure refers to how different industries are classified and
differentiated based on their degree and nature of competition for
services and goods.
 ● The four popular types of market structures include perfect
competition, oligopoly market, monopoly market, and monopolistic
competition.
● Market structures show the relations between sellers and other
sellers, sellers to buyers, or more.

Understanding Market Structures

In economics, market structures can be understood well by closely
examining an array of factors or features exhibited by different players. It is
common to differentiate these markets across the following seven distinct
features.

1. The industry’s buyer structure

2. The turnover of customers
3. The extent of product differentiation
4. The nature of costs of inputs
5. The number of players in the market
6. Vertical integration extent in the same industry
7. The largest player’s market share

By cross-examining the above features against each other, similar traits can
be established. Therefore, it becomes easier to categorize and differentiate
companies across related industries. Based on the above features,
economists have used this information to describe four distinct types of
market structures. They include perfect competition, oligopoly market,
monopoly market, and monopolistic competition.

Types of Market Structures

1. Perfect Competition
Perfect competition occurs when there is a large number of small
companies competing against each other. They sell similar products
(homogeneous), lack price influence over the commodities, and are free to
enter or exit the market.

Consumers in this type of market have full knowledge of the goods being
sold. They are aware of the prices charged on them and the product
branding. In the real world, the pure form of this type of market structure
rarely exists. However, it is useful when comparing companies with similar
features. This market is unrealistic as it faces some significant criticisms
described below.

● No incentive for innovation: In the real world, if competition exists

and a company holds a dominant market share, there is a tendency
to increase innovation to beat the competitors and maintain the
status quo. However, in a perfectly competitive market, the profit
margin is fixed, and sellers cannot increase prices, or they will lose
their customers.
● There are very few barriers to entry: Any company can enter the
market and start selling the product. Therefore, incumbents must
stay proactive to maintain market share.

2. Monopolistic Competition
Monopolistic competition refers to an imperfectly competitive market with
the traits of both the monopoly and competitive market. Sellers compete
among themselves and can differentiate their goods in terms of quality and
branding to look different. In this type of competition, sellers consider the
price charged by their competitors and ignore the impact of their own
prices on their competition.

When comparing monopolistic competition in the short term and long term,
there are two distinct aspects that are observed. In the short term, the
monopolistic company maximizes its profits and enjoys all the benefits as
a monopoly.
The company initially produces many products as the demand is high.
Therefore, its Marginal Revenue (MR) corresponds to its Marginal Cost
(MC). However, MR diminishes over time as new companies enter the
market with differentiated products affecting demand, leading to less
profit.

3. Oligopoly
An oligopoly market consists of a small number of large companies that
sell differentiated or identical products. Since there are few players in the
market, their competitive strategies are dependent on each other.
For example, if one of the actors decides to reduce the price of its products,
the action will trigger other actors to lower their prices, too. On the other
hand, a price increase may influence others not to take any action in the
anticipation consumers will opt for their products. Therefore, strategic
planning by these types of players is a must.
In a situation where companies mutually compete, they may create
agreements to share the market by restricting production, leading to
supernormal profits. This holds if either party honors the Nash equilibrium
state and neither is tempted to engage in the prisoner’s dilemma. In such
an agreement, they work like monopolies. The collusion is referred to as
cartels.

4. Monopoly
In a monopoly market, a single company represents the whole industry. It
has no competitor, and it is the sole seller of products in the entire market.
This type of market is characterized by factors such as the sole claim to
ownership of resources, patent and copyright, licenses issued by the
government, or high initial setup costs.
All the above characteristics associated with monopoly restrict other
companies from entering the market. The company, therefore, remains a
single seller because it has the power to control the market and set prices
for its goods.
(b) Centralization
Centralization refers to the process in which activities involving planning
and decision-making within an organization are concentrated to a specific
leader or location. In a centralized organization, the decision-making
powers are retained in the head office, and all other offices receive
commands from the main office. The executives and specialists who make
critical decisions are based in the head office.

Similarly, in a centralized government structure, the decision-making

authority is concentrated at the top, and all other lower levels follow the
directions coming from the top of the organization structure.

Advantages of Centralization
An effective centralization offers the following advantages:
1. A clear chain of command
A centralized organization benefits from a clear chain of command
because every person within the organization knows who to report to.
Junior employees know who to approach whenever they have concerns
about the organization. On the other hand, senior executives follow a clear
plan of delegating authority to employees who excel in specific functions.
The executives also gain the confidence that when they delegate
responsibilities to mid-level managers and other employees, there will be
no overlap. A clear chain of command is beneficial when the organization
needs to execute decisions quickly and in a unified manner.

2. Focused vision
When an organization follows a centralized management structure, it can
focus on the fulfillment of its vision with ease. There are clear lines of
communication and the senior executive can communicate the
organization’s vision to employees and guide them toward the achievement
of the vision. In the absence of centralized management, there will be
inconsistencies in relaying the message to employees because there are no
clear lines of authority. Directing the organization’s vision from the top
allows for a smooth implementation of its visions and strategies. The
organization’s stakeholders such as customers, suppliers, and
communities also receive a uniform message.

3. Reduced costs
A centralized organization adheres to standard procedures and methods
that guide the organization, which helps reduce office and administrative
costs. The main decision-makers are housed at the company’s head office
or headquarters, and therefore, there is no need for deploying more
departments and equipment to other branches. Also, the organization does
not need to incur extra costs to hire specialists for its branches since
critical decisions are made at the head office and then communicated to
the branches. The clear chain of command reduces duplication of
responsibilities that may result in additional costs to the organization.
4. Quick implementation of decisions
In a centralized organization, decisions are made by a small group of
people and then communicated to the lower-level managers. The
involvement of only a few people makes the decision-making process more
efficient since they can discuss the details of each decision in one meeting.
The decisions are then communicated to the lower levels of the
organization for implementation. If lower-level managers are involved in the
decision-making process, the process will take longer and conflicts will
arise. That will make the implementation process lengthy and complicated
because some managers may object to the decisions if their input is
ignored.

5. Improved quality of work

The standardized procedures and better supervision in a centralized
organization result in improved quality of work. There are supervisors in
each department who ensure that the outputs are uniform and of high
quality. The use of advanced equipment reduces potential wastage from
manual work and also helps guarantee high-quality work. Standardization
of work also reduces the replication of tasks that may result in high labor
costs.

Disadvantages of Centralization
The following are the disadvantages of centralization:

1. Bureaucratic leadership
Centralized management resembles a dictatorial form of leadership where
employees are only expected to deliver results according to what the top
executives assign them. Employees are unable to contribute to the
decision-making process of the organization, and they are merely
implementers of decisions made at a higher level. When the employees
face difficulties in implementing some of the decisions, the executives will
not understand because they are only decision-makers and not
implementers of the decisions. The result of such actions is a decline in
performance because the employees lack the motivation to implement
decisions taken by top-level managers without the input of lower-level
employees.

2. Remote control
The organization’s executives are under tremendous pressure to formulate
decisions for the organization, and they lack control over the
implementation process. The failure of executives to decentralize the
decision-making process adds a lot of work to their desks. The executives
suffer from a lack of time to supervise the implementation of the decisions.
This leads to reluctance on the part of employees. Therefore, the
executives may end up making too many decisions that are either poorly
implemented or ignored by the employees.

3. Delays in work
Centralization results in delays in work as records are sent to and from the
head office. Employees rely on the information communicated to them
from the top, and there will be a loss in man-hours if there are delays in
relaying the records. This means that the employees will be less productive
if they need to wait long periods to get guidance on their next projects.

4. Lack of employee loyalty

Employees become loyal to an organization when they are allowed
personal initiatives in the work they do. They can introduce their creativity
and suggest ways of performing certain tasks. However, in centralization,
there is no initiative in work because employees perform tasks
conceptualized by top executives. This limits their creativity and loyalty to
the organization due to the rigidity of the work.

Summary
Centralization refers to a setup in which the decision-making powers are
concentrated in a few leaders at the top of the organizational structure.
Decisions are made at the top and communicated to lower-level managers
for implementation.
© Market Economy System.
A market economy is an economic system in which economic decisions and
the pricing of goods and services are guided by the interactions of a country's
individual citizens and businesses. There may be some government
intervention or central planning, but usually this term refers to an economy
that is more market oriented in general.

KEY TAKEAWAYS
● In a market economy, most economic decision making is done through
voluntary transactions according to the laws of supply and demand.
● A market economy gives entrepreneurs the freedom to pursue profit by
creating outputs that are more valuable than the inputs they use up, and
free to fail and go out of business if they do not.
● Economists broadly agree that market-oriented economies produce
better economic outcomes, but differ on the precise balance between
markets and central planning that is best for a nation's long-term
wellbeing.

1:32

Market Economy
Understanding Market Economies
The theoretical basis for market economies was developed by classical
economists, such as Adam Smith, David Ricardo, and Jean-Baptiste Say.
These classically liberal free market advocates believed that the “invisible
hand” of the profit motive and market incentives generally guided economic
decisions down more productive and efficient paths than government planning
of the economy. They believed that government intervention often tended to
lead to economic inefficiencies that actually made people worse off.

Market Theory
Market economies work using the forces of supply and demand to determine
the appropriate prices and quantities for most goods and services in the
economy. Entrepreneurs marshal factors of production (land, labor, and
capital) and combine them in cooperation with workers and financial backers,
to produce goods and services for consumers or other businesses to buy.
Buyers and sellers agree on the terms of these transactions voluntarily based
on consumers preferences for various goods and the revenues that
businesses want to earn on their investments. The allocation of resources by
entrepreneurs across different businesses and production processes is
determined by the profits they hope to make by producing output that their
customers will value beyond what the entrepreneurs paid for the inputs.
Entrepreneurs that successfully do so are rewarded with profits that they can
reinvest in future business, and those who fail to do so either learn to improve
over time or go out of business.

Modern Market Economies

Every economy in the modern world falls somewhere along a continuum
running from pure market to fully planned. Most developed nations are
technically mixed economies because they blend free markets with some
government interference. However, they are often said to have market
economies because they allow market forces to drive the vast majority of
activities, typically engaging in government intervention only to the extent it is
needed to provide stability.

Market economies may still engage in some government interventions, such

as price-fixing, licensing, quotas, and industrial subsidies. Most commonly,
market economies feature government production of public goods, often as a
government monopoly. But overall, market economies are characterized by
decentralized economic decision making by buyers and sellers transacting
everyday business. In particular, market economies can be distinguished by
having functional markets for corporate control, which allow for the transfer
and reorganization of the economic means of production among
entrepreneurs.

Although the market economy is clearly the popular system of choice, there is
significant debate regarding the amount of government intervention
considered optimal for efficient economic operations. Economists mostly
believe that more market oriented economies will be rather successful at
generating wealth, economic growth, and rising living standards, but often
differ on the precise scope, scale, and specific roles for government
intervention that are necessarily to provide the fundamental legal and
institutional framework that markets might need in order to function well.