What Is Economics?

Economics is what drives the creation and consumption of goods and services. Economics is the underlying social science behind many of the issues you see in newspaper headlines everyday—financial crises, health care, taxes, international trade, urbanization, and globalization.

Microeconomics
This is economics on a small scale: how individuals like families or small businesses interact with and impact markets.

Macroeconomics
This is the whole economic picture: the overall health of a nation’s economy, including unemployment, creation and consumption of goods and services, growth, government policies, and more.

International Economics
International economics analyzes the effect of trade across borders.

“Each individual generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it...He intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.”
—Adam Smith, An Inquiry Into the Nature and Causes of the Wealth of Nations, Book 4, Chapter 2

Economists have been creating, debating, and testing theories about the economy for more than 250 years. Almost every “new” idea anyone has about the economy has probably been debated and discarded long ago. That doesn’t mean that it’s impossible to have genuinely original insights. It simply means that to do so, one must study an enormous amount of economic history.

As unique as today’s events seem, they often have close parallels in the past. For example, the Panic of 1893 was remarkably similar to the Great Recession of 2008. The current era of globalization shares much in common with the wave of globalization that occurred in the late 1800s.

The field of economics itself developed alongside a dramatic shift in the way economies operated in general.

Adam Smith and the Industrial Revolution

Before the Industrial Revolution, the economy in most places looked nearly the same century after century. Suddenly, in the mid 1700s, the technological innovations in manufacturing and transportation brought rapid growth and change to England’s economy.

Adam Smith, who is widely credited with creating the discipline of economics with his book The Wealth of Nations (1776), realized that this dramatic transformation in the way economies worked was driven in large part by the division of labor. He used the example of a pin factory to show how a group of workers, each specializing in one aspect of pin manufacturing, could produce more pins faster than the same number of master craftsmen working alone. Thus, he argued, countries were rich or poor not based on their levels of precious metals or other stores of wealth, but based on their capacity to produce the everyday things their citizens needed and wanted.

Smith’s theory created a prevailing belief among economists that prosperity was assured if productive capacity was increased using the types of processes that Smith identified. If the prosperity of an entire economy declined, it was assumed that something had gone wrong with its productive capacity.

Say’s Law: Supply and Demand

There was also a general belief among economists in something called Say’s Law.

Say’s Law states that supply creates its own demand. By “supply” economists mean the creation of goods and services. By “demand” economists mean the desire to purchase goods and services. Say’s Law suggests that on average the quantity of goods created will be equal to the quantity people want to buy.

Say’s Law suggests that there could never be a general lack of demand. That is, it could not be the case that consumers simply didn’t want to buy as many goods as were being offered for sale. This creates a puzzle, however, because economists observe what is known as the business cycle: at times it seems like almost all businesses are able to sell as much as they want, while at other times virtually all business are having trouble selling as much as they want.

The Great Depression and Keynesian Economics

John Maynard Keynes eventually solved this puzzle by connecting several dots.
First, people like to have a little extra money in reserve in case of an emergency.

Second, if everyone becomes fearful at once, everyone will attempt to increase their reserves at the same time.

Third, if everyone increases their reserves at the same time, there will not be enough spending to buy all the goods and services for sale.

Fourth, if there is not enough spending to buy all the goods and services for sale, the level of fear in the economy will increase.

This fear will, in turn, cause people to want to increase their reserves of money and the cycle will build on itself. This cycle is difficult to stop because people cannot get the very thing they want—more money in reserve—because the only way to get money is by selling something to other people. Those people will be reluctant to buy because they too are trying to increase their reserves.

It is no accident that Keynes developed his theory during the Great Depression. Economists were perplexed by business cycles prior to the Great Depression, but the length and intensity of this recession created a sense of profound urgency to finally solve the mystery.

Keynes explained that the prosperity of whole economies could decline even if their capacity to produce was undiminished. Even productive economies could get caught in a trap where a lack of spending could cause businesses to cut back on production. The cuts in production would then lead businesses to reduce the number of workers they employed.

The story of the Great Capitol Hill Babysitting Co- Op Crisis helps illustrate Keynes’s insight on a smaller scale. In this example, the essential principle modeled here—that every sale is also a purchase—also helps us understand why economies go into recessions, which are periods in which economic activity declines overall.

The Great Capitol Hill Babysitting Co-Op Crisis

The story of the Great Capitol Hill Babysitting Co- Op Crisis is a simple and true story that illustrates the Keynesian principles in action.

The story concerns a group of parents who worked on Capitol Hill. Babysitters in downtown DC can be expensive, so they decided to form a co-op to trade babysitting responsibilities. They printed coupons, each good for a half-hour of babysitting. When a couple wanted to go out for a night they would find another couple who was staying in and willing to babysit. The couple that went out would give the couple who stayed in a coupon for each half-hour they babysat that night. All couples started out with a fixed number of coupons, so that no couple would be able to abuse the system by always going out more than they babysat.

The system worked great for a while, until a bunch couples stopped going out, all at the same time. That meant it was easy to find a sitter but hard to find an opportunity to sit. The couples who were still going out started to run low on coupons. Some of them began to get nervous and they started saving their coupons for special occasions. That resulted in even fewer couples going out, making it even harder to find an opportunity to sit.

The cycle fed on itself. Eventually, all the couples were afraid of potentially running out of coupons and so they only rarely went out, making it nearly impossible for a couple to earn coupons to use when they needed them. The lack of opportunity to earn created a scarcity mindset, which made couples too afraid to use the coupons they had. Needless to say this defeated the entire purpose of the co-op, which was to allow couples to go out more. This happened not because there weren’t enough sitters, but because there weren’t enough coupons. This shortage of coupons changed the incentive to go out.

We think of the couples who go out as “buying” a night of babysitting from the couples who stayed in. However, they were also “selling” extra coupons to the couples who stayed in. Both getting a babysitter for the night and having extra coupons were desirable.

Economists before Keynes would have said that all that is needed for the Babysitting Co-Op to prosper is for there to be enough couples willing and able to babysit. In fact, however, the Babysitting Co-Op has two sides. In addition to being willing and able to babysit, couples also have to be willing and able to go out and spend their babysitting coupons.

This second problem, the unwillingness to spend coupons, has a solution so straightforward that it seems too good to be true. Indeed, even today many economists who haven’t specialized in studying money or recessions find it hard to believe.

The solution is simply to print more coupons and give them to people.

If for some reason giving the coupons away is problematic, then the Babysitting Co-Op could offer to pay coupons to its members for services other than babysitting, such as sending out announcements or hosting meetings.

Applying Keynesian Theory to Solve Real World Problems

These solutions match exactly the options available to real governments. In most cases, governments can mitigate and reverse downturns by printing more money and effectively loaning it out at cheap interest rates. If that solution is problematic, then government can pay people to build public works, cut taxes, or expand safety net programs.

There are two fundamental insights at the heart of economics.

People respond to incentives.

Obvious opportunities to be better off are rarely left unexploited. Every economic transaction has two sides: each side gets something and each side gives up something.

When we consider the whole economy, those two sides have to add up. For everything we buy there must be something that we sell. For every good imported into our country something must be exported. These two rules taken together can provide tremendous insight into how economies work.

The Circular Flow Model

The second principle is often illustrated using the circular flow model. The economy can be thought of as two cycles moving in opposite directions. In one direction, we see goods and services flowing from individuals to businesses and back again. This represents the fact that, as workers, we go to work to make things people want or provide a service that people need. Then, as consumers, we receive the things we want and need from other businesses.

In the opposite direction, we see money flowing from businesses to households and back again. This represents the payments that we make for the things we buy and the income from the work that we do. The key takeaway is that both cycles are needed to make the economy work. When we buy things, we give up money for the things we want. When we go to work we make things in exchange for money.

It’s easy to allow the money flow to fade into the background, but if something disrupts it, then the result can be an economic recession. Read about the circular flow model for more information.

At its heart, economics is about people—specifically, it’s about how people make their way in the world. It’s about how they earn a living and how they spend their income. By restricting focus to these basic elements of human life, economists are able to identify a few primary motivations such as the desire to provide for one’s family, or the need for a business to earn a profit.

These motivations are simple, but from them economists have been able to generate very complex and insightful stories about issues ranging from how people save for retirement to how the growth of China will affect US wages. These stories are the heart of economic theory.

Economic theory is often presented in mathematical models, which ensure that economists are rigorous in their thinking and logical in their conclusions. However, those complex equations are nothing more than stories translated into the language of mathematics.

Using those stories or theories, economists are able to predict a wide variety of human behavior. In our ordinary lives, it may seem impossible to predict what anyone will do next, even those who are closest to us.

Predictability and the “Invisible Hand”

Yet, if there weren’t some underlying predictability to our collective human story, life as we know it wouldn’t be possible. For example, you predict that when you go to the supermarket there will be eggs and milk for sale. The supermarket in turn predicts that the distributors will deliver eggs and milk regularly to their warehouses and lastly the distributors predict that farmers will offer eggs and milk for sale.

All of this has to happen regularly—every day in fact—to ensure that fresh eggs and milk are available all across the country. Who controls this process? No one, it turns out. It happens because each person or company is predictable enough in their behavior to make the whole system run. Adam Smith referred to this process as the “invisible hand” of the market.

Economists study this predictability—and they try to understand how it works and why sometimes it goes wrong. The theories that economists present may seem like an oversimplification—but this is on purpose. Simplification makes it possible to see through to the heart of what makes the economy tick. Otherwise there would be too many factors.

The Danger of Oversimplifications

Good economists, however, realize the limits of their oversimplifications. They know that their theories hold only an average. They look for exceptions to the rule and then study those exceptions.

Economists who specialize in a particular type of exception can add richness to the more basic theories that all economists use. For example, behavioral economists study how things like stress at home or automatic enrollment into 401ks can affect how families decide how much to save.

The Law of Comparative Advantage and the Law of Diminishing Returns

Many economists consider David Ricardo one of the most important classical economists, after Adam Smith. Ricardo was able to articulate through words and simple examples concepts that would come to be fundamental tools of economic analysis.

He outlined the Law of Comparative Advantage, which explains how trade is beneficial to all parties involved. He also offered probably the first analysis of how automation could hurt workers. Ricardo also articulated the Law of Diminishing Returns, which today underlies economists’ understanding of supply and demand, and how prices and wages are determined.