Decades of controversy about the nature and appropriate boundaries of his discipline led the economist Jacob Viner to observe that "economics is what economists do." Somewhat more precisely, economists engage in systematic inquiry into the effects of those human activities which are grouped under three broad headings:  production, exchange, and consumption.  The nature and magnitude of these activities and their implications for individual and social welfare constitute the focus of economics and the policy prescriptions that economists make.

BASIC CONCEPTS

The basic objective of all economic activity is to achieve the highest possible level of present consumption of goods and services that is compatible with the supply of human and material resources (or factors) available to produce them.  The scarcity of human and material resources, as evidenced by the existence of prices, imposes the necessity of allocating resources among alternative present and future uses (see \Tprice system\t).  Choice, therefore, is the essence of economic decision making.  It is necessary to evaluate the relative worth of different kinds and quantities of consumer goods and services (bread, automobiles, houses, schools, and health care, for example) against one another and against future supplies that are likely to become available if present resources are diverted into the production of capital goods (blast furnaces, loading docks, cargo vessels, roads, bridges, and factories, for example).

The choice process occurs both at the level of the household and at that of the business firm.  Households that are free to exercise their choices in the marketplace are assumed to behave in a manner that will yield maximum satisfaction, or utility. The essence of rational behavior for a household is to spend its last (or marginal) unit of money income for that item or service which will provide the greatest possible utility.  Such choices underlie households' demands for goods and services in the marketplace at various possible prices, which then act as signals to businesses about consumers' preferences (see \Tsupply and demand\t).

Rational behavior in the business sector implies that firms direct their efforts toward maximizing profits.  To do this they must, first, be responsive to the demands of the household sector for goods and services and, second, combine the labor and material resources they employ in such a way as to minimize their production costs.  This is the essence of efficient production.  To the extent that it is accomplished, it will yield the largest possible output of goods and services with a minimum expenditure of resources.

Inquiry into the nature and results of the choices that households and business firms make is the concern of microeconomic analysis, the focus of which is the behavior of the individuals, organizations, and institutions in the economy.  Whereas all acts are, of course, individual acts, individuals frequently make decisions and act on behalf of some organization or institution, public or private.

The study of the behavior of households and business firms is only one part of economic analysis, however.  The other part is concerned with the study of the behavior of economic aggregates--macroeconomics (see \Teconomy, national\t).  The results of economic performance can be measured in terms of production and income.  Chief among the "yardsticks" that measure the economy's overall performance is \Tgross national product\t, which aggregates the market value of all final goods and direct services produced during the year.  The values of intermediate goods (such as raw materials) and indirect services that go into making goods are excluded because their inclusions would result in "double counting" and thus overstate the \TGNP\t aggregate.  Production costs, on the other hand (wages, rent, interest, depreciation, managerial profits, and taxes), that are incorporated into consumer prices constitute an income stream that corresponds to \TGNP\t--gross national income, which aggregates the income earned by the owners of the productive factors (labor, capital, and natural resources) used by business firms (see \Tincome, national\t).

The size of the \TGNP\t, and its income counterpart, reflects the level of employment, another important macroeconomic aggregate. The level of employment is dependent on aggregate effective demand, which consists of the consumption and investment (or capital goods) demands of households and businesses. Macroeconomic aggregates are thus critically linked to the microeconomic decisions made in the household and business sectors of the economy.  A major concern of macroeconomics is the influence of the government and the \Tcentral bank\t on aggregate demand through implementation of \Tfiscal policy\t and \Tmonetary policy\t, respectively.

HISTORY OF ECONOMIC THOUGHT

When economics first began to emerge as a separate discipline in the 18th century, its concern was chiefly with phenomena that are today classified as macroeconomic.  In the three decades preceding the French Revolution the \Tphysiocrats\t presented a plea for "revolution from above" through a monarch enlightened about the natural order in relation to the economic well-being of the economy.  The physiocrats maintained that tax abuses, large public debts, foreign wars, court extravagances, and special stimuli for the production of luxury goods (tapestries, silks, velvets, porcelain) that were exported--in accordance with the principles of \Tmercantilism\t--to obtain gold progressively diminished the economy's well-being.  In their view, the goods derived from land (and therefore "natural"), not gold, constitute wealth.  The physiocrats, who were fond of referring to themselves as "the economists," constructed a theory of an ideally functioning economy that would tend automatically to achieve optimum results, but for the disturbances injected by human beings uneducated in the ways of the natural order.  This rationale is the basis for the famous maxim Laissez faire, laissez passer ("Let it be, let it go"; see \Tlaissez-faire\t).

The Scottish moral philosopher Adam \TSmith\t, who intended his Inquiry into the Nature and Causes of the Wealth of Nations (1776) as a capstone to his work as a philosopher, commended the physiocrats not only for understanding the true nature of wealth, but also for recognizing the essential role of economic freedom in promoting its growth.  The central theme of the \TWealth of Nations\t is the growth of national wealth.  Smith's focus, therefore, parallels that of the physiocrats.  For Smith, however, it is not nature but human effort that makes commodities available.  Smith believed that the natural trend of economic development is upward and that this trend is most likely to manifest itself within the framework of an "obvious and simple system of liberty," or perfect competition.  His principal concern was to maintain the system of natural liberty that would facilitate the accumulation and direction of capital into employments that are most desirable from the standpoint of maximizing general welfare.  The implication is that if businesses are free to seek out the best opportunities for maximizing gains, the most productive employments will be sought out first.  Legitimate areas of government intervention exist, but ideally, the activities in which the state engages ought to be minimal because the labor of the sovereign and other governmental servants is "unproductive." The incomes they receive are transfers and do not generate wealth.

For the most part Smith expressed faith in the operation of the "invisible hand"--the marketplace operating according to supply and demand mechanisms--for bringing about a harmony of social interests in the still primarily agricultural economy of the late 18th century.  The subsequent appearance of capital in the form of machinery, and the mechanization of industry that accompanied it, however, made questionable Smith's doctrine that the accumulation and employment of capital would automatically coincide with the advancing material progress of all classes of society.

Whereas Adam Smith had little concern with distinguishing between economics as a science and economics as a branch of politics, his French disciple Jean Baptiste \TSay\t concentrated on the use of the deductive method to derive the laws that govern the production, distribution, and consumption of wealth.  Say's method, and his arrangement of the subject matter of economics, has become classical.  His teachings were introduced into England by James \Tmill\t, father of John Stuart Mill.  It was the elder Mill who taught the deductive method of analysis to the British economist David \TRicardo\t, whose work became the prototype for a whole school of thinkers who sought to discover universal laws of production, exchange, and distribution.  The term classical is used in connection with their work to convey the virtually universal acceptance of their methodology and economic principles up to about 1870, and to distinguish their work from that of various dissenting schools.  Classical economic theory attempted to provide, first of all, a simplified model of the operation of the actual economic system.  It attempted, second, to offer a hypothesis concerning its probable long-run development.  Finally, its philosophical and psychological foundations were thought to offer a policy of economic and political laissez-faire.

During the 19th century, Continental philosophers challenged the doctrine of natural law that underlies the classical tradition of political economy.  Georg Wilhelm Friedrich Hegel developed a philosophy of history that maintained that the course of history reflects the gradual realization by human beings of their own nature.  The course of their development can be understood by using a method of reasoning that Hegel called the dialectic:  one phenomenon (a thesis) works against another (the antithesis) to produce something wholly new (the synthesis).  Thus the feudal system (the thesis) of the Middle Ages encountered the force of the market system (the antithesis) of the mercantilistic era, and their inevitable clash produced an entirely new system, \Tcapitalism\t (the synthesis).

Karl \TMarx\t came under the influence of Hegel's philosophy, which underlies Marx's objective, expressed in volume 1 of Das Kapital, "to lay bare the economic 'law of motion' of modern society." The prime mover of social change, he maintained, was to be found in changes in the mode of production.  The mode of production is associated with the whole complex of social relationships that reflects the ownership and use of the material means of production.  According to Marx, it is the contradiction that develops between the altered mode of production and existing social relationships that generates changes and conflicts in the relationships among social classes.  Conflict between the ruling class and the exploited class is always present.

In a capitalistic economy, which Marx viewed as a transitory stage in the historical evolution of society, the antagonistic classes are the bourgeoisie and the proletariat.  The essential feature of the mode of production under capitalism is that ownership of the means of production (that is, capital and land) is vested in the bourgeoisie, while the work is performed by the proletariat.  The relationship between them determines the mode of production, and hence, the whole society.  The only form of property that workers own is their labor power. Because the means of production needed to exploit the laborers' productive capabilities are owned by the capitalist class, workers have no choice but to sell their labor power to the capitalist class at the going competitive wage rate.  The exchange relationship between the worker and the employer, however, requires the worker to labor the entire working day, which is typically longer than is needed for producing the worker's subsistence.  Under capitalism the creation of surplus value is therefore inherent in the mode of production and is the source of the inevitable conflict between laborers and capitalists.  The objective of the capitalist is constantly to increase the surplus that accrues by such means as lengthening the working day, "speeding up" the production process, and substituting machinery for labor.  These actions accentuate the contradictions and conflicts that characterize the capitalistic system.  Ultimately, the contradictions make the system untenable.  Conditions are then ripe for the proletariat to seize the instruments of production and establish socialism, which is the first stage of full communism.  This, in Marx's view, cannot come about without revolution (see \TMarxism\t).

The powerful criticism that Marxism leveled against classical political economy summoned up the counterattack, in the late 19th century, of the marginalist school, which, in Britain, ultimately evolved into the neoclassical tradition.  The origin of the neoclassical tradition is virtually synonymous with the name of Alfred \TMarshall\t.  Whereas the work of the marginalists modified the classical paradigm by emphasizing the importance of demand and utility (where the classicists explained commodity values largely in terms of cost of production), neoclassicism explained economic phenomena as the outcome of the choices of rational (or "economic") people who conduct their activities in a laissez-faire world ruled by perfect competition.

Whereas the classical economists were concerned chiefly with the production side of the private-enterprise system, the neoclassicists articulated a supply-and-demand theory of values and a theory of \Tdistribution\t that explained the sharing of income among the productive factors--land, labor, capital, and enterprise.  Thus the chief concern of neoclassical economics was with explaining those economic phenomena which are today categorized as microeconomic.  There was little concern with macroeconomics because it was presumed that powerful market forces tend to ensure that the economy will tend to fully employ its labor and capital resources, so that none will be involuntarily idle.

This assumption was effectively challenged by John Maynard \TKeynes\t in his important book The General Theory of Employment, Interest and Money (1936).  His chief argument was that market forces, in the form of wage and interest-rate reductions, cannot be relied on to channel all workers seeking employment into jobs or all savings into investment.  A full-employment equilibrium results only if the level of aggregate demand is sufficiently high to ensure that the employment of labor and the investment of savings is profitable (see \TSavings\t AND \Tinvestment\t).  This ideal situation is sometimes impeded by the dynamic nature of a modern capitalistic economy, which renders itself particularly vulnerable to uncertainty.  Inability to predict the profitability of investment encourages the accumulation of assets in the form of money to the detriment of the level of aggregate demand and, consequently, the level of employment.  Bank policy to reduce interest rates may be impotent when expected profit levels are very low or even negative.  Direct intervention by government in the form of public works may then become necessary, Keynes maintained, to restore full employment.  The importance of empirically testing these conclusions encouraged the development of \Teconometrics\t.

THE POST-KEYNESIAN ERA

Shortly after Keynes's General Theory was published, strenuous efforts were made to reaffirm the traditional neoclassical view that the economy is characterized by powerful equilibrium forces, despite the painful experience of the Depression of the 1930s.  The technical analysis developed to support this contention is known as "the neoclassical synthesis." The most prominent branch of the neoclassical tradition is the monetarist school, whose leading representative is Milton \TFriedman\t.  Espousing a laissez-faire philosophy and rejecting Keynesian fiscal policy, monetarists support the use of monetary policy to encourage stable economic growth.

The neoclassical economists also addressed another problem that Keynes never anticipated:  \Tinflation\t--the general rise in all commodity and factor prices--in a period in which resources are not fully employed.  Historically, when resources are not fully employed, wage and interest rates tend to fall to sufficiently low levels to stimulate their reemployment.  For reasons not well understood, however, this failed to happen during the 1970s and early 1980s.  The U.S.  economy experienced rates of unemployment that at times reached more than 10 percent, accompanied by an even higher inflation rate.  Neither responded to the traditional government policy measures--fiscal policy and monetary policy--that have been developed to deal with these twin evils.  The high interest rates recommended by the monetarists did not combat inflation, and the employment and related antipoverty programs recommended by latter-day Keynesians did not significantly reduce unemployment. Perversely, both inflation and high unemployment were accompanied by reduced rates of private investment and a rising role of government in the affairs of the economy.

Beginning in 1981, the administration of Ronald Reagan tried an alternative approach, which combined large cuts in federal spending with large tax cuts.  On the premise that savings and investment should be encouraged, the tax cuts benefited chiefly business and middle- to upper-income persons.

By mid-1984, inflation was quiescent, unemployment decreasing, and the economy on an upswing.  Powered by deficit spending--much of it for the military--and a loosening of the money supply by the Federal Reserve Board, the economy sustained an upward surge through Reagan's second term.  When he left office in 1989, Reagan also left a record federal deficit;  he had borrowed more money to make up his budget deficits than had all earlier U.S.  presidents combined, and the United States had become a debtor nation.  INGRID H.  RIMA

Bibliography:  Canterbury, E.  Ray, The Making of Economics, 3d ed.  (1987);  Dillard, Dudley, The Economics of John Maynard Keynes (1948);  Fusfeld, Daniel R., The Age of the Economist, 4th ed.  (1982), and Economics, 3d ed.  (1987);  Galbraith, J.K., Economics in Perspective:  A Critical History (1987); Heilbroner, Robert, The Worldly Philosophers, 5th ed.  (1979), and Behind the Veil of Economics (1988);  Rima, Ingrid H., Development of Economic Analysis, 3d ed.  (1978);  Samuelson, Paul, Economics, 11th ed.  (1980);  Samuelson, Paul, and Nordhaus, W.D., Economics, 13th ed.  (1989);  Schumpeter, Joseph A., Ten Great Economists (1965);  Silk, Leonard, The Economists (1976).

See also:  \Tbanking systems\t;  \Tinternational trade\t;  \Tmoney\t; \Tmonopoly and competition\t.