October 13, 2010Economic Theoryby EW Industries and Business Team

Economics Theory

What is Economics?

In simplest terms, economics is the study of how people choose to use limited resources. The term "resources" refers to things such as money, time, people, talents or knowledge, land, buildings, equipment, tools, crops, minerals, or virtually any other product or service of which there is a limited supply. Thus, economics is the study of the ways in which people make important choices every day regarding how to acquire, sell, and use things of which there is a limited supply.

It is also the study of how and why people decide to use their time for work, school, or leisure.  Further, it can be how they allocate their resources (most often money) in order to provide for their daily needs of desires; and how they behave to shape laws and institutions affecting taxes, the role of government in their financial affairs, and domestic and international commerce. Economics generally assumes that people will act in their own best interest to maximize their well-being. "Well-being" might mean wealth, power, and health, but it could also refer to even more intangible concepts like happiness or spiritual enlightenment. Thus, what a wealthy person considers their well-being may be different from a poor person or a person from another culture.

Although the behavior of individuals is important, economics also refers to the study of collective behavior, such as that exhibited by nations, businesses, industries, and all the people of the world as a whole. "Microeconomics" generally refers to how individuals make decisions about the use and acquisition of limited resources, while "macroeconomics" looks at "the big picture," and considers outcomes the outcomes of multiple people or groups, all making their own economic decisions. While the two approaches are different, one must understand both views in order to gain a comprehensive understanding of most economic phenomena.

Economics In Practice

Economics affect the lives of every person on Earth every day. Anyone who has ever wondered why things cost money, why food prices go up when oil prices do, why interest rates are low for savings accounts but high for credit accounts, or why the government worries when another nation talks about going bankrupt – that person has actually been thinking about economics.

Economics examines the production and consumption of goods and services and the transfer of wealth to produce and obtain those resources. Thus, economics explains how people interact within the framework of different markets in order to get what they want. Economics is a way of looking at human interactions and studying it to reveal why people, institutions, and governments behave in particular ways.

Studying economics can reveal many aspects of a country's behavior, such as why it settles on certain political policies, how it protects its resources and acquires new ones, and how it regulates the financial affairs of those it governs. Economics can help gauge the outcome of an individual's financial investments.  Moreover, it can explain the behavior of consumers toward a particular product or service and help understand why businesses succeed or fail.

Thus, economics is a lens through which to better understand and predict the behavior of individuals, nations, and institutions. As such, it is useful to not only to make sense of what has already happened, but it is also useful in helping to anticipate the outcome of planned courses of action.

Different Schools of Economic Thought

Those who study economics are economists. Economists seek to understand the world by answering questions about how people, industries, and countries will seek to maximize their well-being through enhanced productivity, wealth creation, financial stability, etc. Because the study of economics encompasses so much, and can have so many different considerations, it has led to a number of different theories about how and why people, governments, and institutions behave under different circumstances. These theories often relate to the motivations of the players involved, and can lead to differing explanations for the same observable phenomenon.

Often called the "Father of Economics," Adam Smith, established the first modern economic theory in 1776 in his groundbreaking work The Wealth of Nations. Smith created the Classical School. Smith and the Classical School believed that while people will act in their own self-interest, the interaction of multiple people acting cooperatively in this fashion would lead to the production of goods and wealth creation that will benefit all of society. This school believed that governments should not restrict or interfere in markets (or do so in the least restrictive means possible) because the collective will of the people in the market would create an "invisible hand" that would guide the market to produce wealth at maximum efficiency. Although they grew up together, Classical Theory describes the philosophy underpinning modern capitalism, and is still a prominent school of thought.

About a hundred years later, another economist devised an entirely different way to look at history and human behavior. Karl Marx, founder of the Marxist theory of economics, believed that all of history could be disputes between those who have things and those who do not. He believed that capitalism would eventually fail because those who owned the means of production acquire and maintain their wealth by exploiting laborers; a practice he felt would inevitably lead to social unrest and had driven the conflicts of history. To Marxists, the best way to ensure social and economic stability was for laborers to own and control the means of production, preventing a divide between the "haves" and the "have-nots." Marxism has been widely criticized and largely rejected by most capitalist societies, but it remains a relevant and highly influential school of economic thought.  Other schools of thought such as communism and socialism came from Marxism.

A more recent school of economic thought, the Keynesian School, describes how governments can act within capitalist economies to promote economic stability. British economist John Maynard Keynes explains his economic philosophy in his book, The General Theory of Employment, Interest and Money, published in 1936 (during the Great Depression). Keynes felt that the Classical School of thought was too simplistic, in that demand does not always equate to supply. Keynesian philosophy calls for government intervention during times of financial crisis, such as depressions and recessions, rather than simply relying upon the "invisible hand" of the market to correct itself. It calls for reducing taxes and increasing government spending when a capitalist economy becomes stagnant, and increasing taxes and reducing spending when the economy becomes too active. This theory has strongly influenced economic policies in the US and around the world.

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