Economics

I INTRODUCTION

Economics, social science concerned with the production, distribution, exchange, and
consumption of goods and services. Economists focus on the way in which individuals, groups,
business enterprises, and governments seek to achieve efficiently any economic objective they
select. Other fields of study also contribute to this knowledge: Psychology and ethics try to explain
how objectives are formed; history records changes in human objectives; sociology interprets
human behavior in social contexts.

Standard economics can be divided into two major fields. The first, price theory or
microeconomics, explains how the interplay of supply and demand in competitive markets creates
a multitude of individual prices, wage rates, profit margins, and rental changes. Microeconomics
assumes that people behave rationally. Consumers try to spend their income in ways that give them
as much pleasure as possible. As economists say, they maximize utility. For their part,
entrepreneurs (see Entrepreneur) seek as much profit as they can extract from their operations.

The second field, macroeconomics, deals with modern explanations of national income and
employment. Macroeconomics dates from the book, The General Theory of Employment, Interest,
and Money (1935), by the British economist John Maynard Keynes. His explanation of prosperity
and depression centers on the total or aggregate demand for goods and services by consumers,
business investors, and governments. Because, according to Keynes, inadequate aggregate demand
increases unemployment, the indicated cure is either more investment by businesses or more
spending and consequently larger budget deficits by government.

II HISTORY OF ECONOMIC THOUGHT

Economic issues have occupied people's minds throughout the ages. Aristotle and Plato in ancient
Greece wrote about problems of wealth, property, and trade. Both were prejudiced against
commerce, feeling that to live by trade was undesirable. The Romans borrowed their economic
ideas from the Greeks and showed the same contempt for trade. During the Middle Ages the
economic ideas of the Roman Catholic church were expressed in the canon law, which condemned
usury (the taking of interest for money loaned) and regarded commerce as inferior to agriculture.

Economics as a subject of modern study, distinguishable from moral philosophy and politics, dates
from the work, Inquiry into the Nature and Causes of the Wealth of Nations (1776), by the Scottish
philosopher and economist Adam Smith. Mercantilism and physiocracy were precursors of the
classical economics of Smith and his 19th-century successors.

A Mercantilism
The development of modern nationalism during the 16th century shifted attention to the problem
of increasing the wealth and power of the various nation-states. The economic policy of the leaders
of that time, known as mercantilism, sought to encourage national self-sufficiency. The heyday of
the mercantilist school in England and western Europe occurred during the 16th through the early
18th centuries.

Mercantilists valued gold and silver as an index of national power. Without the gold and silver
mines in the New World from which Spain drew its riches, a nation could accumulate these
precious metals only by selling more merchandise to foreigners than it bought from them. This
favorable balance of trade necessarily compelled foreigners to cover their deficits by shipping gold
and silver.

Mercantilists took for granted that their own country was either at war with its neighbors,
recovering from a recent conflict, or getting ready to plunge into a new war. With gold and silver,
a ruler could hire mercenaries to fight, a practice followed by King George III of the United
Kingdom of Great Britain when he used Hessian troops during the American Revolution. As
needed, the monarch could also buy weapons, uniforms, and food to supply the soldiers and sailors.

Mercantilist preoccupation with precious metals also inspired several domestic policies. It was
vital for a nation to keep wages low and the population large and growing. A large, ill-paid
population produced more goods to be sold at low prices to foreigners. Ordinary men and women
were encouraged to work hard and avoid such extravagances as tea, gin, ribbons, ruffles, and silks.
It also followed that the earlier that children began to work, the better it was for their country's
prosperity. One mercantilist writer had a plan for children of the poor: “When these children are
four years old, they shall be sent to the county workhouse and there taught to read two hours a day
and be kept fully employed the rest of the time in any of the manufactures of the house which best
suits their age, strength, and capacity.”

B Physiocracy

Physiocracy was briefly in vogue in France during the second half of the 18th century as a reaction
against the narrow and restrictive policies of mercantilism. The founder of the school, François
Quesnay, was a physician at the royal court of King Louis XV. His major work, the Tableau
économique, an attempt to trace income flows through the economy, crudely anticipated 20th-
century national income accounting. All wealth, in the doctrine of the physiocrats, originates in
agriculture; through trade, wealth is distributed from farmers to other groups. The physiocrats were
partisans of free trade and laissez-faire. They maintained that the revenue of the state should be
raised by a single direct tax levied on the land. Adam Smith met the leading physiocrats and
wrote—for the most part, favorably—of their doctrines.

C The Classical School

As a coherent economic theory, classical economics starts with Smith, continues with the British
economists Thomas Robert Malthus and David Ricardo, and culminates in the synthesis of John
Stuart Mill, who as a young man was a follower of Ricardo. Although differences of opinion were
numerous among the classical economists in the three-quarters of a century between Smith's
Wealth of Nations and Mill's Principles of Political Economy (1848), members of the group agreed
on major principles. All believed in private property, free markets, and, in Mill's words, that “only
through the principle of competition has political economy any pretension to the character of a
science.” They shared Smith's strong suspicion of government and his ardent confidence in the
power of self-interest represented by his famous “invisible hand,” which reconciled public benefit
with individual pursuit of private gain. From Ricardo, classicists derived the notion of diminishing
returns, which held that as more labor and capital were applied to land, yields after “a certain and
not very advanced stage in the progress of agriculture steadily diminished.”

Through Smith's emphasis on consumption, rather than on production, the scope of economics was
considerably broadened. Smith was optimistic about the chances of improving general standards
of life. He called attention to the importance of permitting individuals to follow their self-interest
as a means of promoting national prosperity.

Malthus, on the other hand, in his enormously influential book An Essay on the Principle of
Population (1798), imparted a tone of gloom to classical economics, arguing that hopes for
prosperity were fated to founder on the rock of excessive population growth. Food, he believed,
would increase in arithmetic ratio (2-4-6-8-10 and so on), but population tended to double in each
generation (2-4-8-16-32 and so on) unless that doubling was checked either by nature or human
prudence. According to Malthus, nature's check was “positive”: “The power of population is so
superior to the power of the earth to produce subsistence for man, that premature death must in
some shape or other visit the human race.” The shapes it took included war, epidemics, pestilence
and plague, human vices, and famine, all combining to level the world's population with the world's
food supply.

The only escape from population pressure and the horrors of the positive check was in voluntary
limitation of population, not by contraception, rejected on religious grounds by Malthus, but by
late marriage and, consequently, smaller families. These pessimistic doctrines of classical
economists earned for economics the epithet of the “dismal science.”

Mill's Principles of Political Economy was the leading text on the subject until the end of the 19th
century. Although Mill accepted the major theories of his classical predecessors, he held out more
hope than did Ricardo and Malthus that the working class could be educated into rational limitation
of their own numbers. Mill was also a reformer who was quite willing to tax inheritances heavily
and even to allow government a larger role in protecting children and workers. He was far more
critical than other classical economists of business behavior and favored worker ownership of
factories. Mill thus represents a bridge between classical laissez-faire economics and an emerging
welfare state.
The classical economists also accepted Say's Law of Markets, the doctrine of the French economist
Jean Baptiste Say. Say's law holds that the danger of general unemployment or “glut” in a
competitive economy is negligible because supply tends to create its own matching demand up to
the limit of human labor and the natural resources available for production. Each enlargement of
output adds to the wages and other incomes that constitute the funds needed to purchase added
output.

D Marxism

Opposition to the classical school of economics came first from early socialist writers such as the
French social philosopher the comte de Saint-Simon and the British reformer Robert Owen. It was
Karl Marx, however, who provided the most important social theories.

To the classical vision of capitalism, Marxism was in large measure a sharp rebuttal, but to some
extent it embodied variations of classical themes. Marx adopted, for example, a version of
Ricardo's labor theory of value. With a few qualifications, Ricardo had explained prices as the
result of the different quantities of human labor needed to produce different finished products.
Accordingly, if a shirt is priced at $12 and a pair of socks at $2, it is because six times as many
hours of human labor entered into the making of the shirt as the socks. For Ricardo, this theory of
value was an analytical convenience, a way of making sense of the multitude of different prices in
shops. For Marx, the labor theory was a clue to the inner workings of capitalism, the master key
to the inequities and exploitation of an unjust system.

An exile from Germany, Marx spent most of his mature years in London, supported by his friend
and collaborator, the German revolutionist Friedrich Engels, and by the proceeds from occasional
contributions to newspapers. He conducted his extensive research in the reading room of the
British Museum. Marx's historical studies convinced him that profit and other property income are
the proceeds from force and fraud inflicted by the strong on the weak.

“Primitive accumulation” in English economic history was epitomized by the record of land
enclosure. In the 17th and 18th centuries, landowners used their control of Parliament to rob their
tenants of traditional rights to common lands. Taking these lands for their own use, they drove
their victims reluctantly into cities and factories.

Deprived both of tools and land, British men, women, and children had to work for wages. Thus,
Marx's central conflict was between so-called capitalists who owned the means of production—
factories and machines—and workers or proletarians who possessed nothing but their bare hands.
Exploitation, the heart of Marxist doctrine, is measured by the capacity of capitalists to pay no
more than subsistence wages to their employees and extract for themselves as profit (or surplus
value) the difference between these wages and the selling price of market commodities.

Although in the Communist Manifesto (1848) Marx and Engels paid grudging tribute to the
material achievements of capitalism, they were convinced that these were transitory and that the
internal contradictions within capitalism would as surely terminate its existence as earlier in history
feudalism had faltered and disappeared.

On this point Marx wrote not in the tradition of English classical economics but rather out of his
training in the metaphysics of the German philosopher Georg Wilhelm Friedrich Hegel. Hegel
interpreted the movement of human history and thought as a progression of triads: thesis, antithesis,
and synthesis. For example, a thesis might be a set of economic arrangements such as feudalism
or capitalism. Its opposite or antithesis was, say, socialism as opposed to capitalism. The clash
between thesis and antithesis evolved into the higher stage of synthesis—in this case communism,
which unites capitalist technology with social public ownership of factories and farms.

In the long run, Marx believed that capitalism was certain to falter because its tendency to
concentrate income and wealth in ever fewer hands created more and more severe crises of excess
output and rising unemployment. For Marx, capitalism's fatal contradiction was between
improving technological efficiency and the lack of purchasing power to buy what was produced
in ever larger quantities.

According to Marx, the crises of capitalism were certain to manifest themselves in falling rates of
profit, mounting hostility between workers and employers, and ever more severe depressions. The
outcome of class warfare was fated to be revolution and progress toward, first, socialism and
ultimately communism. In the first stage a strong state would still be required in order to eliminate
the remnants of capitalist opposition. Each person's work would be rewarded according to the
value of his or her contribution. Once communism was achieved, the state, whose central purpose
was class domination, would wither away, and each individual would in the utopian future be
compensated according to need. See Communism; Socialism.

E The Neoclassicists

Classical economics proceeded from the assumption of scarcity, such as the law of diminishing
returns and Malthusian population doctrine. Dating from the 1870s, neoclassicist economists such
as William Stanley Jevons in Britain, Léon Walras in France, and Karl Menger in Austria shifted
emphasis from limitations on supply to interpretations of consumer choice in psychological terms.
Concentrating on the utility or satisfaction rendered by the last or marginal unit purchased,
neoclassicists explained market prices not by reference to the differing quantities of human labor
needed to produce assorted items, as in the theories of Ricardo and Marx, but rather according to
the intensity of consumer preference for one more unit of any given commodity.

The British economist Alfred Marshall, particularly in his masterly neoclassicist work Principles
of Economics (1890), explained demand by the principle of marginal utility, and supply by the rule
of marginal productivity (the cost of producing the last item of a given quantity). In competitive
markets, consumer preferences for low prices of goods and seller preferences for high prices were
adjusted to some mutually agreeable level. At any actual price, then, buyers were willing to
purchase precisely the quantity of goods that sellers were prepared to offer.
As in markets for consumer goods, this same reconciliation between supply and demand occurred
in markets for money and human labor. In money markets, the interest rate matched borrowers
with lenders. The borrowers expected to use their loans to earn profits larger than the interest they
had to pay. Savers, for their part, demanded a price for postponing the enjoyment of their own
money. A similar accommodation had to be made in wages paid for human labor. In competitive
labor markets, wages actually paid represented at least the value to the employer of the output
attributed to hours worked and at least acceptable compensation to the employee for the tedium
and fatigue of the work.

By implication, if not direct statement, the tendency of neoclassical doctrine has been politically
conservative. Its advocates distinctly prefer competitive markets to government intervention and,
at least until the Great Depression of the 1930s, insisted that the best public policies were echoes
of Adam Smith: low taxes, thrift in public spending, and annually balanced budgets. Neoclassicists
do not inquire into the origins of wealth. They explain disparities in income as well as wealth for
the most part by parallel differences among human beings in talent, intelligence, energy, and
ambition. Hence, men and women succeed or fail because of their individual attributes, not because
they are either beneficiaries of special advantage or victims of special handicaps. In capitalist
societies, neoclassical economics is the generally accepted textbook explanation of price and
income determination.

F Keynesian Economics

John Maynard Keynes was a student of Alfred Marshall and an exponent of neoclassical
economics until the 1930s. The Great Depression bewildered economists and politicians alike. The
economists continued to hold, against mounting evidence to the contrary, that time and nature
would restore prosperity if government refrained from manipulating the economy. Unfortunately,
approved remedies simply did not work. In the U.S., Franklin D. Roosevelt's 1932 landslide
presidential victory over Herbert Hoover attested to the political bankruptcy of laissez-faire
policies.

New explanations and fresh policies were urgently required; this was precisely what Keynes
supplied. In his enduring work The General Theory of Employment, Interest, and Money, the
central message translates into two powerful propositions. (1) Existing explanations of
unemployment he declared to be nonsense: Neither high prices nor high wages could explain
persistent depression and mass unemployment. (2) Instead, he proposed an alternative explanation
of these phenomena focused on what he termed aggregate demand—that is, the total spending of
consumers, business investors, and governmental bodies. When aggregate demand is low, he
theorized, sales and jobs suffer; when it is high, all is well and prosperous.

From these generalities flowed a powerful and comprehensive view of economic behavior—the
basis of contemporary macroeconomics. Because consumers were limited in the amounts that they
could spend by the size of their incomes, they could not be the source of the ups and downs of the
business cycle. It followed that the dynamic forces were business investors and governments. In a
recession or depression, the proper thing to do was either to enlarge private investment or create
public substitutes for the shortfalls in private investment. In mild economic contractions, easy
credit and low interest rates (monetary policy) might stimulate business investments and restore
aggregate demand to a figure consistent with full employment. More severe contractions required
the sterner remedy of deliberate budget deficits either in the form of spending on public works or
subsidies to afflicted groups.

G Mathematical Economics

Both neoclassical price theory and Keynesian income theory have been illustrated by the
mathematics of calculus, linear algebra, and other sophisticated techniques. The most powerful
and popular—if not necessarily the most successful—alliance of economics with mathematics and
statistics occurs in the specialty called econometrics. Econometricians are model builders who link
together hundreds or even thousands of equations that purport to explain the behavior of an entire
economy. As forecasting tools, econometric models generally are used by both corporations and
government departments, although their record of accuracy is neither better nor worse than that of
alternative ways of looking into the future.

Operations research and input-output analysis are two additional specialties in which economic
analysis and higher mathematics operate in tandem. Operations research stresses a systems
approach to problems. Typical puzzles involve coordinating the functions of a multiple-plant
corporation, fabricating many products, and using equipment so as to minimize costs and
maximize efficiency. Researchers make use of the expertise of engineers, economists, industrial
psychologists, statisticians, and mathematicians.

In the words of its inventor, the Russian American economist Wassily Leontief, input-output
analysis tables “describe the flow of goods and services between all the individual sectors of a
national economy over a stated period of time.” Although constructing such a table is a challenge,
this method has had a major impact on economic thinking. It is now widely used in socialist as
well as capitalist countries.

III ECONOMIC SYSTEMS

All organized communities mix, in various proportions, market activity and government
intervention. Private markets themselves differ widely in the degree of competition under which
they operate, all the way from single-firm monopolies to the fierce rivalry among hundreds of
retailers. Much the same point applies to government intervention, which ranges from mild and
comparatively uncoercive manipulation of tax, credit, contract, and subsidy policies through
mandatory controls over wages and prices to the detailed central planning of Communist countries.

Even those societies most completely committed to central planning, however, grudgingly modify
official ideology by some concessions to private enterprise. For example, the USSR allowed its
farmers, although organized in collective enterprises, to market crops grown on their own small
plots. During the Communist period in Poland, most farming was in the hands of individual owners.
The former Yugoslavia experimented in worker management of factories during its Communist
period.

Similar variation exists among capitalist economies. In most of them, the government owns and
operates railroads and airlines. Even where outright government ownership or operation is
exceptional, as in Japan, the central government exerts tremendous influence over economic
activity. The United States, the most devoted of major capitalist economies to free enterprise, has
nevertheless rescued faltering corporations such as Lockheed and Chrysler and has, for all practical
purposes, converted a number of major defense contractors into federal subsidiaries. Many
American economists have come to accept the concept of a “mixed economy,” combining private
initiative with some government control.

A Free Enterprise

The major differences between Communist and American economic organization concern
ownership of factories, farms, and other enterprises, as well as contrasting principles of pricing
and income distribution. In the U.S. two-thirds of the nation's gross national product (GNP) is
directly generated by profit-making business enterprises, farmers, and such voluntary
nongovernmental entities as private universities, hospitals, cooperatives, and foundations. Of the
remaining one-third of the GNP, which is generated by the government, more than half represents
transfers from taxpayers to old-age pensioners, veterans, welfare recipients, and other groups of
beneficiaries. See Gross National Product.

In recent years in the U.S., the federal government has begun to deregulate industries such as air
transportation and thus to diminish its influence over prices and the provision of services. Indeed,
the most important price controlled by public influence is the price of money—that is, the rate of
interest.

Although American opposition to both controls and national planning is strong, the U.S.
government has repeatedly resorted to these measures in times of emergency, such as during World
War II and the Korean War. In general, however, free-enterprise economies consider state
ownership of productive facilities and government interference in price setting as deplorable
exceptions to the rule of private ownership and price determination through the mediation of
competitive markets.

B Central Planning

Precisely the reverse attitude toward economic central planning is the case in China and certain
other Communist countries. Although small private enterprises are increasingly being tolerated,
and no centrally planned economy has been able to function without some reliance on private
ownership of agricultural land, the dominant ideology favors state planning over competitive price
setting, and public ownership of factories, farms, and large retail establishments.
Strictly speaking, there is no reason why a democratic community could not freely choose to plan
production, prices, and the distribution of income and wealth. In contemporary experience,
however, central economic planning has generally run parallel to Communist Party control of
political life. Nonetheless, important differences exist in the strictness of these constraints in
different Communist countries and even within the same country at different times. It is also true
that capitalism has frequently been accompanied by repressive government, as for example in
Chile and Brazil.

The gravest problems of capitalism are unemployment, inflation, and economic injustice. Parallel
problems in centrally planned economies include underemployment, rationing, bureaucracy, and
scarcity of many consumer items.

C Liberal Socialist Economies

Falling somewhere between societies that emphasize either central planning or free enterprise are
those that practice social democracy or liberal socialism. Examples of social democracy are the
Scandinavian countries, Sweden in particular. Sweden organizes the bulk of productive activity
under private ownership but regulates this activity closely, intervenes to protect the jobs of workers,
and redistributes substantial portions of profits and large individual incomes to low-income groups.

On the other hand, the former Yugoslavia from the 1950s through the 1980s supplied an example
of a liberal socialist society. Although the Communist Party dominated, censorship was mild,
emigration was easy, religion was freely exercised, and a unique mixture of state ownership,
worker management, and private enterprise combined to operate a comparatively prosperous
economy.

IV CURRENT ECONOMIC PROBLEMS

Between 1945 and 1973, the economies of the industrialized nations of Western Europe, Japan,
and the U.S. grew fast enough to vastly improve living standards for their residents. A similarly
favorable growth was registered by some, but far from all, of the developing or industrializing
nations, in particular such thriving Southeast Asian economies as Taiwan, Hong Kong, Singapore,
and South Korea. Clearly several circumstances contributed to this almost unique historical
performance. After the devastation of World War II, a substantial rebuilding boom, combined with
lavish flows of aid from the U.S., generated rapid growth in Western Europe and Japan. American
multinational corporations invested heavily in the rest of the world. Perhaps most important of all,
energy was plentiful and cheap.

A Energy Problems

By 1973, increasing international demand made oil a scarce and valuable commodity. At that time
the Organization of Petroleum Exporting Countries (OPEC), which controls the bulk of the world's
oil reserves, seized the opportunity to sharply raise prices. OPEC's policies dramatically reduced
the possibilities of rapid economic growth both in the industrialized countries and in those
developing nations without oil of their own. Oil, which in the autumn of 1973 cost $2 per barrel,
sold in mid-1981 at nearly 20 times that figure. For rich countries, their oil import bill was the
equivalent of a tremendous annual transfer of claims on their output and wealth to OPEC suppliers.
Third World importers borrowed enormous sums, mostly from major banks in Western Europe
and the United States. Staggering under the interest payments, poor nations have been compelled
to slow the pace of their development plans. Although the sharp oil price decline in the mid- and
late 1980s greatly benefited consumers in oil-importing nations, it added immensely to the burdens
of oil exporters such as Mexico, Nigeria, Venezuela, and Indonesia, as well as the United States
Sun Belt.

B Inflation and Recession

Some advanced economies, notably Japan and West Germany (now part of the united Federal
Republic of Germany), fared better than others during the 1970s and '80s. All of them, however,
confronted persistent combinations of high inflation, severe unemployment, and sluggish
economic growth. OPEC's transformation of the world energy market increased inflation by
raising not only gasoline and home-heating fuel charges but also the prices of all the important
manufactures into which petroleum enters, among them chemical fertilizers, plastics, synthetic
fibers, and pharmaceutical products. These higher prices reduce purchasing power in much the
same manner as would a severe new tax. Reduced purchasing power in turn depresses sales of
consumer items, resulting in layoffs of factory and sales personnel. The entire procedure has a
spiraling effect in all sectors of the economy.

For Americans, the lower oil prices of the mid- and late 1980s tend to restrain inflation and, like a
cut in taxes, leave more income available for other purchases. Experts believe, however, that the
crisis is likely to reappear in the 1990s, particularly if conservation efforts and development of
energy alternatives continued to lag. See Inflation and Deflation.

C The Role of Government

The various economic problems of recent years have stimulated serious debate about the proper
role of public policy. Parties on the political left in Europe have advocated more controls and more
planning. In the 1980s a different solution was offered by the Conservative Party government of
Prime Minister Margaret Thatcher in the United Kingdom and by the Republican administration
of President Ronald Reagan in the U.S. In both countries, attempts were made to diminish taxation
and government regulation on private enterprise and thus, by enlarging the potential profits of
corporations, encourage additional investment, higher productivity, and renewed economic growth.
These were the central elements of supply-side economics, the guiding doctrine of the two leaders.
Implicit in this government decision to provide businesses with increased incentives to invest, take
risks, and work harder were the hopes that technology would reduce the costs of alternatives to oil
as an energy source and that the nonenergy sectors of the economy, such as data processing and
scientific agriculture, would experience rapid growth as a result of encouragements to invention
and innovation.

D Underdeveloped Economies

Poor nations desperately need aid from the rich nations in the form of capital and of technological
and organizational expertise. They also need easy access to the markets of the industrialized
nations for their manufactures and raw materials. However, the political capacity of rich nations
to respond to these needs depends greatly on their own success in coping with inflation,
unemployment, and lagging growth rates. In democratic communities, it is exceedingly difficult
to generate public support for assistance to foreign countries when average wage earners are
themselves under serious financial pressure. It is no easier politically to permit cheap foreign
merchandise and materials to freely enter American and European markets when they are viewed
as the cause of unemployment among domestic workers.

E Outlook for the Future

By the early 1990s, the dissolution of the Soviet Union, coupled with the fall of Communist
governments in most of Eastern Europe, underlined the trend away from centrally planned
economies and toward a freer market system. Seeking to overcome a legacy of inefficiency and
mismanagement, the post-Communist nations found themselves competing with Third World
countries for investment capital and technological assistance.

Opinions differ as to how long sustained economic growth can continue. Optimists pin their hopes
on the ability to improve crop yields and enhance industrial productivity through technological
innovation. Pessimists point to diminishing resources, unchecked population growth, excessive
military spending, and the reluctance of rich countries to share their wealth and expertise with less
fortunate nations. Government instability, endemic corruption, and wide swings in economic
policy make the Third World's economic prospects seem even less auspicious in the 1990s.

Reference: Microsoft Encarta