Foundation of Economics

The science of economics begins with a simple assumption: human wants are virtually unlimited and insatiable, but resources are limited. While this assumption may be exaggerated, it does, nonetheless, yield useful insights into how economies work. And if human wants are unlimited, then surely not enough economic resources exist to fulfill those wants entirely, which is why economic resources are often described as scarce resources. Since scarce resources can only produce so much, people must decide about what they want and how much they are willing to pay for it.

Economists describe goods and services as having utility, meaning that they must provide some satisfaction. Hence, the goal of all economic activity is to fulfill the wants of the people. People, businesses, and governments all have wants. However, the wants of businesses and governments are to create products and services that the people want.

Scarce Resources are the Factors of Production

In economics, resources are described as scarce, meaning they have a cost. These resources are used to produce goods and services that people desire. Hence, scarce resources are called factors of production (a.k.a. economic inputs), which includes factories, equipment, tools, machinery, technology, land and mineral resources, and even labor and entrepreneurship.

The factors of production can be classified as property resources, including land, raw materials, and capital, and as human resources in the form of labor. Even though it is a form of labor, entrepreneurship is sometimes treated as a separate class because of its importance in the economy.

Resource Categories

Although land is often thought of as just being real estate, land, as a factor of production, includes all natural resources, including not only minerals, oil, and water, but also the biosphere, which includes forests and agriculture. Even the wind is a resource in that it can be used to produce energy. Hence, land can be considered anything provided by nature — lithosphere, hydrosphere, atmosphere, and the biosphere.

Capital (aka capital goods, investment goods) includes all technology used in producing goods and services, such as tools, machinery, equipment, factory, storage, transportation and distribution facilities. Capital goods differ from consumer goods in that capital goods are used to produce consumer goods. Economists use the term investment to mean the actual purchase of these capital goods. This differs from the way most people think of investments, such as buying stocks or bonds. While financial investments can lead to economic growth, it can only accomplish this if the financial investments are used to buy what economists frequently refer to as real capital, which is necessary to produce products or services. Hence, although money is used to purchase real capital, it is not an input itself. Hence, it is not an economic resource. Money is simply used to buy real capital.

Labor is the human effort required to produce products and services.

Although entrepreneurship is a form of labor, it is the most important form of labor, because entrepreneurs are the ones that create businesses that use the factors of production to create the products and services of an economy. Entrepreneurs take the initiative in combining the resources of land, capital, and labor to produce a good or service. The entrepreneur is an innovator and risk-bearer in organizing a business to produce a product or service efficiently.

To provide the factors of production, the owners of resources receive resource payments in the form of rental income or a lump-sum payment for supplying land and raw materials, and interest income, for supplying the financing for real capital. The income received by labor is called wages, and includes any form of compensation for work, including bonuses, commissions, and royalties. Entrepreneurial income is in the form of business profits or losses.

Productive and Allocative Efficiency

In economics, there are 2 types of efficiencies. Productive efficiency is efficient production of any mix of goods and services for the least cost. Productive efficiency leaves more resources for producing other goods and services. Allocative efficiency is the production of the goods and services that are most desired by society. In other words, the factors of production are allocated to the most desired products and services.

Households and Firms are the Main Economic Agents

Households and firms are the main economic agents who interact in the markets to either buy or sell the factors of production or to buy or sell the created products or services. Although the government is also an important economic agent, the study of economics is simplified by considering only households and firms as the most important economic agents.

Firms produce goods and services using factors of production, while households own the factors of production and consume the goods and services that the firms produce. Households and firms interact in 2 types of markets. In the markets for goods and services, households are buyers and firms are sellers while in the markets for the factors of production, households are sellers and firms are buyers.

A simplified schematic diagram depicting a simple economy of households and firms, and the marketplace where the factors of production and goods and services are bought and sold.

The economy of households and firms is often depicted as a circular-flow diagram — a simplified schematic of economic activity and society, which ignores the role of government and of international trades. Even among firms and households it is not completely true. For instance, firms can also sell land and capital, as occurs in vertical industries and households often sell products or services that they create directly to other households.

The diagram consists of 2 types of arrows. One type depicts the flow of inputs and outputs, while the other depicts the flow of dollars to pay for the inputs and outputs.