Why Does Economics Exist?

Economics can sometimes feel like a rather odd collection of subjects.

One moment you are learning about why the price of coffee has gone up. The next you are looking at unemployment, pollution, taxation, banks, government borrowing or interest rates set by the Bank of England. Later still you might find yourself studying exchange rates, international trade or economic growth.

What connects all these things?

A useful way to understand economics is to forget about the subject for a moment and imagine building an economy from scratch. Start with people and businesses. See what happens when they trade with each other. Then gradually introduce some of the institutions we now take for granted.

As we do that, the reason economics exists becomes much easier to see.

People and businesses

People provide their time and skills in return for money, then decide how much to spend, save or invest.

Businesses provide goods and services to people and other businesses. They decide what to produce, what prices to charge, how many people to employ and whether to invest.

For now, imagine an economy containing only households and businesses. There is no government or Bank of England, and assume that the total amount of money is fixed.

People work, earn and spend; businesses sell things and pay workers and suppliers.

Why not just let them get on with it?

If households and businesses are capable of making their own decisions, why should anyone else become involved?

In many situations, there may be no good reason.

Suppose people stop buying one particular type of shoe because fashions change. The manufacturer may cut its price, produce fewer shoes or make something else instead. Workers may eventually move to other jobs.

That may be unpleasant for the company and its employees, but it does not necessarily mean the market for those shoes is working badly. Change is a normal part of an economy.

Economists use the word market to describe buyers and sellers coming together to exchange a particular good or service.

Sometimes, however, markets do not work so well. Economists call these situations market failures.

There are several reasons why this can happen.

One side knows more than the other

Imagine buying a second-hand car. The seller may know that something is wrong with it, while you may not find out until after you have paid.

Economists call this asymmetric information. It means one side in a transaction knows more than the other.

This can make the market work badly because buyers may be worried about being cheated and may be unwilling to pay as much for a car they cannot properly judge.

Inspections, warranties, guarantees and trusted dealers can all help reduce this problem.

Economists ask whether measures like these help the market work better.

Sometimes businesses become very powerful

Competition usually limits how much a business can charge, because customers can go elsewhere.

But if one company controls most of a market, or only a few large firms compete, customers may have less choice and prices may be higher.

Economists therefore study market power, monopoly and competition. They ask how much market power a firm has, what effect it is having on prices and consumers, and what might happen if competition rules are changed.

Sometimes a transaction affects somebody else

Suppose a factory makes a product that customers want to buy, but also pollutes a nearby river.

The buyer and seller may both be happy with the transaction, but people living downstream are affected even though they were not involved.

Economists call this an externality.

The price paid by the customer may cover the factory’s own costs, but not the harm caused to people downstream.

Economists ask how large that extra cost is and compare different ways of reducing it, such as regulation or taxation.

Some useful things may not be provided at all

Some things benefit lots of people, but businesses may struggle to charge everyone who benefits.

Take national defence. If one person pays for soldiers to defend the country, everyone else benefits too. That gives people an incentive to think:

“Why should I pay if I will be protected anyway?”

If everyone thinks like that, too little defence may be provided.

National defence is an example of what economists call a public good. Some forms of policing, street lighting and flood protection can have similar features.

This creates a new question: if businesses will not provide enough of something that benefits society, should government step in?

And that brings another participant into our economy. Government.

Government enters the economy

Government can provide things such as defence, policing, schools and healthcare. Unlike an ordinary business, it can require people to contribute through taxation.

Government then spends that money on our behalf, buying everything from medicines to roads and military equipment.

This raises more economic questions. Who should pay tax? What should government spend it on? Is it getting good value for money?

Markets can fail, but governments can make mistakes too. Economists therefore compare the likely results of different choices.

For example, suppose the government thinks renters are being treated unfairly and introduces new rules to protect them.

An economist would ask how landlords might respond. If the rules make renting out property less attractive, some may sell or decide not to become landlords. The supply of homes to rent could fall.

The policy might therefore have an unintended effect.

Economists try to go beyond the immediate intention of a policy and ask how people are likely to respond.

What do economists actually do?

Identifying a problem is only the beginning.

Economists build models — simplified versions of how parts of the economy work — and use them to work out what might happen if something changes.

They then use evidence and data to test those models and estimate how large the effects might be.

In the rental example, an economist might ask how much the supply of rental homes would fall if being a landlord became less attractive, how rents might respond, and whether a different policy might achieve the same aim with fewer drawbacks.

As economics becomes more advanced, mathematics and statistics are used to make these models more precise and to measure the effects more accurately. That is one reason maths becomes increasingly important in economics.

Economists also study who gets what

Even when markets work as expected, society may dislike the result.

A poor harvest, for example, may make food scarcer and therefore more expensive. But that may leave poorer households unable to afford enough.

Economists therefore study distribution and redistribution: who receives income and wealth, and what happens when governments change that through taxes, benefits or public services.

Economics can explain the consequences of different choices, but it cannot tell us exactly how equal society ought to be.

Government can borrow as well as tax

Government does not always have to pay for all of today’s spending from today’s taxes. It can also borrow.

In Britain, much of this borrowing is done by selling government bonds called gilts. Investors lend money to the government and receive interest in return.

Borrowing allows government to spend more now and repay the money over time.

This creates another set of questions for economists. When should government borrow rather than tax? How much debt is manageable? How expensive will the borrowing be? And does it matter whether the borrowing is used for long-term investment or for spending that brings only short-term benefits?

Economists therefore study government borrowing because it affects public finances today and creates obligations for the future.

Sometimes the whole economy runs into trouble

So far, much of what we have looked at has concerned individual people, businesses and particular markets. This is broadly the territory of microeconomics.

But sometimes millions of individual decisions combine to affect the whole economy.

Suppose people become worried about the future and decide to spend less and save more. That may be sensible for each household, but if millions do it at the same time, businesses may lose sales, cut production and employ fewer workers.

Economists therefore study the economy as a whole, including recessions, unemployment, economic growth and total spending.

This is called macroeconomics.

Macroeconomists try to understand why whole economies sometimes grow quickly and sometimes struggle, and what, if anything, can be done about it.

So far, our economy contains households, businesses and government. But there is another important participant we have not yet added: commercial banks.

Commercial banks

Banks provide accounts, process payments and make loans.

But they are unusual because a bank loan can create a new bank deposit.

That means bank lending can create new purchasing power, although it cannot create the houses, machines or other real resources that money buys.

Economists therefore study how much banks lend, who receives the money and what it is used for. They also study debt, bank failures and financial crises.

This is why money and credit become another important part of economics.

But commercial banks do not operate on their own. Behind them sits another institution with a very different role: the central bank.

The central bank

Britain’s central bank is the Bank of England.

It sits at the centre of the banking system, sets Bank Rate and helps maintain financial stability.

Economists analyse how its decisions affect borrowing, spending, investment, inflation and the wider economy.

So far, however, we have not considered how our economy fits into the wider world or trades with other countries.

The rest of the world

British households buy goods made overseas, British businesses sell abroad, and money moves between countries.

Because different countries use different currencies, changes in exchange rates can affect the prices of imports and exports.

Economists analyse how trade and exchange rates affect businesses, workers, prices and economic growth.

This area of the subject is called international economics.

Economics is really about choices

We can now see why economics contains so many apparently different subjects. They are all parts of the same economic system.

It is tempting to think economics is mainly about money.

It is not.

Money is useful because it allows people to buy things, exchange with each other and move purchasing power through time. But underneath the money are the things that really matter: people’s time and skills, land, energy, buildings, machines, knowledge, raw materials and the environment.

None of these resources is unlimited.

That is the fundamental problem from which economics begins.

We cannot do everything. So we have to choose.

Households choose. Businesses choose. Banks choose whom to lend to. Governments choose what to tax and what to spend. Central banks make choices about interest rates and monetary conditions.

And all those choices affect the choices available to everybody else.

That is why economics exists

Economics tries to understand how people and institutions make choices when resources are limited, how those choices interact, when the resulting system works well, when it does not, and what is likely to happen if we try to change it.

To do this, economists use models, evidence and data to work out what is likely to happen when something changes. People and businesses respond to changes, so the final effects of a decision may be very different from its immediate or intended effects.

The price of bread, pollution, unemployment, taxation, mortgages, government borrowing and Bank Rate are therefore not really unrelated subjects.

They are all parts of the same question:

How do we decide what to do with the limited resources available to us, and what happens when millions of those decisions interact?