Download What is the economy/economics ?

I N F O R M AT I O N S H E E T S
What is the economy/economics ?
1
Every trade has its own jargon, every specialism has its basic concepts. That also applies
to the sometimes very rarefied world of central banks. Yet even the everyday press
refers to GDP, interest rates, growth, inflation, etc. The assumption is that all these
terms are understood, but are we always sure what they mean ?
We shall clarify some of them here.
The management of
scarce resources, or all the
human behaviour connected
with the production,
distribution and consumption
of goods and services ?
“Economy” frequently refers to just one particular
aspect of human behaviour, namely the attempt to
make optimum use of scarce resources to satisfy
needs which, by contrast, are numerous and
unlimited.
Economics is the study of how society manages
its scarce resources (1).
However, there is no consensus on the definition
of economic science. For example, it could be
defined in the broader sense as the study of
all behaviour connected with the production,
distribution and consumption of goods and
services. But such a definition is all-embracing,
covering all human activities requiring not only
economic choices, but also political or ethical
ones. However, it has the merit of demonstrating
the interdependence of human behaviour and the
difficulty of defining precisely the respective areas
covered by the various social sciences (economics,
sociology, political science, psychology, etc.). The
difficulty of specifying the limits of the analysis
while recognising the interdependences is inherent
in all human sciences.
The term “economics” comes from the Greek
word which means “relating to household
management”. There are many similarities
between the economy and a household.
Managing a household means allocating domestic
duties, taking decisions on expenditure, making
choices : if I buy a car, I shall not be able to go
on holiday. The same issues arise in managing
the economy : what types of goods or services to
produce, how to allocate the available resources,
such as labour, land or certain facilities among
the various types of production desired ? Who
will decide on that production and for what
consumption purposes ? How will incomes be
distributed ? Will the money be spent – and on
what – or saved – and why ?
The answer to these questions implies choices,
which are all the more necessary where the
resources (land, commodities, working time,
machines, etc.) are limited. By studying scarcity
and the choices which it imposes, economics
also takes part in the debate on the distribution
of wealth and sustainable development. The
economy thus represents a social and political
issue. These choices may be studied at the level
of consumers, firms or the economy as a whole.
(1) Principles of Economics, N. Gregory Mankiw, Economica,
September 2004. In French, the word “économie” is used to denote
both the science of economics and the economy itself.
© National Bank of Belgium, 1 September 2014
All rights reserved. Reproduction of all or part of this publication for
educational and non-commercial purposes is permitted provided that
the source is acknowledged.
Microeconomics and macroeconomics
Microeconomics is the study of individual
behaviour, particularly that of consumers, producers
or the owners of resources, and the analysis of
their interaction. Macroeconomics examines the
economy as a whole, by trying to understand
the links between the various aggregates such as
income, employment, investment and savings.
It is impossible to grasp and comprehend the reality
in all its complexity. In Belgium, there are several
million consumers and almost 600 000 enterprises
active in hundreds of different markets, some
of them concerning exports. It is impossible
to understand the behaviour of each of these
economic agents. So how can we measure the
impact of an economic decision or compare two
actions in terms of the costs and benefits for the
economy as a whole ?
In an attempt to do that, microeconomics has to
put forward a number of hypotheses and reduce
the reality to a few types of reference behaviour.
Neo-classical microeconomics proposes an
approach – and this is a first important hypothesis –
in which human behaviour is considered to be
rational. People are therefore guided primarily
by reason and not by feelings, passions or other
external influences. Another important hypothesis
is that each individual is assumed to have complete
and immediate information. It is because they are
perfectly informed that consumers and producers
can take the most rational decisions, which
conform most closely to their objective economic
interests. Finally, individuals are independent and
no-one can impose his decisions on anyone else :
there is “perfect competition”.
These hypotheses lead to the construction of
fairly simple models which aim to simulate certain
economic behaviour : how does consumer demand
for a product vary ? How does a firm’s supply
respond ? How are prices fixed ? In this theoretical
environment, all the economic agents will want
to maximise their objectives while being subject
to certain constraints. The firm will want to
maximise its profit, while being limited by technical
constraints and costs. The consumer will try to
maximise his preferences within the constraints
of his income. It is the market, the place where
consumers and producers meet, that will determine
the quantities traded and the prices.
Macroeconomics considers the possible
interactions between larger units. A country’s
gross domestic product, unemployment, exports
or imports are known as macroeconomic data.
They tell us nothing about a particular firm or
household, but they do tell us about the state
of the economy as a whole and the interactions
between its main components. Some of these
concepts are presented on subsequent pages.
Macroeconomics as founded by the economist
J. M. Keynes (°1883 – †1946), tries to
answer questions such as : why do we have
unemployment ? Why do prices rise ? Why do
output and employment increase in some years
and not in others ? How do incomes vary and how
are they distributed ?
Since what happens to the national economy
depends on the behaviour of millions of
individuals, it is not possible to understand
macroeconomic developments without looking
at the underlying microeconomic decisions.
Economists today devise syntheses and
macroeconomic models based on microeconomic
foundations, by modifying some of the classical
microeconomic hypotheses (e.g. by taking account
of market “imperfections” : market power
exercised by large firms and unions, asymmetric
information, etc.) and by going beyond the
mechanical links of Keynesian macroeconomics
(e.g. by taking account of the expectations of
economic agents).
Economic policies
In economic life, the government is not the same as
other stakeholders : it can exert a decisive influence
on the economy via its legislation and transactions.
First, it is the government that decides the rules,
e.g. via contract law, company law, competition
rules, etc.
The government also plays an economic role via
its transactions : it supplements the market by
supplying public services, for example in the form
of infrastructure, education, health care, money,
etc.
The government also arranges the redistribution of
income (taxes, social security, etc.).
Finally, it influences overall demand either by
adjusting the quantity of money in circulation,
interest rates and exchange rates (monetary policy),
or by decisions on the amount of public revenue
and expenditure, and hence the movement in the
public debt ratio : this is fiscal policy.
The science of economics also analyses the
action of the government and is used to make
recommendations on economic policy. It provides
possible answers to numerous questions facing
the government : what are the consequences of
protecting national producers (“protectionism”) by
high rates of customs duty ? How do various forms
of taxation modify behaviour ? What price should
be charged for public services ? What incentives can
reduce pollution at the lowest cost ? What are the
consequences of various labour regulations ? What
is the most appropriate fiscal policy in a particular
environment ?
Is economics a science ?
Economists try to apply a scientific method. As in
the case of physics, they aim to :
– observe reality while not judging by appearances ;
– construct coherent theories, increasingly
resorting to mathematics ;
– measure the validity of these theories by
comparing them with the facts.
However, there are some important differences
between physics and economics :
– the economy, as the outcome of millions
of decisions, is extremely complex so that
economics is more like meteorology, and it is
difficult if not pointless to create laboratory
conditions or reproducible experiments ;
– economic science analyses the behaviour of
subjects, innovative players, so that the patterns
observed in the past are always conditioned by
their historical context, and are liable to change ;
– economic science itself modifies its research
subject, because the economic views of the
stakeholders affect their behaviour.
These characteristics, a feature of all human
sciences, explain the persistence of competing
theories.
Hypotheses and models
To define a complex reality, scientific reasoning
establishes hypotheses which simplify reality
and make it easier to understand. For example,
the analysis of consumer behaviour cannot take
account of everything that may influence the
consumer’s decisions, or all the choices confronting
him. The analysis is therefore simplified by studying
consumer demand for a particular product in
the light of variations in its price. To identify this
link, it is necessary to establish hypotheses : the
consumer’s income remains constant or his tastes
do not change. These hypotheses make it possible
to isolate the link between the two variables (the
quantity of demand for a product and the variation
in its price) and limit the analysis, in this case the
study of demand for a product, to make it possible
to measure how demand for the product changes
as its price varies.
The models are often expressed in the form of
diagrams or equations. On the basis of a number
of hypotheses, they make it possible to show up
the links between two or more variables. Of course,
these hypotheses will attract criticism, and the
models that they help to build will be compared
with reality. If their ability to explain a situation is
not satisfactory, the hypotheses will be modified
and other links will be established in order to
improve the theory, to introduce new concepts or
to construct a new model. It is unusual for a theory
or analysis to be entirely good or entirely bad. Each
one succeeds in explaining certain situations and
can always be improved. That work is the essence
of scientific thought.