What Is an Economy?

What Is an Economy?

An economy is the system through which people and institutions organize the production, distribution, exchange, and consumption of goods and services.

That includes far more than buying and selling. An economy includes work, businesses, households, natural resources, technology, transportation, finance, laws, public services, and the institutions that establish and enforce the rules under which economic activity occurs.

Economies can be examined at different scales. We can study the economy of a town, a country, a region, or the world. These economies are not isolated. A product purchased locally may depend on materials, workers, financing, technology, and transportation from many countries.

At its most basic level, economics examines how people make choices and coordinate activity when the resources available to them are limited.

Scarcity and Choice

One of the starting points of economics is scarcity. Resources are limited, while there are more possible uses for those resources than can all be satisfied at the same time.

Scarcity does not necessarily mean that something is rare or that people are poor. It means that using a resource for one purpose can limit its availability for another purpose.

Land used for housing cannot simultaneously remain undeveloped open space. Money spent on one public program cannot be spent on another unless additional resources are raised. A worker who spends an hour on one task cannot spend that same hour doing something else.

Because choices must be made, choices involve tradeoffs. Choosing more of one thing may mean accepting less of something else.

Economics does not by itself determine which tradeoffs society should choose. It can help identify alternatives, costs, benefits, and likely consequences.

The Resources an Economy Uses

Producing goods and services requires resources. Economists traditionally group productive resources into several broad categories.

Three Basic Economic Questions

Every economy, regardless of how it is organized, must answer three broad questions.

How Are Economic Decisions Coordinated?

Billions of economic decisions are made every day. No single mechanism coordinates all of them. Societies use several methods at the same time.

Modern economies combine these methods. Even strongly market-oriented economies rely on governments, organizations, households, laws, and social institutions. Governments likewise operate within economies that also contain private businesses and markets.

Why Economic Institutions Matter

Economic activity depends on institutions: established rules and organizations that shape how people interact.

Property law helps determine who may use or transfer resources. Contract law provides a framework for agreements. Courts can resolve disputes. Banks and financial institutions connect savers and borrowers. Governments establish currencies, collect taxes, provide public services, and enforce many of the rules governing commerce.

Informal institutions matter as well. Trust, social expectations, professional standards, and cultural practices can influence whether people are willing to cooperate, lend, invest, hire, or trade.

The same basic resources can therefore produce different economic outcomes depending partly on the institutions through which people use them.

Households, Businesses, and Government

Introductory economics often describes an economy as a flow of resources, goods, services, and money among several major groups.

Households supply labor, purchase goods and services, save, invest, and provide substantial amounts of unpaid work and care.

Businesses combine labor, capital, natural resources, technology, and organization to produce goods and services. They pay workers and suppliers and receive revenue from customers.

Governments tax, spend, employ workers, purchase goods and services, provide public goods and programs, transfer income, and establish many of the rules under which economic activity takes place.

These groups are deeply interconnected. A person can simultaneously be a worker, consumer, taxpayer, saver, investor, business owner, and recipient of public services.

What Makes an Economy Successful?

This question has no purely technical answer because people do not always agree about what an economy should accomplish.

Possible goals include:

• Producing more goods and services
• Raising living standards
• Providing opportunities for work and entrepreneurship
• Maintaining stable prices and employment
• Reducing poverty and economic insecurity
• Providing essential public services
• Encouraging innovation
• Protecting individual economic freedom
• Limiting damaging environmental effects
• Expanding economic opportunity

Some goals can reinforce one another. Others may involve tradeoffs. Policies that promote one goal may sometimes make another harder to achieve.

Economics can provide evidence about these tradeoffs. Deciding how much importance to place on competing goals also involves social and political values.