Economics is one of the oldest and most influential of intellectual disciplines. Practically all of the great thinkers, from Aristotle to Einstein, have tried their hand at it, and the great economists like Adam Smith, Thomas Malthus, David Ricardo, John Maynard Keynes and Milton Friedman rank among the most influential minds in our history. The economic paradigm permeates our thinking about practically every area of human activity. Military analysts talk in terms of “assets” and “trade offs” while theologians quote economic statistics. Adam Smith’s ideas about competition had a strong influence on Charles Darwin’s study of biology. Insect colonies are said to “invest” in nest building. Our thinking about politics and social behavior draws heavily on ideas about incentives, trading, and maximization that come from economics.

The word economics comes from ancient Greece (like so many words and important ideas) when an “economist” was the manager of an estate. Those very practical economists grappled with all the basic problems of economic decision-making facing a modern executive today. What is the optimal mix of crops? How much to invest in new equipment? Or irrigation instead? Should we sell our grain now, or wait until prices improve? Modern economics returns the compliment by providing the foundations of business administration today. Successful executives have often told the author that the principles they draw on every day in making decisions are those that they learned in their first courses in economics. Good reason to “invest” in learning the foundations of economic analysis!

What are the “Economy” and “Economics”?

Every society must provide goods and services for the welfare of its citizens. The economy consists of all of the activities involved in the production and distribution of these goods and services. Economics, as the study of the economy, seeks to address three basic questions:

  • Are there fundamental principles that help us understand how the economy works?

  • How well does the economy perform in achieving social objectives?

  • How would changes in laws or political institutions affect the performance of the economy?

The production and distribution of goods and services requires the use of economic resources called factors of production. They may be thought of as falling into one of four categories:

Land

This includes not only territory but all of the natural resources, such as minerals and fossil fuels, which the economy is endowed with.

Labor

This refers to the services of human beings who bring not only their time and effort to the economy but also their skills.

Capital

This consists of the human-made tools used in the economy: machinery, computers, buildings, vehicles, and transportation systems. These tools of production are called capital goods.

Entrepreneurship

This is the bringing together of land, labor, and capital into productive units. For example, when Henry Ford organized the mass production of automobiles early in this century, he brought labor and capital together in a new way on an assembly line, bringing the cost of an automobile down to within the reach of the average American. Bill Gates recognized the potential of the personal computer when most thought it was simply a hobby toy, and the result is one of the most valuable companies in the world today, and one of the most important industries of our time.

How do we measure the success of an economy? By the standard of living that it delivers.

The Standard of Living

By the standard of living we mean not only the goods and services we consume, but also other aspects of the quality of life including health, leisure time, and environmental amenities. Welfare is another word that also conveys the idea of well-being. But it is not easy to measure the standard of living of a population in quantitative terms. We care not just about the quantity of goods and services but also their quality, and that can be difficult to measure. Think of the remarkable improvements in the quality of electronic devices, and in the effectiveness and safety of medical services; but how to quantify that? We also are to measure changes in the amount of leisure time, and the historical trend is towards more leisure. While the work-week has remained around 40 hours in the U.S. in Europe it is considerably less than that and vacations are also much longer there. These differences have to be taken into account in making standard of living comparisons between the two.

The environment gets increasing attention as we become more aware of the negative effects of our activities on nature and how that affects our own welfare. Affluent societies have both the greatest impact on the environment and also the greatest ability to mitigate that impact. It is very difficult to measure environmental impact, nor is it easy to get agreement on how it should be valued, but there is no doubt that it will occupy increasing attention in the years ahead.

Income Inequality

In measuring the standard of living we are concerned not simply with the average level of consumption or income, but also its distribution among households. Which society enjoys a higher standard of living, one with a higher average income but greater inequality, or one with a lower average income but less inequality? The answer is ultimately a value-based judgement, but most people would probably say that there is a trade-off between level and inequality, so the answer depends on how large the if ferences are. In recent years there has been considerable discussion about the effect of the economic boom of the past 20 years on income distribution; the share of total income going to the highest income groups increased dramatically. Evidently, the boom raised both the average income and the inequality of distribution. Is it better to have a higher average even if it means greater inequality? Your answer might depend on whether the greater inequality is only temporary, related to the now-faded financial boom, or is it a long term trend? An economy with extremely unequal household consumption levels cannot be considered completely successful, but we do not expect a successful economy to produce exact equality either.

Economic Growth

The process of economic growth, a continuing increase in the standard of living that persists over decades, can only come from growth in the productivity of labor. An increase in the standard of living requires, in turn, that a society devote a portion of its economic output to research and development of new technologies, to education and training of workers, and to the production of new capital goods. This can only happen if society is willing to forgo some immediate consumption of goods and services, freeing a portion of the current output of the economy for investment in future growth. It is for this reason that the very low savings rate in the U.S. has been a matter of concern for our future welfare.

Exercises 1.1

A. Discuss the extent to which society can change each of the four factors of production. Give some examples.

B. Education is sometimes referred to as “human capital.” In what sense is education like capital goods?

C. Compare briefly the standard of living in Switzerland and in India. Trace the difference to the productivity of labor, and hence to differences in the quantity and quality of the factors of production present in the two countries. Alternatively, pick two contrasting countries of your choice.

D. What are some options that a country has if it wishes to raise its standard of living? Can we say that people are happier in a country with a higher standard of living?

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