Economics

Economics (from the Greek οίκος , 'house', and νομος , 'rule', hence "household management") is a social science that studies the production, distribution, trade and consumption of goods and services. Economics is said to be positive when it tries to objectively predict and explain consequences of choices, given a set of assumptions or a set of observations. The choice of which assumptions to make in building a model as well as which observations to highlight, however, is a normative choice. Economics is also said to be normative when it recommends one choice over another, or when a subjective value judgement is made.

Economic assumptions

Supply and demand

Main article: Supply and demand.

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In microeconomic theory supply and demand attempts to describe, explain, and predict the price and quantity of goods sold in competitive markets. It is one of the most fundamental economic models, ubiquitously used as a basic building block in a wide range of more detailed economic models and theories.

Related Topics:
Microeconomic - Theory - Price - Market - Models

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In general, the theory claims that where goods are traded in a market at a price where consumers demand more goods than businesses are prepared to supply, this shortage will tend to increase the price of the goods. Those consumers that are prepared to pay more will lead to an increase in the market price. Conversely, prices will tend to fall when the quantity supplied exceeds the quantity demanded. This process continues until the market approaches an equilibrium point, a point at which there is no longer any impetus to change. When producers are willing to supply the same quantity as buyers are willing to buy, the market is at equilibrium point where both the buyers as well as the sellers are agreeable to the price level.

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The theory of supply and demand is important in the functioning of a market economy in that it explains the mechanism by which many decisions about resource allocation are made.

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Price

Main Article: Price

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In order to measure the ebb and flow of supply and demand, a measurable value is needed. The oldest and most commonly used is price, or the going rate of exchange between buyers and sellers in a market. Price theory, therefore, charts the movement of measurable quantities over time, and the relationship between price and other measurable variables. In Adam Smith's Wealth of Nations, this was the trade-off between price and convenience. A great deal of economic theory is based around prices and the theory of supply and demand. In economic theory, the most efficient form of communication comes about when changes to an economy occur through price, such as when an increase in supply leads to a lower price, or an increase in demand leads to a higher price.

Related Topics:
Adam Smith - Wealth of Nations - Supply and demand

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In many practical economic models, some form of "price stickiness" is incorporated to model the fact that prices do not move fluidly in many markets. Economic policy often revolves around arguments about the cause of "economic friction", or price stickiness, and which is, therefore, preventing the supply and demand from reaching equilibrium.

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Another area of economic controversy is about whether price measures value correctly. In mainstream market economics, where there are significant scarcities not factored into price, there is said to be an externalization of cost. Market economics predicts that scarce goods which are under-priced are over-consumed (See social cost). This leads into public goods theory.

Related Topics:
Externalization - Social cost - Public good

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Scarcity

Main article: Scarcity

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Scarcity is central to economic theory, known more commonly as the Economic Problem, or Basic Economic Problem. Economic analysis is fundamentally about the maximization of something (leisure time, wealth, health, happiness - all commonly reduced to the concept of utility) subject to constraints. These constraints - or scarcity - inevitably define a trade-off. For example, one can have more money by working harder, but less time (there are only so many hours in a day, so time is scarce). One can have more radishes only at the expense of, say, fewer carrots (you only have so much land on which to grow food - land is scarce).

Related Topics:
Economic Problem - Utility

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Scarcity is defined as: when the price is zero, the quantity demanded exceeds the quantity supplied. Price is a measure of relative scarcity. When the price is rising, the commodity is becoming relatively more scarce. When the price is falling, the commidity is becoming relatively less scarce.

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Adam Smith considered, for example, the trade-off between time, or convenience, and money. He discussed how a person could live near town, and pay more for rent of his home, or live farther away and pay less, "paying the difference out of his convenience".

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Marginalism

Main article: marginalism

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In marginalist economic theory, the price level is determined by the marginal cost and marginal utility. The price of all goods will be the cost of making the last one that people will purchase, and the price of all the employees in a company will be the cost of hiring the last one the business needs. Marginalism looks at decisions based on "the margins", what the cost to produce the next unit is, versus how much it is expected to return in profit. When the marginal return of an action reaches zero, the action stops. Marginal utility is how much more happiness or use a person receives from a purchase in contrast with buying less. Marginal rewards are often subject to diminishing returns: Less reward is obtained from more production or consumption. For example, the 10th bar of chocolate that a person consumes does not taste as good as the first, and so brings less marginal utility.

Related Topics:
Marginalist economic theory - Marginal cost - Marginal utility - Diminishing returns

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Marginalism became increasingly important in economic theory in the late 19th century, and is a tool which is used to analyse how economic systems will react. Marginal cost of production divides costs into "fixed" costs which must be paid regardless of how many of a commodity are produced, and "variable costs". The marginal cost is the variable cost of the last unit. Marginalism states that when the profit from the next unit will be zero, that unit will not be produced.

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The marginalist theory of price level runs counter to the classical theory of price being determined by the amount of labour congealed in a commodity.

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Value

It could be argued that beneath an economic theory is a theory of value. Value can be defined as the underlying activity which economics describes and measures. It is what is "really" happening.

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Adam Smith defined "labour" as the underlying source of value, and "the labor theory of value" underlies the work of Karl Marx, David Ricardo and many other classical economists. The "labour theory of value" argues that a good or service is worth the labour that it takes to produce. For most, this value determines a commodity's price. This labour theory of price and the closely related cost-of-production theory of value dominates the work of most classical economists, but those theories are far from the only accepted basis for "value". For example, neoclassical economists and Austrian School economists prefer the marginal theory of value.

Related Topics:
Labor theory of value - David Ricardo - Cost-of-production theory of value - Neoclassical - Austrian School - Marginal theory of value

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"Market theory" argues that there is no "value" separate from price, that the market incorporates all available information into price, and that so long as markets are open, that price and the value are one and the same. This theory rests on the idea of the "rational economic actor". This was originally asserted by Mill.

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Another set of theories rest on the idea that there is a basic external scarcity, and that "value" represents the relationship to that basic scarcity. These theories include those based on economics being limited by energy or based on a "gold standard".

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All of these value theories are used in current economic work.

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