- What Is This Thing Called the Economy?
- The economy is the sum total of all the economic activity within a given region, from a single city to a whole country to the entire world. The economy can be a difficult thing to get your mind wrapped around because it is so complex, constantly in motion, a subject of heated dispute, and at times hard to see even though it’s everywhere around us. People who devote their lives to studying it can have a hard time agreeing on how the economy works, when it might be “broken,” or how to fix it if it is broken. However, business leaders need to understand and pay attention to some key principles.
Economics is the study of how a society uses its scarce resources to produce and distribute goods and services. Economics is roughly divided into a small-scale perspective and a large-scale perspective. The study of economic behavior among consumers, businesses, and industries that collectively determine the quantity of goods and services demanded and supplied at different prices is termed microeconomics. The study of a country’s larger economic issues, such as how firms compete, the effect of government policies, and how an economy maintains and allocates its scarce resources, is termed macroeconomics.
Although microeconomics looks at the small picture and macroeconomics looks at the big picture, understanding the economy at either scale requires an understanding of
- how the small and large forces interact. For instance, numerous macro forces and policies determine whether homeowners can afford to install solar energy systems. In turn, the aggregate behavior of all those homeowners at the micro level affects the vitality and direction of the overall economy.
FACTORS OF PRODUCTION
Each society must decide how to use its economic resources, or factors of production . Natural resources are things that are useful in their natural state, such as land, forests, minerals, and water. Human resources are people and their individual talents and capacities. Capital includes money, machines, tools, and buildings that a business needs in order to produce goods and services. Entrepreneurship is the spirit of innovation, the initiative, and the willingness to take the risks involved in creating and operating businesses. Knowledge is the collective intelligence of an organization. Knowledge workers, employees whose primary contribution is the acquisition and application of business knowledge, are a key economic resource for businesses in today’s economy.
Traditionally, a business or a country was considered to have an advantage if its location offered plentiful supplies of natural resources, human resources, capital, and entre-preneurs. In today’s global marketplace, however, intellectual assets are often the key.
Companies can easily obtain capital from one part of the world, purchase supplies from another, and locate production facilities in still another. They can relocate some of their operations to wherever they find a steady supply of affordable workers, or they can assemble virtual teams of knowledge workers from anywhere on the planet. Chapter 3 discusses this issue of economic globalization in more detail.
THE SCARCITY
The impact of scarcity, meaning that a given resource has a finite supply, is fundamental to understanding economics? Looking back over the factors of production, you can see that the supply of all these resources is limited. Even entrepreneurial energy is limited in the sense that there are only so many entrepreneurs in the economy, and each entrepreneur can accomplish only so much during a given time span.
Scarcity has two powerful effects: It creates competition for resources, and it forces trade-offs on the part of every participant in the economy. First, at every stage of economic activity, people and organizations compete for the resources they need. Businesses and industries compete with each other for materials, employees, and customers. As a consumer, you compete with other consumers. If you were the only person in town who needed a loaf of bread, you would have tremendous power over the bakeries and grocery stores as the only customer. However. because you compete with thousands of other consumers for a limited supplv of bread. vou have far less control over the bread marker.
Second, this universal scarcity of resources means that consumers, companies, and governments are constantly forced to make trade-offs, having to give up one thing to get something else. You have to decide how to spend the 24 hours you have every day, and every choice involves a trade-off: The more time you spend on one activity means less time for every other activity you could possibly pursue. Businesses must make similar trade-offs, such as deciding how much money to spend on advertising a new product versus how much to spend on the materials used to make it, or deciding how many .. employees to have in sales versus in customer support. Just like you, businesses never have enough time, money, and other resources to accomplish what they’d like to, so success in life and in business is largely a matter of making smart trade-offs.
By the way, economists have a name for the most-attractive option not selected when making a trade-off. Opportunity cost refers to the value of the most appealing alternative from all those that weren’t chosen? In other words, opportunity cost is a way to measure the value of what you gave up when you pursued a different opportunity.
ECONOMIC SYSTEMS
The roles that individuals, businesses, and the government play in allocating a society’s resources depend on the society’s economic system, the basic set of rules for allocating resources to satisfy its citizens’ needs (see Exhibit 2.2 on the next page). Economic systems are generally categorized as either free-market systems or planned systems, although these are really theoretical extremes; every economy combines aspects of both approaches.
FREE-MARKET SYSTEMS
In a free-market system, individuals and companies are largely free to decide what products to produce, how to produce them, whom to sell them to, and at what price to sell them. In other words, they have the chance to succeed-or fail—by their own efforts.
Capitalism and private enterprise are the terms most often used to describe the free-market system, one in which private parties (individuals, partnerships, or corporations) own and operate the majority of businesses and where competition, supply, and demand determine which goods and services are produced.
In practice, however, no economy is truly “free” in the sense that anyone can do what-
Unit ever he or she wants to do. Local, state, national, and even international governments such for t as the European Union intervene in the economy to accomplish goals that leaders deem
More socially or economically desirable. This practice of limited intervention is characteristic of
a mixed economy or mixed capitalism, which is the economic
PLANNED SYSTEMS:
Economic system in which the government controls most of i he factors of production and regulates their allocation.
In a planned system, governments largely control the allocation of resources and limit freedom of choice in order to accomplish government goals. Because social equality is a major goal of planned systems, private enterprise and the pursuit of private gain are generally regarded as wasteful and exploitive. The planned system that allows individuals the least degree of economic freedom is communism, which still exists in a few countries, most notably North Korea and China. As an economic system, communism can’t be regarded as anything but a dismal failure. In fact, even as its government remains strongly communist from a political perspective, China has embraced many concepts of capitalism in recent years and has become one of the world’s most powerful and important economies as a result.
Socialism lies somewhere between capitalism and communism, with a fairly high degree of government planning and some government ownership of capital resources.
However, government ownership tends to be focused on industries considered vital to the
common welfare, such as transportation, health care, and communications. Private ownership is permitted in other industries.
Although “socialism” is sometimes used as a pejorative term in today’s heated political and economic dialogues, and many people believe capitalism is inherently superior to socialism, that opinion is not universal. For example, many European countries, including economic heavyweights France and Germany, incorporate varying degrees of socialism.
Moreover, although free-market capitalism remains the foundation of the U.S. econ-omy, some important elements of the U.S. economy are socialized and have been for many years. Public schools, much of the transportation infrastructure, various local and regional utilities, and several major health-care programs all fit the economic definition of socialism. Socialism and capitalism are competing philosophies, but they are not mutually exclusive, and each approach has strengths and weaknesses, which is why most modern economies combine aspects of both.
NATIONALIZATION AND PRIVATIZATION
The line between socialism and capitalism isn’t always easy to define, and it doesn’t always stay in the same place, either. Governments can change the structure of the economy by nationalizing taking ownership of-selected companies or in extreme cases even entire industries. They can also move in the opposite direction, privatizing services once performed by the government by allowing private businesses to perform them instead.
In recent years, governments of various countries have done both, for different reasons and in different industries. For example, private companies now own or operate a number of highways, bridges, ports, prisons, and other infrastructure elements in the United States, providing services once provided by the government. The primary reason for this trend is the belief that private firms motivated by the profit incentive can do a more efficient job of running these facilities’
The Forces of Demand and Supply
At the heart of every business transaction is an exchange between a buyer and a seller. The ca buyer wants or needs a particular service or good and is willing to pay the seller in order to obrain it. The seller is willing to participate in the transaction because of the anticipated financial gains. In a free-market system, the marketplace (composed of individuals, firms, and industries) and the forces of demand and supply determine the quantity of goods and services produced and the prices at which they are sold. Demand refers to the amount of a good or service that customers will buy at a given time at various prices. Supply refers to the quantities of a good or service that producers will provide on a particular date at various prices. In other words, demand refers to the behavior of buyers, whereas supply refers to the behavior of sellers. The two forces work together to impose a kind of dynamic order on the free-market system.
UNDERSTANDING DEMAND
The airline industry offers a helpful demonstration of supply and demand. A demand curve is a graph that shows the amount of product that buyers will purchase at various prices, all other factors being equal. Demand curves typically slope downward, implying that as price drops, more people are willing to buy. The black line labeled Initial demand in Exhibit 2.3 shows a possible demand curve for the monthly number of economy tickets on one airline’s Chicago-to-Denver route. You can see that as price decreases, demand increases, and vice versa. If demand is strong, airlines can keep their prices consistent or perhaps even raise them. If demand weakens, they can lower prices to stimulate more purchases. (Airlines use sophisticated yield management software to constantly adjust prices in order to keep average ticket prices as high as possible while also keeping their planes as full as possible.)
This movement up and down the demand curve is only part of the story, however.
Demand at all price points can also increase or decrease in response to a variety of factors.
If overall demand for air travel decreases, the entire demand curve moves to the left.