Economics is the study of choice. It is about people and how they choose to use limited resources in an effort to satisfy unlimited wants. Economists often divide the study of economics into two separate categories; microeconomics and macroeconomics.
Microeconomics is the study of the individual parts of the economy such as individual households, businesses, and groups of businesses. Macroeconomics, on the other hand, is the study of the economy as a whole. It includes such topics as unemployment, inflation, and economic growth for the entire economy.
There are two important components to this definition: limited resources and unlimited wants. Together they form what is known as the problem of scarcity, which is the most basic of all economic problems. If we stop and think for a moment, we can see why scarcity is such a problem----- there are not enough resources on this planet for people to get everything they want. As a result, choices must be made.
Because of the problem of scarcity, nations, businesses, and individuals all must make choices in an effort to satisfy unlimited wants with limited resources. These choices are not always easy. Suppose you have saved some money and are thinking of buying a new bicycle. Before buying the bicycle, however, you may give some consideration to the possibility of buying something else instead. Would a stereo system give you more pleasure than the bicycle? What about the possibility of buying a used bike so you will have enough money left over to buy the new shoes you need or to put some money aside for college? Or would it be better to save the money toward a down payment on a used car that you can use on your part-time job as well as at college? Because your income is limited and you can buy only a limited number of things, you probably will give considerable thought to the situation before making your purchase.
However you decide to use your money, you will have to give up the opportunity to purchase something else that also may have given you pleasure. If you decide to purchase the second-hand bicycle so that you will have some money to put aside for college, you will have to give up the opportunity to buy the stereo system or to buy the new bicycle. Economists use the term opportunity cost to refer to the next best alternative that is given up when a decision is made to use resources in a particular way. In this example, if your second choice would have been the purchase of a stereo system, then the opportunity cost of buying the used bicycle and putting aside the money for college is the stereo system you could have had.
Money is not the only scarce resource that individuals have. Time is also a scarce resource. Suppose that on a particular Saturday night you have the opportunity to go out on a date with a person you like very much. At the same time, you also have the opportunity to go roller skating with several of your friends. Because you can't do both, you must make a choice. No matter which choice you make, you are going to pay a price in terms of the opportunity cost of your decision. If you decide to go out on the date, the opportunity cost of your choice is giving up the opportunity to go roller skating. If you decide to go roller skating, the opportunity cost of that decision is giving up the opportunity to go out on the date.
Nations, too, are constantly faced with the realities of opportunity costs. For example, the federal government must decide how much it will spend for national defense and how much will be spent on nondefense programs, such as education, transportation, and other public services. Since the government has a limited amount of money, a decision to spend more money on national defense usually will require funding for nondefense programs to be cut. Thus, the opportunity cost of the increased defense spending is the reduction in funding of nondefense programs.
Economics is the study of how individuals and society choose to use limited resources in an effort to satisfy people's unlimited wants. Satisfying such wants involves the production of economic goods and services. We will first define the terms "economic goods " and "economic services, " and then turn our attention to the factors of production.
Economic goods are things of value that you can see, touch, and show to others. They are things like bicycles, books, stereos, and clothing. Economic goods also include such things as factories, stores, machines, and tools.
Economic services are intangible thing that have value but often cannot be seen, touched, or shown to others. For example, suppose you go bowling on Saturday night. At the bowling alley, you pay for the rental of a pair of bowling shoes and a bowling ball and for the privilege of bowling several games. You enjoy the evening immensely and consider the outing worth the money you spent. However, in terms of tangible purchases, you have nothing to show for your money. This is an example of an economic service. Other examples of economic services are medical care, legal advice, movies, and national defense.
Factors of production, which are also called productive resources, are the basic resources needed for the production of economic goods and services. Economists, traditionally, have divided the factors of production into three basic categories: (1) natural resources; (2) capital goods; (3) labor. In addition, many economists add a fourth factor of production, entrepreneurship, to the list.
Natural resources are things provided by nature. Land, air, water, forests, coal, iron ore, oil, and other minerals are examples of natural resources. Natural resources are the basic materials an economy has to work with. They are the starting point of all production, and they represent the most basic limitation on the productive capacity of an economy. In other words, no matter how much skilled labor and technological knowledge an economy has, it cannot create goods if it lacks natural resources.
Capital goods are human-made resources that are used for the production of other goods and services. Factories, machines, tools, railroads, and business buildings are all examples of capital goods. Without capital goods, natural resources would not be very useful. For example, timber is a natural resource. No matter how much timber a nation has, however, it is of little use unless capital goods are available to turn it into lumber, firewood, or other usable products. In this instance, possible capital goods might include a simple axe, a chain saw, or a giant sawmill.
It is important to distinguish between capital goods and consumer goods.
Consumer goods---- which are not a factor of production---- are finished products sold to consumers for their own personal use. They include such things as food, clothing, TV sets, and newspapers. In contrast, capital goods are things that are used in the production of consumer goods and services. A factory that manufactures TV sets is a capital goods. Some things can be either consumer goods or capital goods, depending on how they are used. For example, an automobile purchased for personal use is a consumer goods. However, automobiles purchased for use as taxis or for other business purposes are capital goods.
Labor, sometimes called human resources, is any form of human effort exerted in production. It includes all kinds of work. The work of a janitor, teacher, lawyer, engineer, and the governor of your state are all examples of labor is essential to production, since natural resources and capital goods are of no value unless they can be put to use.
Entrepreneurship may be defined as the function of combining and organizing natural resources, capital goods, and labor; assuming the risks of business failure; and providing the creativity and managerial skills necessary for production to take pace. An entrepreneur is a person who carries out these tasks in the hope of making financial gains from the endeavor.
In order to better understand the important role of entrepreneurship, let us look at the fictitious small community of Rossville. For many years, the Rossville Tile Factory manufactured farm drainage tiles form the high-quality clay soil of the area. Most of the community's labor force was employed by that factory. However, new technology resulted in the development of plastic drainage tiles that could be sold for a lower price. This caused the company to begin reducing production and laying off workers until the owner of the Rossville Tile Factory finally decided to close the factory permanently. Thus, Rossville is a community with natural resources (high-quality clay), capital goods (the old tile factory), and labor (the unemployed tile workers). The fourth factor of production----- entrepreneurship------ which had been supplied by the owner of the tile factory for many years, is now missing. As a result, the other resources----- the clay, the tile factory, and the unemployed workers----- are all idle.
Suppose that Sarah Sharpe, who has just inherited some money from her grandmother, is looking for a business opportunity. Sarah hears about the old tile factory, which is up for sale, and wonders if it might be used for the manufacturing of bricks. She knows that clay can be used for the production of bricks and has also found out that there are no brick factories nearby. Given the situation thinks she can earn a profit by producing bricks in Rossville. She decides to convert the old tile factory into a brick factory, and soon the unemployed workers have new jobs. The entrepreneurship provided by Sarah has resulted in the combining of the other factors of production-----the clay, the old tile factory, and the unemployed workers-----to start a new production unit.
No nation has sufficient productive resources to produce all the goods and services its people want. As a result, the nation must make difficult choices.
There are three basic economic questions that every nation must consider when making these choices. They are (1) What goods and services shall be produced? (2) How shall they be produced? and (3) For whom shall they be produced? In order to answer the basic economic questions, every society must have some kind of organized set of procedures. This organized set of procedures is called the economic system. Although every nation's economic system has some unique characteristics, there are basically three kinds of economic systems in the world. They are (1) traditional economies; (2) command economies; (3) market economies.
(I) Traditional economies are found primarily in the rural, nonindustrial areas of the world. In such areas, there is no national economy. Instead, there are many small segmented economies, each centered around a family or tribal unit. Each unit produces most of its own goods and consumes what it produces. The basic economic questions of "what", "how" and "for whom" are answered directly by the people involved, and the answers are usually based on tradition.
For example, in the East African country of Somalia, more than 75 percent of the people are nomadic. They raise herds of camels, cattle, goats, and sheep, and they live in small, collapsible huts. When the grass and water of an area are used up, these people move on to a new spot, just as their ancestors did for centuries before them. Their life is relatively simple, and their method of answering basic economic questions is based on a tradition passed down from one generation to the next.
(II) In command economies, the basic economic questions are answered by government officials. Individuals have little control or influence over the way the basic economic questions are answered. They are told what to produce, how to produce it, and what they will receive.
Command economies are often called planned economies because the government engages in elaborate, detailed planning in an effort to produce and distribute goods and services in a way that is consistent with the wishes of government leaders. Command economies usually are also characterized by government ownership of the economy's natural resources and capital goods. The economies of the former Soviet Union are example of predominantly command economies.
(III) In a market economy, basic economic questions are answered by individual households and businesses through a system a of freely operating markets. A market can be defined as the arrangement through which potential buyers and sellers come together to exchange goods and services. A market can be a specific place, such as a local farmer's market, but it usually refers to a much broader geographic area. The area covered by a specific market may be a local community, the entire nation, or, in the case of commodities such as gold and silver, the world.
In market economies, natural resources and capital goods are usually privately owned. In such economies, buyers and sellers have a great deal of economic freedom, and they send signals to one another as they interact through the system. For example, by purchasing more of an item than usual, buyers send a signal to producers to increase production of that item. Similarly, by reducing their purchases of an item, buyers signal producers to reduce production of that item.
The American economy is predominantly a market economy. Other examples of predominantly market economies include the economies of Canada, Japan, and many of the countries of Western Europe.
In actual practice, there are no real economies in the world that rely solely on freely operating markets or on government decisions to answer basic economic questions. There is also much planning in the nonsocialist countries-----by corporations to ensure the supply of steel and components for the automobiles they will produce; by their marketing men to ensure that consumers will want the new automobile design when it appears; and by the government to provide highways on which the cars can be driven, to ensure gasoline to propel them and also the purchasing power to buy them. To some extent, all modern industrial economies are extensively planned.