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1 The Basics of Economic Thinking

While people have made economic decisions since the beginning of humankind, the formal study of economics has only recently emerged. Its origins can be traced back to the sixteenth and seventeenth centuries as the fledgling nation-states of Europe grappled with the basic economic questions of what, how, and for whom to produce. This chapter explores the content and methodology of economic science, introduces key economic principles, and traces how different schools of economic thought have influenced the decisions of people and countries over time.


Scarcity is the universal economic problem. Scarcity exists because people have unlimited needs but limited resources to satisfy their material desires. Scarcity is called the universal economic problem because it affects all people in all societies and has done so throughout history. Even the wealthy who have sufficient resources to satisfy their basic needs cannot buy everything they may want. As long as resources are scarce, people will have to make choices about how to use their scarce resources.

Resources that are used to produce goods and services are called the factors of production. The three main factors of production are natural resources, or land; human resources, or labor; and capital goods, or capital. Natural resources are the gifts of nature such as rivers, sunlight, fish and animals, natural forests, and soil. Human resources are the people who are involved in production such as teachers, scientists, carpenters, farmers, and assembly line workers. Capital goods are items that are designed to produce other products. Capital goods include cement mixers, shopping malls, business computers, oil tankers, and factory buildings. Resources that have been processed but are designed for use in the production of another product are called intermediate goods. Lumber, for example, is an intermediate good because it is destined for use in the construction of houses or the manufacture of furniture. Some economists include entrepreneurship as a fourth factor of production. Entrepreneurship represents the risk taking and innovation of entrepreneurs—people who create new products, businesses, or production methods.

A wind turbine is a capital good, whereas the wind that powers the turbine is a natural resource.

A wind turbine is a capital good, whereas the wind that powers the turbine is a natural resource.

Economics as a Social Science

Economics is the study of how people choose to use their scarce resources to satisfy their needs. Thus, economics deals with the production, distribution, and consumption of goods and services. The term “economics” comes from oikonomikos, which means “skilled in household management.”[1] It wasn't until the early twentieth century that the term “economics” came into common usage, replacing the more familiar “political economy”—a term that was introduced in the early 1600s and popularized during the 1700s.

Economics is a social science because it systematically studies human relationships and behaviors of people. The economic choices and behaviors of households, businesses, and government are at the heart of economic science. Economics, like the other social sciences—anthropology, human geography, political science, psychology, and sociology— are not exact sciences, however. This is because the social sciences deal with human behaviors, and people sometimes behave in unpredictable ways. The social sciences also study human behaviors in the real world, not in a laboratory or other controlled environment. Thus, the social scientist is unable to isolate or account for all of the variables that affect the actions of individuals or groups. Today, the study of economics is often divided into two main branches, microeconomics and macroeconomics.

Microeconomics is the branch of economics that focuses on interactions among the individual decision-making units within an economy. Microeconomics is the older of the two branches of economics, occupying much of the attention of the early schools of economic thought. The most important participants in the microeconomy are households, business firms, and the government. The private sector, or nongovernmental sector of the economy, consists of households and firms. Households make decisions about consuming products, saving and investing money, and employment. Businesses, on the other hand, make production decisions related to output, product pricing, and hiring workers. Government decision making in the microeconomy deals with providing public goods, providing social programs, and regulating business activity.

Macroeconomics is the branch of economics that deals with the economic performance of the entire economy. Macroeconomics, as a broad field of study, arose during the twentieth century, largely in response to the global depression of the 1930s. Macroeconomics focuses on economic growth and economic stability in a nation. Economic growth is often measured by tracking a nation's real gross domestic product over time. The real gross domestic product (GDP) is the dollar value of all newly produced goods and services in an economy in a given year, adjusted for inflation. Economic stability refers to maintaining stable prices and a fully employed labor force. In sum, macroeconomics deals with aggregates such as national output, national income, national savings rates, and the national unemployment rate. It follows that macroeconomics also deals with government stabilization policies such as monetary policy and fiscal policy that influence these national aggregates.

  • [1] Federal Reserve Bank of San Francisco, “Major Schools of Economic Theory,”
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