What We Will Learn
This chapter introduces the importance of economics, how the role and relevance of economics has changed and examines the role of money in this transition.
It will examine the types and validity of economic theory, command and market economies, the way in which markets work, examine the concepts of resources, opportunity and competitive advantage and look at how these factor in to International Trade Theory. The chapter will also examine the choices that consumers face, supply and demand, equilibrium, price elasticity, utility and scarcity.
The chapter concludes by discussing monetary theory and fiscal policy, examining trends, looking at the approaches of Keynes and Friedman, and the function of money and inflation and the role of government, banking and other financial institutions.
What is an Economy?
At a fundamental level, an economy is a system comprised of individuals and organisations that either consciously or unconsciously contribute to the production of goods and services. By this understanding we can see that the primary concerns of an economy are efficiencies in production of said goods and services and an effective use of resources enabling individuals or organisations to maximise output while reducing costs.
A Brief Historical Introduction
Ever since human beings discovered that they had different aptitudes from those around them, there became the obvious need for an exchange of goods and services. The farmer produced crops for the consumption of the shepherd who in exchange provided meat. As time went on, the structures and mechanisms for this have become increasingly complex, and over time, when new cultures, languages, religions and political ideologies were introduced we have seen what started as a simple human need mushroom into something far more intricate.
In 1815 when Adam Smith wrote his modern-day economic epic The Wealth of Nations, the newly born British Empire (with its eyes on other resources) used some of the ideas expounded by Smith as a prism through which they saw the world in front of them. Smithâs ideas were used to utilise the resources Britain gained in its newly acquired colonies to further its goal of further colonial expansion. Smith was a philosopher and expounded a philosophy of modern economics that, at heart, is not mere science but borders on a variety of other academic disciplines, from philosophy to geopolitical theory to religion.
The study of economics is, therefore, the study of the very basic values that underpin much of modern thinking; influencing much of life as we know it today. One needs only to examine the ingredients of a soft drink and then look into from where those ingredients were sourced, how they were manufactured, produced, shipped and delivered to get a small insight into this. Each of these components has an economic weight not only in the countries in which the activity takes place but on a global scale as well. Globalisation, with its complex view of markets and legislation, has had a profound effect on the science of economics.
The academic study of economics has been developed to allow us to frame our understanding of the rate of development of any economy, creating metrics for growth, and even determining which country or indeed which region in a country is desirable to live and work in. These metrics have been used to justify war, peace and everything in between, and understanding them is crucial in our quest to understand business and answer-pressing questions such as âWhy did the financial crash happen and what does it mean to me?â and âWhat will Brexit bring to my standard of living?â
As with all matters of academia, it is important to understand the importance of terms, and economics is no exception; in that understanding the language used by economists is the first step to delving into some of the deeper concepts at play.
Thinkbox 1: What are Microeconomics and Macroeconomics?
Microeconomics examines the effect of primarily individual choices such as the determination of price in a market, the effect on an economy of the behaviours of individuals and firms, how these are coordinated by markets, production cost efficiencies, supply and demand and uncertainty.
Macroeconomics examines the effect of the aggregate of all micro-economic factors, contributing to an understanding of growth, business cycle, employment, inflation, monetary policy, public sector considerations, interest rates and banks.
A fundamental starting point is to discuss what some of the terms mean. What is a Resource? In economic terms resources can be classified as human and nonhuman.
Human (e.g. labour, management)
Nonhuman (e.g. land, capital)
What is an Opportunity?
Command Economies versus Control Economies
Fundamentals
At its essence, Economic Theory speaks of control and where this should lie. When examining economic theory, this should never be far from the readerâs mind. While analysing any economic system, one must consider the following:
As an economy is made up of individuals, firms and governments, the issue of control surrounds who has the power to dictate price and production of goods and services.
In a command economy, control is exercised from the centre, be that through government or central institutions and these will have the largest control over all matters of production, pricing and supply. We see this type of economy appear to varying degrees in dictatorships, communist entities and even far right political systems. The justification for this level of control is often underpinned by the ideas that the state has the best of intentions for the people and is the most capable of allocating resources in an equitable manner.
Conversely, a market (or open) economy has much less centralisation and gives control to the individuals and firms. In this case the market will dictate the price and supply by means of finding an equilibrium for goods and services.
In reality, modern economies are a mixture of the two, with various levels of central control present even the most open of market economies. Governments, by their very nature will always exhibit some level of control, regardless of their political leanings, and this will naturally have an effect on any economy. We will see the manifestation of this when we discuss money supply later in the chapter.
Classical Economic Theory examines an economy based on:
Classical Economic Theory has a heavily microeconomic focus and deals with the idea that if individuals and firms are allowed to function in self-interest without interference, then the market itself will become efficient. Classical Economic Theory held sway from Adam Smithâs Wealth of Nations in the eighteenth century to around the end of the Second World War in Europe where new approaches were developed to deal with a more complex economic environment in post-war Europe. The reader would be justified in asking, given human beings have fundamentally changed very little (in terms of core nature) in this relatively short period of human history, why are there so many models? The simple answer is that as boundaries and borders change and demand changes, there is a change in the way in which individuals, organisations and nations perceive the world around them and how they believe things should be done. Additionally, and critically, over time, resources become more scarce/plentiful for some than for others, and new individuals or entrants to a market bring their own cultural, historical, philosophical and religious perspectives. Thus it is important to look in more depth at some of the key figures in the development of economic thought and models.
Adam Smith
Smith was a Scottish Philosopher (1723â1790) and is considered the âFather of Economicsâ. In 1776, in his book An Enquiry into the Nature and Causes of the Wealth of Nations, Smith put forward the idea that an âInvisible Handâ, a driving force in the economy brought about by competition and self-interest had the effect of benefiting society.
Adam Smith introduced the idea of absolute advantage, where a country or firm can produce a product more efficiently than others, that is, using fewer resou...