What is economics? How the economy works, in plain words

Economics is the study of how people, businesses and governments make choices when they can't have everything they want. Time, money, land, labor and materials are limited, so every use of them means giving up another. Economics looks at those choices one at a time, in microeconomics, and at how millions of them add up to prices, jobs, inflation and growth across a whole country, in macroeconomics.

In short

• The starting point is scarcity: wants outrun resources, so every choice has a cost, the best thing given up.
• Microeconomics studies individual people, firms and markets. Macroeconomics studies whole economies: output, unemployment, inflation and growth.
• A few ideas carry most of the weight: opportunity cost, incentives, supply and demand, gains from trade, and money.

What does economics actually study?

Economics studies choice under scarcity. The British economist Lionel Robbins put it in a definition from 1932 that most textbooks still echo: economics is "the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses." A modern textbook, OpenStax's Principles of Economics, says it more simply: the study of how humans make decisions in the face of scarcity.

Scarcity doesn't mean poverty. A billionaire still has 24 hours in a day, and a rich country still has to decide whether a hospital or a highway gets the next billion dollars. Scarcity means that wants exceed what is available, so something has to decide who gets what. In a market economy, prices do much of that deciding. In a household, a company or a government budget, people do it directly.

The subject is older than its name. Adam Smith's The Wealth of Nations, published in 1776, is usually taken as the founding text. Its most famous example is a pin factory, where splitting the work into 18 separate tasks let 10 workers make about 48,000 pins a day, far more than they could each make alone. Smith's point was that specialization and trade, not gold or conquest, make nations rich.

Microeconomics and macroeconomics: what's the difference?

The field splits into two halves that use many of the same tools at different scales.

	Microeconomics	Macroeconomics
Looks at	Individual people, households, firms and markets	The economy as a whole
Typical questions	Why did the price of eggs rise? How many workers should a café hire? What happens when a city caps rents?	Why is unemployment rising? What causes inflation? Why do some countries grow faster than others?
Key measures	Prices, quantities, costs, wages, profits	[[what-is-gdp
Main actors	Consumers and businesses	Households and firms in total, plus governments and central banks

Macroeconomics became a distinct field after the Great Depression, when mass unemployment lasted for years and older theories struggled to explain it. John Maynard Keynes's General Theory of 1936 is usually credited with founding it, as the International Monetary Fund's guide to the divide notes. The two halves connect: inflation is millions of individual prices rising at once, and a recession is millions of firms cutting back at the same time.

The ideas everything else builds on

A handful of ideas explain a surprising share of economics.

Opportunity cost. The real cost of anything is the best alternative given up. The real cost of an evening spent studying is whatever else you would have done with it, such as a film with friends. Firms and governments face the same trade.

Incentives. People respond to rewards and penalties. A tax on sugary drinks makes them dearer, and people tend to buy fewer. A subsidy does the reverse. Many policy surprises come from incentives nobody noticed.

Supply and demand. In a market, the price moves until the amount buyers want matches the amount sellers offer. When demand rises or supply falls, the price goes up, which is the core of supply and demand.

Gains from trade. Two people, or two countries, can both end up better off by specializing and trading, even when one is better at everything. The worked example below shows why.

Money and interest. Money makes trade easier than barter and lets people save and borrow across time. Interest rates are the price of borrowing it, and central banks such as the Federal Reserve adjust them to steady the economy.

A worked example: why trade helps both sides

Take two people working one day each. Ana can bake 10 loaves of bread or knit 5 scarves. Ben can bake 4 loaves or knit 4 scarves. Ana is better at both, so it might seem she has nothing to gain from Ben.

Now look at opportunity cost. For Ana, one scarf costs 2 loaves of bread she could have baked instead (10 ÷ 5). For Ben, one scarf costs only 1 loaf (4 ÷ 4). Scarves are cheaper for Ben to make, in what he gives up, so he has the comparative advantage in scarves, and Ana has it in bread.

	Bread	Scarves
Each splits the day in half: Ana 5 + 2.5, Ben 2 + 2	7 loaves	4.5 scarves
Each leans toward their comparative advantage: Ana spends 80% of her day baking (8 loaves + 1 scarf), Ben knits all day (4 scarves)	8 loaves	5 scarves

Same two people, same hours, more of both goods, just from each doing more of what costs them least to give up. If they then trade, they can share the extra. David Ricardo set out this logic in 1817 with England, Portugal, cloth and wine. It is the reason economists of almost every school favor trade in general, even while they argue over who loses from it and what to do for them.

How does a whole economy work?

At the largest scale, an economy is a loop. Households sell their work to businesses and are paid wages. They spend those wages on what businesses produce, which pays for more wages. Some income is saved, and banks and markets lend it to firms that invest in machines, buildings and ideas. Governments tax part of the income and spend it on services and transfers. Trade with other countries adds another loop.

GDP measures the total output of that loop in a year. When it grows, incomes and jobs usually grow with it. When spending drops sharply, firms cut output and jobs, and the economy can fall into a recession. When spending grows faster than the economy can produce, prices rise across the board, which is inflation. Much of macroeconomic policy, from central bank interest rates to government budgets, is an attempt to keep that loop running steadily between the two dangers.

Why do economists disagree?

Economists agree on more than the arguments on television suggest, especially on the basic tools. Disagreements come in two kinds. Positive questions ask what is: does a higher minimum wage cost jobs, and how many? Evidence can settle them, in principle, though the evidence is often messy. Normative questions ask what should be: is a given loss of jobs worth higher pay for others? Those turn on values, and economics alone can't settle them.

Still argued

Schools of thought differ most on how well markets fix themselves. Keynesian economists argue that economies can stay stuck below full employment and that government spending and central banks should step in during downturns. Monetarists, led by Milton Friedman, put more weight on steady growth of the money supply and doubted that active management helps. Austrian and other free-market economists warn that intervention distorts prices and creates the next crisis. Behavioral economists question the assumption that people choose rationally at all. Each school has had episodes that seemed to vindicate it, and most working economists today borrow from several. How capitalism should be managed, and how much, is still argued.

The rest of this topic goes deeper into each piece: how GDP is counted, what causes inflation and recessions, and what history's great crises, from the Great Depression to 2008, taught the people who run economies.

Check yourself

• Without looking back: what is opportunity cost, and why does it make trade worthwhile even for someone better at everything?
• What is the difference between a microeconomic question and a macroeconomic one? Give an example of each.
• Why can't economics alone settle a normative question?

Sources

• 1.1 What Is Economics, and Why Is It Important? — OpenStax, Principles of Economics 3e, Rice University
• 1.2 Microeconomics and Macroeconomics — OpenStax, Principles of Economics 3e, Rice University
• Micro and Macro: The Economic Divide — G. Chris Rodrigo, International Monetary Fund, Finance and Development
• An Inquiry into the Nature and Causes of the Wealth of Nations — Adam Smith, 1776, Library of Economics and Liberty
• On the Principles of Political Economy and Taxation — David Ricardo, 1817, Library of Economics and Liberty
• Opportunity Cost — Concise Encyclopedia of Economics, Library of Economics and Liberty