Economics

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Economics

The methodology of economics

The functions of an economic system

Money, income, and the price level

Subfields of economics

Organization and growth of the profession

BIBLIOGRAPHY

References to specific topics in economics will be found throughout this article. For articles giving an overview of some of the major fields of economics, seeEconometrics; Economic growth; Economic thought; History, article oneconomic history; Income and employment theory; International trade; andWelfare economics. For guides to major fields not summarized in single articles, see the entries underAgriculture; Industrial organization; Money; Public finance; andLabor economics.

Economics, according to a widely accepted definition, is the study of the allocation of scarce re-sources among unlimited and competing uses. It is the social science that deals with the ways in which men and societies seek to satisfy their material needs and desires, since the means at their disposal do not permit them to do so completely.

Much of the work of the discipline can be fitted into this framework, and no other comes so close to accommodating all of it. However, the framework has a serious shortcoming: it does not encompass the problem of depression, or the inadequacy of aggregate demand. Most modern market economies experience periods in which large quantities of resources are idle—particularly labor and plant capacity—so that the principal question is not in what way to use them, but how to put them to any use at all. The distinction between the problems of allocating resources among uses and of achieving their full use corresponds very roughly to the distinction between the two main branches of economics: microeconomics and macroeconomics. The latter, however, includes some aspects of money and the general level of prices that also have important implications for resource allocation.

Decisions about resource allocation are made in their simplest form within the household, in the familiar process of “making ends meet,” or budgeting; the original meaning of economics was the practice of economy at the household level. What is now called economics was at first called political economy, to draw attention to its broader theater of action.

The concept of scarcity is crucial to an under-standing of resource allocation. Almost all resources are scarce under most circumstances, in the sense that if they were available without cost, more would be used than could be supplied. Even air, the classic example of a limitless resource, can become scarce. Pure air is now the exception in crowded urban areas and air pollution can be prevented only at substantial costs. Water is free in many places but scarce and costly in and or densely populated areas [seeWater resources]. Goods, such as sand or dirt, that may be free in their original location have costs when they are transported to the places at which they are needed.

The counterpart of pervasive scarcity is the unlimited extent of material wants. The overwhelming majority of the world’s population would always like a little more (often a lot more) income and consumption than it has, almost regardless of the current level. The exceptions to this generalization are of two kinds—ascetics (a rare breed in modern societies) and the minute fraction of the world’s population so wealthy that it need never, so to speak, consult the price column of the restaurant menu. Even among the very wealthy, with no desire to increase their consumption, there are some who seek to increase their incomes as a game or as a means of augmenting their power.

Economics as a social science does not examine what people ought to want, as distinguished from what they do want. The first question lies largely in the realm of ethics, aesthetics, or religion. Nevertheless, much writing by professional economists makes assumptions, explicit or implicit, about the proper goals of economic activity. Such writing can be considered economic philosophy rather than economic science narrowly defined. The former is often called normative economics and the latter positive economics. It is a positive statement to say that, other things being equal, a fall in the price of milk will increase its consumption—and the validity of such a statement can be tested against evidence. It is a normative statement to say that therefore the price of milk should be lowered. The second statement is not subject to disproof by evidence and implies that the speaker has personal or social values according to which the consumption of milk is “better” or more important than competing alternatives. If such values are widely shared, they may form an appropriate basis for social policy, but the validity of the values themselves nevertheless remains beyond the reach of scientific confirmation or testing.

The goals of economic activity are often subsumed under the heading “utility,” a construct embracing all of the satisfactions to be obtained through consumption, production, and related behavior [seeUtility]. It is generally assumed that the objective of economic activities is to maximize utility, subject to the limitations of resources, and that utility will be increased by the increased consumption of goods and services. In principle, utility can also be increased by such intangible factors as beautiful scenery, pleasant working conditions, amiable companions, or political power. However, such desiderata are seldom explicitly introduced into economic analysis, for a variety of reasons—some are not subject to measurement, some cannot be produced through economic activity—and when they are specified in detail almost all are very differently evaluated by different people. Moreover, some lie in the domains of other social science disciplines whose methods are better suited to analyze them. The assumption that the principal goal of economic activity is to produce goods and services, while clearly an oversimplification, is nevertheless useful in a wide variety of problems and can be modified in special cases, as seems appropriate.

In a dictatorship the utility to be maximized is that of the dictator; in a slave society it is that of the slave owners rather than the slaves. In free societies it is usually assumed that each person seeks to maximize his own utility and in general will be the best judge of how to do so.

An improved method of raising beef increases utility for beef-eating Americans or Argentines, although not for vegetarians; however, the explanation of such cultural, religious, or taste differences in assessing the value of additional output is not the economist’s task. The national output includes bread and circuses, cathedrals and billboards, vitamins and poisons. The economist can study the forces affecting the market price or cost of each and under some circumstances can also say that a market price does not correctly reflect the underlying values of consumers and producers. Like any other citizen, he has personal opinions based on values that transcend market values, but if he cloaks these with the authority of his discipline, he arrogates wisdom.

The economic value of a particular good will not ordinarily depend on the use to which it is put— the price of a stick of dynamite is the same whether it is used to mine coal or to blow up a bridge.

Almost all societies would judge the value of the outcome to be positive in the first case and negative in the second, but the standards by which this judgment is made are not provided by economists in their scientific capacities.

The methodology of economics

The purpose of science is to achieve understanding either for its own sake—the satisfaction of “idle” curiosity—or as a basis for prediction and control. Although both elements are present in economics, the latter is particularly evident. [SeePrediction and forecasting, economic.] The predictions sought generally refer to the aggregate behavior of sizable groups of people and not to the behavior of individuals. In most economic inquiries it is sufficient to reach such conclusions as that in a given market the consumption of milk increases 1 per cent in response to a 2 per cent reduction in its price; the economist ordinarily does not care whether this occurs because each family increases its consumption 1 per cent or because half the families increase their consumption 2 per cent and the other half not at all. (This indifference will disappear if the division of families into two groups is nonrandom; for example, it might be valuable to know that low-income families increase their consumption more than high-income families.) An economist almost never attempts to predict the consumption behavior of a particular individual in response to a price change. In some economic studies, data are used in which the observations refer to individuals; such studies as yet typically fail to explain a major part of the variance in individual behavior.

The focus on aggregates makes it possible to summarize the accumulation of economic knowledge in statements of observed regularities, or “laws,” that do not apply to individuals considered singly. The preceding example about milk is a special case of the “law of demand”—the quantities of a commodity or service purchased move inversely with its price, other things being equal. This law is not contradicted by the discovery that some consumers stop buying a commodity whose price falls, because it no longer confers social distinction on the user (the so-called snob effect), so long as such behavior does not dominate the market for any commodity.

Partly because of the focus of economics on large-group behavior, economists can seldom use the method of laboratory experiment. (The few exceptions lie chiefly on the borderlines between economics and psychology; for example, subjects are given money to spend, gamble, or use in similar economic games.) The use of laboratory experiment is not, of course, a requisite of a science. Among natural sciences much of astronomy and meteorology are similarly disadvantaged. In economics the place of the laboratory experiment is largely taken by other methods of testing hypotheses, in which variables extraneous to the hypothesis being tested can, within limits, be held under statistical, rather than physical, control.

The use of statistical control of extraneous variables corresponds to the common theoretical device of “holding other things constant” in analyzing the functional relationship between two variables. For example, the statement that the consumption of milk increases in response to a fall in price can be represented as a demand curve, a downward sloping line on a graph whose vertical axis measures the price of milk and whose horizontal axis measures the rate of consumption. [SeeDemand and supply.] This relationship assumes that other factors affecting milk consumption, such as consumer income and tastes, do not change. A change in one of these factors will cause the demand curve to shift. A more complicated relationship, which expresses the rate of consumption as a function of both price and income, is often more useful and can be estimated statistically. Such a three-dimensional demand surface is hard to show graphically and is therefore less common in elementary expositions.

A more complete analysis of the market for milk would include the conditions of supply as well as of demand. The relationship between the price of milk and the quantity supplied (generally positive, or upward sloping) is known as the supply schedule or the supply curve. Together the supply and demand curves determine the quantity sold and the price. For given supply and demand conditions, the position so determined is a stable equilibrium position, and quantity and price will tend to return to it if the market is subjected to a small accidental disturbance. [SeeEconomic equilibrium.] However, if the disturbance changes the underlying conditions of demand or supply, the market will move to a different equilibrium position. For ex-ample, if the taste for milk changed so that people wanted it more than before, the result would prob-ably be a permanently higher consumption of milk, perhaps at a higher price.

The method that confines analysis to comparisons of the initial and final equilibrium positions of a market or system of markets is known as the method of comparative statics because it is not concerned with the path of the adjustment through time—that is, with such questions as whether milk consumption expands first quickly and then slowly in response to some initial impetus or expands at a steady rate. Dynamic analysis is concerned with the time path of movement. [SeeStatics and dynamics in economics.] For example, in a study of hyperinflation the time pattern of response to a previous increase in the price level is a crucial attribute of a satisfactory theory. Although “static” is sometimes used as a term of reproach and “dynamic” as one of praise, the choice between dynamic and static analysis must rest on the nature of the problem, with no general presumption that one is superior. Dynamic analysis requires additional knowledge about human behavior—knowledge that is not always available, for it involves knowing not only how people respond to economic stimuli, but at what rate.

As the foregoing observations suggest, economics makes extensive use of quantitative data and has a large body of abstract theory that can be extended and explored for consistency through the use of formal logic. For this reason economists began to use mathematics and statistics earlier and more intensively than most other social scientists. [The use of such methods in economics is discussed inEconometrics.]

The functions of an economic system

We now turn to an overview of the substance of economics and in particular to the central problem of resource allocation. This will be approached through a classification of the functions of an economy devised by Knight (1933). Of his five functions, we shall consider four, designated here as: (a) determining the composition of output; (b) organizing production; (c) distributing the product (or income); and (d) providing for the future. (The fifth concerns the allocation of a fixed stock of goods over short periods of time.) Later we shall turn to the discussion of money, the price level, and the level of employment, which, as noted earlier, lie largely outside the resource-allocation framework.

Determining the composition of output

Modern societies determine what to produce in two basic ways—through political or governmental decisions and through the use of markets. These methods can be combined in varying proportions. Even in a country as noted for the use of markets as the United States, many important classes of goods and services—such as schools, roads, police protection, and national defense—are provided wholly or largely outside the market system in the sense that consumers pay for them through taxes rather than by the direct purchase of the services. The nonmarket sector is much larger in such socialist countries as the Soviet Union, and their reliance on the market to guide production decisions is usually weaker where markets are used. However, even the Soviet Union has a few legal private markets, particularly for perishable farm produce. The activities in which government services are provided without explicit charge are not coextensive with the government sector of an economy—for example, government post offices sell mail services to users by means of postage stamps (though not always at prices that cover costs), much as private businesses sell their services.

In the market sector, consumer preferences are transmitted to producers through decisions to purchase the goods and services offered for sale. (Producers may also use survey techniques or experimental markets to test consumer acceptance of new products [seeMarket research].) When consumers want more of a product that is sold on a free market, its price will tend to rise and its production will become more profitable. Existing producers will increase their output and new producers may enter the market. Conversely, if consumer desires for a product weaken, prices and output will tend to fall. [SeeDemand and supply] Although prices are in general the best signals to producers of changes in the pattern of demand, consumer preferences can also be transmitted through markets in which prices are fixed. In such markets, decreases in demand are indicated by unsold inventories of goods or by idle capacity to perform services; increases in demand are indicated by the disappearance of inventories and by queues. Most markets for consumer goods in socialist economies operate in this fashion, as do those monopolistic markets in capitalist economies in which prices are administered by sellers.

In socialist economies, decisions about the quantities of resources to devote to consumer goods are made centrally through government planning. Once these decisions are made, the planners have an incentive to heed market signals of surpluses and shortages and to allocate resources to particular products or to change product prices so as to achieve maximum consumer satisfaction with the allotted resources. However, the mechanisms for doing this in planned economies are not yet very successful. [SeeCommunism, economic organization of; andPlanning, economic, article Oneastern europe.]

An economy in which all markets were fully responsive to changes in consumer tastes would exemplify consumer sovereignty [seeConsumer sovereignty]. Complete consumer sovereignty under free enterprise would require the absence of monopolies, so that consumers could be provided with that amount of each commodity whose costs of production they were just willing to pay. (A monopoly would be able to restrict output below this level to obtain a price in excess of costs.) In equilibrium such a system would have the property, given the distribution of income, that the composition of output could not be changed without reducing the satisfaction of one or more consumers. Informative advertising would be permissible, or even desirable, but advertising that persuades without informing represents a departure from consumer sovereignty [seeAdvertising, article oneconomic aspects]. In principle, consumer sovereignty would be possible in a socialist economy if planners were willing to abide by decision rules that simulated the behavior of competitive markets.

The pattern of production resulting from consumer sovereignty depends not only on consumer tastes but also on the distribution of income and wealth. If income and wealth were redistributed more equally, there would be less production of goods and services consumed largely by the highest income groups (Cadillacs, domestic service) and by the lowest (potatoes, bus rides). Theoretically, there is less equality in decision making through the market than through democratic political processes, for in political elections each person has one vote, while in the market his “voting power” is proportional to his expenditures. The actual contrast is less sharp, for there are concentrations of political power as well, and not every citizen has equal influence on the outcome of political decisions.

An important advantage of a market system is that it characteristically provides for the tastes of minorities. It is often worthwhile for producers to make a product wanted by only a few people, provided that these few are willing to pay a little more than the price of a standard commodity. Consider, for example, the large number of different varieties, sizes, and shapes of bread offered for sale in a big city with a diverse population. By contrast, the provision of goods or services by governments has tended toward standardization and uniformity. Some critics of market economies view this variety as wasteful and argue that the efficiencies of standardization outweigh the importance of minor differences in tastes.

The market system also offers strong incentives to producers to develop new or improved products, in the hope that these will gain consumer acceptance and prove profitable. Innovation in consumer goods is a more conspicuous feature of market economies than of planned economies, although neither system can guarantee that innovations which would succeed will always be forthcoming.

Organizing production

Production is the combination of resources (factors of production) to produce desired output. Early in the history of economics the concept of production was associated with making physical products. Agriculture, mining, manufacture, and construction were considered productive activities, whereas transportation, trade, and such services as education were not. This distinction has long been abandoned. It is now recognized that transportation and trade add to the value of commodities by making them available where they are wanted and that furnishing services can contribute as much to the satisfaction of consumers as furnishing commodities [seeInternal trade].

Specialization and exchange and the division of labor are central concepts in the economics of production [seeSpecialization and exchange]. In undeveloped economies, much production is carried out by individuals and small groups (families, tribes, communities) which consume their own output. For example, in the early colonial period in North America, families usually grew or caught most of their own food, built their own houses, and made their own cloth, clothing, furniture, soap, and candles. In modern economies, most workers are specialized in the production of a particular commodity or service and usually perform a specialized task within the production process. Specialization increases output because workers acquire specialized skills and save time that would otherwise be spent in switching from one activity to another. Specialization usually enlarges the scale of production, and large-scale production justifies the use of expensive specialized tools and machinery. Moreover, the production of each good can be carried on in the most suitable locations. Although within some limits the division of labor undoubtedly increases output, it is sometimes argued that it deprives the worker of the satisfaction of creating a complete product and of variety in job content, thereby also diluting standards of craftsmanship and contributing to industrial unrest.

The possibility of specialization rests on the principle of relative advantage, which states that it is advantageous for a productive activity to be carried on by an inferior producer, provided that the superior producers are even more superior at doing something else. To take a familiar example, suppose that a doctor can mow his lawn in an hour, and the best gardener he can hire takes two hours. It will nevertheless pay him to hire the gardener at $2 an hour if he can earn $5 in an additional hour of medical practice. (We assume that the doctor attaches less than $1 an hour of recreational value to lawn mowing.) The principle just illustrated also underlies the specialization of production among nations and is therefore the cornerstone of the theory of international trade. [SeeInternational trade, article onTheory.]

Efficient production involves combining resources so as to minimize the cost of the output. We are all accustomed to partial measures of efficiency that relate useful output to the use of a single input— for example, miles per gallon of gasoline as a measure of the efficiency of an automobile. Partial measures of efficiency or productivity, such as output per man-hour, are also found in economics, but economists are usually more interested in the efficiency with which all resources together are used. A measure of this is “total factor productivity”— that is, useful output divided by the total input of economic resources, weighted by their respective prices or costs. [SeeProductivity.] This measure reflects the condition that it pays to conserve one factor by increasing the use of a second only if the added costs of the second factor are less than the value of the savings of the first. For example, an automobile that runs more miles per gallon is economically inefficient if the added cost of the better engine exceeds the cost of the gasoline saved over its lifetime, both valued at the same point in time.

Economists have long thought of resources, or inputs, in three traditional categories: land, labor, and capital. Land consists of the natural properties of soil, minerals, and climate; labor, of the current services (mental and physical) of humans; and capital, of such things as structures, machines, vehicles, livestock, inventories, and improvements to land such as clearing and terracing [seeCapital; Land; National wealth; Agriculture, article onCapital]. There is, however, nothing sacred about this particular trinity. The traditional factors are often very difficult to separate, as in the case of land and improvements to it. The factors can be more finely subdivided (for example, management can be distinguished from labor), or the scheme can be extended to recognize additional inputs, such as entrepreneurship [seeEntrepreneurship]. Humans can also be regarded as embodying investment made through education and training [seeCapital, human].

The relation between the combination of inputs in a production process and the resulting output is like a recipe in which labor, capital, and other classes of inputs replace such ingredients as butter, eggs, and milk. Such recipes are called production functions. [SeeProductionandEconomies of scale.] Cookbook recipes usually call for constant proportions of the various ingredients; in economic production, however, the proportions of inputs are generally varied in response to changes in factor prices so as to subst’lute less expensive for more expensive inputs. Although the possibility of substitution among factors may be limited by technology, it is often much greater than might at first be supposed. Steel mills in the United States, where labor is expensive, and in India, where labor is cheap, may use very similar basic production processes, yet Indian mills will find it economical to use much more labor and less capital in such auxiliary operations as materials handling.

For some purposes, the cost of an input is adequately represented by its market price. For others, one must turn to the more fundamental concept of opportunity cost, or alternative cost, which states that the cost of employing a unit of a factor of production in any activity is the output lost by the failure to employ that unit in its best alternative use. For example, the cost to the economy of changing the use of a tract of land on the outskirts of a city from farming to residences is represented by its value as farmland, which in turn depends on its contribution to farm output. However, if there were several residential or industrial development plans in each of which the value of the land was higher than in farming, the cost of using it in any one plan would be its highest value in any of the others. [SeeCost.]

Difficult problems arise when some of the outputs or inputs in a production process have no market value or when some of the costs of productive activity are not borne by the enterprise engaged in it. The evaluation of a proposal to convert farm-land near a city into a free public recreation area is essentially a question of judging whether the benefits exceed the costs. Production costs imposed on parties not engaged in the production process are exemplified by air and water pollution from industrial wastes, especially where the losses are so widely diffused that individual lawsuits to recover damages are impractical. [SeeExternal economies and diseconomies.] The presence of benefits or costs with no market valuation often leads to government regulation or intervention (such as the zoning of land or the prohibition of child labor) in the production processes of market economies.

In the classical period of economics, until about 1870, it was held that the cost of production determined the price or value of a commodity [seeValue, labor theory of]. The beginning of the neoclassical period is marked by the recognition that value is jointly determined by cost and by demand. The costs of producing a commodity often rise as total output is expanded and as resources less suited to its production are drawn into use. In such cases, an increase in demand requires the expansion of production into areas of higher costs and therefore causes an increase in price. However, changes in price can also arise on the supply side through changes in the underlying cost conditions, including changes in the supply of productive resources or in the technology of production, and through changes in the extent of monopoly power.

Once resources have been committed to a particular kind of production, they often cannot be easily withdrawn. For example, only a small fraction of the original construction cost of a railroad line could be retrieved as scrap value or from sale of the right of way. The remaining original construction costs, often called fixed costs or sunk costs, become irrelevant to day-to-day decisions about pricing and the nature of service. It will pay for the line to continue in operation if a pattern of prices and service is possible in which revenues cover current operating costs and interest on salvage value. Financial losses to the owners of specialized fixed capital are not social losses, and are not really costs, since such capital has no alternative use. As specialized capital equipment wears out, the costs of replacing it become relevant to decisions concerning the abandonment or continuation of the activity in which it is used. Analogous problems arise in the case of labor with specialized training.

The period within which some costs are fixed is called the short run; in the long run, all costs can be changed by changes in inputs. The length of the short run in chronological time varies with the nature of the production process and the durability of the capital goods used. It may be a hundred years for a hydroelectric project and a few weeks for an establishment making inexpensive cotton dresses.

Decisions about the organization of production also involve determining the lowest-cost location of productive facilities. Some kinds of facilities are located where raw materials are accessible (iron and steel mills, for example). Some activities take place close to sources of low-cost power (aluminum reduction and production of electrochemicals), others close to important markets for the product (automobile assembly), and still others where suitable labor is available or inexpensive (manufacture of garments). [SeeSpatial economics.]

Distributing income

The third basic function of an economy is to distribute income. In a society based on subsistence agriculture most income is distributed in kind; each family consumes largely the products of its own labor and land. In complex economies most income is distributed in money, representing generalized purchasing power or command over all goods and services offered for sale. The dominant use of money-income payments results from both specialization in production and the increasing variety of things consumed. The producer uses money income to purchase small quantities of many products, not necessarily including the one that he himself makes.

Income is the net value of production during a period—the amount available for consumption or net saving after initial wealth or capital has been maintained. In other words, income is the maximum amount that an economy (or an individual) could consume during a period without becoming poorer. If actual consumption is less than this, there has been saving during the period, and wealth has increased.

The functional classification of income depends on the kind of productive services furnished by the income recipient [seeIncome distribution, article onfunctional share]. Wages and salaries are the return for furnishing labor services, interest is the return for furnishing capital, and rent, in one sense of the term, is the return for furnishing land [seeWages; Interest; Rent]. (These categories are less neat in income statistics than in theory; a landlord who receives rent for a building, for example, is furnishing both land and capital.) The income share called profit is hard to identify with a particular factor of production. Much of what is called profit in both business and national accounts is a return to equity capital and corresponds to interest in economic theory. Some accounting profit represents a return to positions of monopoly power, sometimes called rent in another sense of the term. The residual, or “pure,” profit is regarded by some economists as the return to entrepreneurship or to innovation and by others as a return (either positive or negative) for taking noninsurable risks. [SeeProfit.]

Certain streams of payments to individuals, called transfer payments, do not correspond to any current contribution to production, but are claims of one set of individuals against the income of another. Public assistance is one example. The sum of wages and salaries, rent, interest, and profits exhausts the national income, and transfer payments arise from a secondary redistribution of these shares.

The basic principle of income distribution in a private enterprise economy is that individuals should receive as income the value of their contribution to production, including both the value of their labor and of the services of any productive land or capital that they own. This system gives each person an incentive to use his resources fully and where their contribution to the value of output is greatest. In practice, differences between the contribution of a factor to production and the income it receives can be caused by some kinds of imperfections in the markets for productive services. The income distribution is also modified by transfer payments, which are received largely by low-income groups; by the provision of free government services; and by taxes, particularly progressive personal income taxes. For most capitalist countries, these modifications seem to work on balance in the direction of greater equality of incomes.

The distribution of incomes in capitalist societies has long been criticized by socialists and reformers as too unequal. The best known competing principle is that of Marx: “From each according to his abilities, to each according to his needs.” No large, complex economy has ever operated on this principle for more than brief periods, although it may operate in certain religious orders and cooperative communities. Attempts to apply the Marxian principle have broken down because of two problems, assessing needs and maintaining incentives to work and to save.

The main difference between the principles of income distribution in contemporary capitalist and socialist countries lies in the treatment of nonlabor income. In both types of economies, workers are paid approximately in accordance with the value of their work. In the socialist countries, however, almost all productive capital is owned by the state, so that personal income from property is negligible. (In the Soviet Union some private income arises from interest on savings deposits and government bonds and from the private ownership of livestock by collective-farm families.) In capitalist economies, property income is much less equally distributed than labor income. It does not follow, however, that the distribution of income, as a whole, is more equal in socialist countries. In developed capitalist countries, labor income is the great bulk of total income; a somewhat less equal distribution of labor income in socialist than in capitalist countries could therefore offset the effect of the property share on the equality of total incomes and probably does offset much of it. However, there appears to be no counterpart in socialist economies to the very highest incomes under capitalism.

The distribution of income among persons is not only unequal but asymmetrical. Almost all income distributions are markedly skewed to the right; a concentration of individuals below the mean is balanced by a long “tail” much above the mean. Since natural abilities were long assumed to be symmetrically distributed and most income was seen as a return to various abilities, the skewness of real-world income distributions motivated much work by economists and statisticians. [SeeIncome distribution, article onsize; andSize distributions in economics.]

The major social problem related to the personal distribution of income is poverty, an older and more pressing concern of economists and sociologists. In economies at a low level of development, most peasants and unskilled workers are considered poor. In the highly advanced economies, relatively few families with employed male heads are considered poor; poverty is largely a problem of the aged, the disabled, the long-term unemployed, and households with female heads. However, there are exceptions. For example, in the United States there are a substantial number of poor farm families and poor Negro families headed by employed men. [SeePovertyandConsumers, article’onconsumption levels and standards.]

The definition of poverty has varied with time and place. In the United States in the mid-1960s, a widely accepted definition was that families with incomes below $3,000 a year were poor; about one-fifth of all families fell below this mark. In earlier times or in underdeveloped countries, the standard of living embodied in this definition would be viewed as comfortable or even luxurious. If the accepted poverty line moves upward as fast as average income, the elimination of poverty becomes exceedingly difficult. But however elusive the definition of poverty, the social problem is real and serious. Low income is a major factor contributing to crime, disease, and ignorance, which in their turn can give rise to new generations of the poor.

Policies to combat poverty fall in three general categories: public assistance or relief, rehabilitation and retraining, and the regulation of product and factor prices. Economists have tended to criticize the simplest forms of direct relief, once on the ground that they raised the natural rate of increase of poor populations and more recently on the ground that they weaken the incentive to work. Education, rehabilitation, and retraining have been preferred because they attack and sometimes eliminate a fundamental cause of poverty—the small actual or potential contribution of low-income workers to production. For the aged or disabled, social insurance is increasingly viewed as the best approach to assuring a decent minimum standard of living [seeAging, article onEconomic aspects].

Greater equality of income is also an announced objective of numerous public policies that directly alter product or factor prices. For example, agricultural price and income policies in many countries raise the incomes of farm families, which are usually lower than those of urban families. Such policies may increase the income of the favored sector, but often not that of the poorest families within it. Such policies also tend to restrict output or distort the allocation of resources, so that the choice is between a given national income unequally shared and a smaller one somewhat more equally shared. Indeed, the result is sometimes to lower income without increasing equality at all. [SeeAgriculture, article onprice and income policies; Subsidies.]

The demand for equalization policy is especially strong in times of war or disaster, when there is a general disposition to prevent the rich from bidding up the prices of goods in short supply. To achieve “fair shares” or “equality of sacrifice,” the role of money in the distribution of income is often supplemented by the direct rationing of certain scarce items on a per capita basis or to users whose needs are judged to be greatest. Such policies also have substantial efficiency costs, which may reduce the income available for distribution. [SeePrices, article Onprice control and rationing.]

Providing for the future

The fourth major function of any economy is to provide for the future through the conservation of natural resources, the maintenance or replacement of existing stocks of physical capital, and the net accumulation of capital. Increases in the stock of human skills and in the fund of accessible knowledge also are important in providing for the future.

The views of economists on conservation often clash with those of others, including natural scientists [seeConservation, article oneconomic aspects]. Two main kinds of conservation problems can be identified, the first of which arises when a resource, such as wild game or fish, cannot be owned. No hunter has an incentive to spare an animal today so that he may take it in the future, for if he fails to act now, the game may be taken by someone else. Conservation under these conditions requires such government controls as closed seasons and bag limits. Interesting economic problems arise in defining the optimum size of the population to be conserved.

Less severe policy problems arise where resources can be owned, as can land and solid minerals. (Oil and natural gas are an intermediate case.) If the owners of such a resource believe that it is becoming scarce and that few substitutes will be available, they have an incentive to conserve it in order to gain from the eventual rise in its price. The higher the cost of holding this asset, including the rate of return on alternative forms of wealth, the weaker will be this incentive. Nevertheless, overexploitation of resources can occur in such cases because of ignorance on the part of resource owners or because the interest rate confronting them does not correctly reflect the social cost of capital.

A larger part of the problem of providing for the future is that of maintaining and increasing physical capital. Capital is increased through saving, much of which is undertaken by individuals to provide for personal contingencies, such as illness and old age, and to accumulate wealth to bequeath to descendants or others. Saving is also undertaken because it yields income (interest), which corresponds to the productivity of capital in production. If the rate of interest is 6 per cent, refraining from consuming $100 of income this year will make possible consumption of $106 next year; alternatively it will make possible the consumption of an income stream of $6 in perpetuity. The return on capital provides both an incentive to accumulate and an incentive to refrain from using up present capital.

Investment provides capital for a growing population and also increases the amount of capital per person available to raise output per head. With unchanging technology the return on capital would tend to fall as the best investment opportunities were used up; however, this tendency is offset by technological changes that create new investment opportunities. The theoretical problems involved in measuring the stock of capital and discovering the principles that determine its yield are among the most difficult in economics. [SeeCapital.]

Determining the optimum rate of investment in a growing economy also raises difficult problems, which have received increasing attention in mathematical economic theory [seeInterestandEconomic growth, article onmathematical theory]. The crucial elements in this analysis are the rate of growth of population, the rate of return on capital, the rate of technological change, and the weights to be attached to the satisfaction of present and future generations.

Society requires many kinds of capital. One important way of classifying these distinguishes capital used in production from that used directly in consumption, such as houses, private automobiles, and home appliances [seeConsumers, article onconsumer assets]. A second important classification distinguishes the capital used in the production of a particular product, such as livestock, machinery, or factories, from capital—such as roads, water supply systems, communications facilities—that enters indirectly into the production of many products. The latter, called social overhead capital, is often publicly owned. [SeeCapital, social overhead.] Adequate provision for overhead facilities may be prerequisite to investment in the production of specific products.

Investment in new physical capital or the acquisition of existing physical assets by individuals, corporations, or governments often requires the investor to raise funds externally by borrowing or issuing shares. In the public mind the resulting financial assets, such as mortgages, bonds, and stocks, are more often identified with capital than are the underlying physical assets. Savings are made available for investment when financial assets are purchased by individual savers or by financial institutions, such as savings banks and insurance companies, in which savers hold their funds. [SeeFinancial intermediaries.]

A third important way of providing for the future is through technological change, including the discovery of new products and processes. Technological change in its broadest sense involves a wide range of activities: the growth of fundamental scientific knowledge through basic research, the invention of machines and methods, the dissemination and diffusion of knowledge through education, and the introduction of new methods in particular applications. An increased stock of knowledge is a more important legacy to succeeding generations than an enlarged stock of physical capital. New technology is usually incorporated, or “embodied,” in the stock of physical capital and in the skills of the labor force. [SeeInnovation; Research and development; Agriculture, article onProductivity and technology.]

Money, income, and the price level

So far our discussion of the functions of the economy has proceeded with little reference to money, yet all but the simplest economies would grind to a halt without this essential lubricant. Some specialization and exchange can take place with the aid of barter, the direct exchange of one commodity or service for another. However, barter requires that each party wants the exact kind and quantity of goods offered by the other, which would happen only by coincidence. Money, by freeing exchange from this coincidence of double demand, permits specialization to be greatly extended. The use of money as a medium of exchange therefore appears very early in economic development; money also furnishes the unit of account and, with other assets, serves as a store of value. [See the general article onMoney.]

Early money consisted of scarce commodities of various kinds, especially precious metals, and the minting of metals into coins was one of the earliest economic functions of the state. In modern economies, banknotes and other paper currency have replaced coins, except in small transactions. These notes were originally redeemable in gold or silver; this has now become uncommon. Paper currencies were once thought to derive their value only from their convertibility into metallic money; however, experience has not supported this belief. It is now clear that money derives its value from its usefulness as a medium of exchange and that irredeemable paper currencies can have stable or even rising value if their issue is restricted.

The largest part of money in developed economies consists of bank deposits, usually transferable by check. Banks, through their lending operations, can create and destroy money in the form of bank notes and deposits. Recognition of this has led to their regulation by central banks (usually agencies of the government) as a means of controlling the quantity of money and thus affecting its value. [SeeBankingandBanking, central.]

The value of money may be defined as the reciprocal of an index number of the general level of prices [seeIndex numbers, article onpractical applications]. Changes in the price level are important because not all individual prices are equally affected and relative prices and resource allocation are therefore influenced. In particular, changes in the price level affect the distribution of real wealth and income; a sustained rise in prices, or inflation, enriches net debtors at the expense of net creditors because the debt is stated in nominal or monetary units rather than in terms of command over real goods. A sustained fall in prices, or deflation, has the opposite effect. [SeeInflation and deflation.]

One of the best developed theories of the value of money is the quantity theory [seeMoney, article onquantity theory]. The demand for money, or cash balances, arises because money lowers the cost of making transactions. Recent formulations of the quantity theory express this demand as a function of real income or wealth, the expected rate of change of prices, the interest rate, and other variables. This function is thought to be reasonably stable in the long run, in which case the general level of prices is largely determined by changes in the quantity of money. Inflation results from sustained increases in the money supply relative to real income, and deflation from sustained decreases.

Changes in the demand for money under conditions of constant supply can often be inferred from the turnover rate of the money supply, usually called the velocity of circulation [seeMoney, article onvelocity of circulation]. A decreased desire to hold money would lead to a rise in velocity as holders sought to dispose of excess balances; an increased desire to hold money would lower velocity.

A decrease in the stock of money or its failure to grow as fast as productive capacity can cause, or contribute to, a fall in aggregate demand, output, and employment. Similarly, increases in aggregate demand brought about by increases in the stock of money or by other means will cause increases in output and employment when there is unused productive capacity. Once capacity is fully used, further increases in aggregate demand only raise the price level. Since capacity output will not be reached at the same moment in all branches of the economy, an intermediate zone exists in which increases in demand will increase output and prices simultaneously. However, behavior in this zone need not be symmetrical for increases and decreases in demand. A decrease in demand is likely at first to reduce output with little effect on prices.

As this suggests, money is a crucial element in economic fluctuations—the business cycle or the alternation of periods of prosperity and depression and of rising or falling prices—which have been one of the most conspicuous features of modern capitalist economies [seeBusiness cycles]. Economists have long studied the sequence of events in business cycles—the amplitudes of fluctuations, the length of expansions and contractions, and the leads and lags of turning points of series at cyclical peaks and troughs. Such observations have helped in the formation of theories of the causes of business cycles. Special attention has naturally been given to the causes of depression and widespread unemployment [seeEmployment and unemployment].

Interest in the construction of such macroeconomic theories was heightened by the great depression of the 1930s and in particular by the work of John Maynard Keynes. Central to Keynes’s thinking was the concept of deficiency of aggregate demand. If income receivers spent their entire incomes on consumption, such a deficiency could not arise; however, a portion of income is saved, and Keynes held that this portion rises as income rises. [See Consumption function.] Still, no problem arises if desired investment equals saving. All savings will then be spent in the purchase of new investment goods, and the flow of income will continue undiminished. But Keynes argued that this equality need not hold—unfavorable investment opportunities and high interest rates can lead to a reduction in desired investment and an excess of saving. [See Investment.] Under these circumstances, aggregate demand will fall short of productive capacity, real income will drop until saving is equal to desired investment, and there will be persistent unemployment. In Keynes’s view, governments should then create the required demand through an excess of government expenditures over tax receipts.

Until Keynes, orthodox economists had argued that unemployment was caused primarily by excessive wage rates and could be alleviated by wage cuts. Keynes assumed that in modern capitalist economies wages do not fall when output falls. In any case, his emphasis on the adequacy of demand led him to counsel against wage cuts. Wages, he pointed out, are incomes as well as costs, and their reduction could lower employment by diminishing the purchasing power of wage earners and their expenditures on consumption.

A crucial relationship in the Keynesian system is that between the quantity of money and the rate of interest, which takes a form that prevents the interest rate from falling below some minimum level. This “liquidity trap” implies that expansion of the money supply during a depression will fail to lower interest rates and therefore will not stimulate investment. [SeeLiquidity preference; for a discussion of the full Keynesian model, seeIncome and employment theory.]

During the 1930s, concern about aggregate demand stimulated work on systems of national income accounting that record the income and expenditures of the whole economy by sector [seeNational income and product accounts]. The simultaneous development of macroeconomic theory and macroeconomic accounting, among other forces, has led to a fundamental change in the attitude of governments toward depression and unemployment. It is now generally accepted that governments can, and should, act to maintain aggregate demand at levels as close as possible to productive capacity, although there are still important disagreements about the best ways of doing this under particular circumstances. The principal possibilities are to increase the quantity of money and hold down or reduce interest rates through expansionary policies of the central bank, to reduce taxes, and to increase government expenditure. [SeeMonetary policyandFiscal policy.] Opposite measures can be used to control inflation resulting from an excess of aggregate demand over capacity. The use of tax reductions or of increases in government expenditures as means of combatting deficient demand implies that the budgets of central governments should be in deficit in times of less than full employment.

Subfields of economics

The theory of resource allocation (microeconomic theory) and the theory of money, income, and the price level (macroeconomic theory) are the core of economics, whose outlines have been sketched above. Surrounding this core are several specialized fields. The mention of these here must be extremely brief, especially for fields described in single articles elsewhere in the encyclopedia.

Mathematical economic theory applies mathematical tools to theoretical problems in economics. Econometrics applies advanced statistical tools to empirical problems in economics. [For a survey of both fields, seeEconometrics.] Scientists in these fields have an international association, the Econometric Society.

The history of economic thought is the study of the work of past economists and their influence on one another, on other disciplines, and on the world of affairs. In this encyclopedia several schools of economics are discussed as such [seeEconomic thought]. However, the article on economic thought does not discuss the English and American classical and neoclassical schools, whose ideas are reflected in many substantive articles and whose leading figures are discussed in biographies [seeSmith, Adam; Ricardo; Millin the classical period;Marshall; Edgeworth; Jevons; Clark, John Bates, in the neoclassical period;Knight; Robertson; Pigouin more recent years]. Similarly, the Keynesian school of economics is included not under economic thought, but under substantive entries and biographies [seeKeynes, John Maynard; Hansen].

Economic history applies economic analysis to problems that are outside the recent past, although such problems often have implications for the present and future [seeHistory, article onEconomic history]. There has been a strong recent movement toward the application of econometric methods to economic history. Interest in the field has been stimulated by concern about the economies of underdeveloped nations and by the lessons those nations can learn from the economic history of developed areas. Economic historians have an active international association and several specialized journals. Closely related to economic history is the rapidly expanding field of economic development, which covers both the theory of growth and the more practical application of economics to the problems of less developed areas [seeEconomic growth].

Most other specialized fields in economics deal with problems of particular parts or aspects of the economy and the institutions peculiar to them.

Industrial organization considers problems arising from the structure of firms, industries, and markets. The firm is the entity that engages in production in the private sector of the economy. In simple economies, firms are owned by individuals or groups of partners, but large-scale economic activity is now carried out principally by corporations—firms that can be owned by many shareholders, who have no liability for corporate debts beyond the possible loss of value of their shares. Shareholders typically have little control over the affairs of the corporation; effective control is in the hands of professional managers. [SeeCorporation.]

An industry is the set of firms or establishments carrying out some branch of economic activity, although the boundaries of such a branch are not always easy to define usefully. A market in its simplest meaning is a place at which transactions are made; more broadly, it is the whole web of relationships between buyers and sellers. [SeeMarkets and industries.] The boundaries of markets, like those of industries, are often difficult to define.

A central concern of the field of industrial organization is the changes that take place in the character of markets as the number of buyers and sellers increases and as collusion among buyers or sellers becomes more difficult. At one extreme lies monopoly [seeMonopoly]. In principle, a monopoly is a market with only one seller, although all sellers are affected to some degree by competition from other markets. A monopolist in aluminum production, for example, would face the competition of other metals in some uses of his product. Markets dominated by a few sellers (oligopolies) raise interesting theoretical problems concerning interaction and collusion among the sellers, which are often approached through game theory [seeOligopoly]. At the other extreme are competitive markets with many sellers and buyers who do not collude [seeCompetition].

With given technology, competition promotes economic efficiency; monopoly or oligopoly tend to produce restriction of output and higher prices.

However, it is sometimes argued that monopoly is indispensable to technological progress. The advocates of this controversial view contend that very large corporations are necessary for innovation because modern research is too expensive to be carried on by small competitive firms [seeResearch and development].

Other topics considered in the field of industrial organization include processes that change the structure of industry and the government regulation of industry structure, output, and prices [seeAntitrust legislation; Mergers; Regulation of industry].

Agricultural economics is concerned with the efficient use of resources in agriculture, the technology of food and fiber production, the distribution of farm products, and the income and welfare of farm populations [seeAgriculture]. Agricultural economists also study the migrations from rural areas that result from the high rate of natural increase of farm populations and the displacement of labor by improved farm technology. The organization of agricultural production differs sharply between different parts of the world—the family farm owned or rented by the operator, the large collective farm and state farm of the Soviet Union, the tropical plantation employing wage workers. The form of organization has important implications for efficiency and welfare. [SeeLand tenure; Communism, economic organization of; Plantations.]

Labor economics is both a branch of economics and of the interdisciplinary field of industrial relations. Although most of this broader field was once occupied by economists, it has increasingly attracted sociologists, psychologists, political scientists, and lawyers. Labor economists are therefore tending to specialize in the analysis of wages, hours of work, and employment [seeWages; Labor force, article onhours of work; Employment and unemployment]. They share with demographers an interest in labor force participation and also study government regulation of working conditions and the provision of social insurance and other wage supplements [seeAging, article onEconomic aspects; Labor force, article OnParticipation; Unemployment insurance; Workmen’s compensation].

A central institution in this field is the labor union—an association of workers formed to improve wages and working conditions through collective bargaining or political action [seeLabor relationsandLabor unions]. Although labor economists concentrate on the impact of unions on wages and employment, they are still concerned with the growth and internal functioning of unions.

Public finance applies economic analysis to the activities of the state and their impact on the private economy, particularly on the level of income and employment [seeBudgeting; Debt, public; Fiscal policy]. A major part of the field is the study of tax systems, including the effect of taxes on income distribution: whether they fall proportionally on all levels of income, are regressive (take a larger share of the lower incomes), or are progressive (take a larger share of the higher incomes) [seeTaxation]. Other studies of taxes deal with the effect of alternative tax systems on incentives to work, to save, and to use resources efficiently. Another part of the field deals with government expenditures—with determining the kinds of economic activity most appropriate to the state and devising criteria for deciding which particular public projects are worth undertaking [seePublic expenditures].

International economics extends economic analysis to the world economy. A country’s transactions with other countries are summarized in its balance of payments [seeInternational monetary economics, article onbalance of payments]. Some of these transactions are trade in commodities and current services, which reflects specialization among countries in production [seeInternational trade]. Economists study both the actual pattern of trade and the theoretical conditions underlying it; the theory of international trade is perhaps the best developed body of theory in any subfield of economics. The effect of tariffs or quotas on the world economy and on the nation imposing them is a central problem in international trade theory. [SeeInternational trade controls.]

Other international transactions are financial, such as the construction of branch plants in one country by companies owned in another and the flow of liquid capital through securities purchases [for examples, seeInternational monetary economics, article onprivate international capital movements]. Conditions of international trade and capital flows are greatly affected by the relations between the values of various national currencies, now a frequent subject of study and of international discussion [seeInternational monetary economics, articles Onexchange ratesandinternational monetary organization].

The preceding list of the fields of economics is not complete. Among the additional fields often set apart by professional associations, specialized journals, or special courses of instruction are consumer economics, comparative economics, welfare economics, and regional economics. Space limitations preclude any discussion of these here, though they are covered elsewhere in the encyclopedia. [SeeConsumers; Capitalism; Communism, economic organization of; Economic growth; Welfare economics; Spatial economics.]

Organization and growth of the profession

Economics has grown rapidly in recent years, as measured either by the membership of professional associations or by the volume of professional literature. The American Economic Association was founded in 1885 and the Royal Economic Society (then the British Economic Association) in 1890. The former had fewer than 200 members in 1886; it passed the 2,000 mark in 1912. The largest increases, however, occurred between 1940 and 1962, during which time the American Economic Association grew from just over 3,000 members to more than 11,000. In 1959 there were about 5,000 fellows of the Royal Economic Society. As of 1964 there were 37 national economic associations affiliated with the International Economic Association, including 20 in Europe, 7 in Asia, and 6 in the Americas.

The growth of professional literature has been just as impressive. In 1961–1962 an Index of Economic Journals was published, covering only articles in English. It requires 270 pages to index the articles published in the 38 years between 1886 and 1924, and 533 pages for the 5 years between 1954 and 1959. The oldest journal covered is the Zeitschrift fur die gesamte Staatswissenschaft (Tübingen), founded in 1844. The next, the Quarterly Journal of Economics (Cambridge, Mass.), began in 1866. By 1900 there were seven—three in the United States, two in Germany, and one each in Britain and Sweden. The number of journals covered in 1961–1962 was 76, of which 29 were published in Europe, 24 in the United States and Canada, 19 in Asia, and 4 in Africa. The Index omits many more journals that publish no material in English.

Most economists are teachers in colleges and universities, although employment in business and government is increasing. Within universities most economists are in departments of economics, but in the United States there are also many on the faculties of schools of business, both graduate and undergraduate. Economists in business schools have worked closely with statisticians and applied mathematicians on problems of business decision theory and operations research.

Economists employed in business are sometimes engaged largely in descriptive statistics and public relations and have had little professional training. A growing number of business firms, however, employ economists with graduate training to do economic analysis.

Perhaps the fastest growing use of economists, almost everywhere, is in government—at all levels from municipalities to international organizations, but particularly in national governments. Economists are involved in a large number of different government functions. Many are involved in collecting and analyzing statistics and preparing statistical estimates such as national income accounts and prices indexes. Economists in central banks and treasuries or ministries of finance are engaged in formulating and executing monetary and fiscal policies. Still others in such agencies as budget bureaus or ministries of defense may be making cost–benefit analyses of public works projects or weapons systems. One of the most important roles of government economists is in central planning organizations, ranging from the very large and powerful central planning agencies of the communist countries, through the highly influential planning agencies of France and the Netherlands, to the largely advisory bodies like the Council of Economic Advisers in the United States.

An example may suggest the impact of changes in economic thought on government policy in the past three decades. In 1932, at the depths of the great depression, when the unemployment rate was over 20 per cent, the United States sharply increased the rates of a number of excise taxes and introduced several new ones in an effort to reduce the budget deficit. Shortly afterward John Maynard Keynes was to argue that such a policy would prolong a depression. In 1964 the United States reduced income taxes sharply in the face of a budget deficit because the unemployment rate of 5.7 per cent was unacceptably high, and it is probably not accidental that unemployment soon began to fall.

The contrast between these opposite policies illustrates strikingly the influence, in this instance a salutary one, of economic thought on policy. This influence is an important force drawing students into the discipline, but it also imposes on economists obligations to develop skills and judgment commensurate with their responsibilities.

Albert Rees