Economy Definition

Economy

Investopedia / Alex Dos Diaz

What Is an Economy?

An economy is a complex system of interrelated production, consumption, and exchange activities that ultimately determines how resources are allocated among all the participants. The production, consumption, and distribution of goods and services combine to fulfill the needs of those living and operating within the economy.

An economy may represent a nation, a region, a single industry, or even a family.

Key Takeaways

  • An economy is a system of inter-related production and consumption activities that ultimately determine the allocation of resources within a group.
  • The production and consumption of goods and services as a whole fulfill the needs of those living and operating within it.
  • Market-based economies, also called free market economies, are self-regulated, allowing goods to be produced and distributed in response to demand from consumers.
  • Command-based economies are regulated by a government body that determines the goods which are produced, their quantities, and the price paid for them.
  • In the modern world, few economies are purely market-based or command-based.
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What's the Economy?

Understanding Economies

An economy encompasses all of the activities related to the production, consumption, and trade of goods and services in an entity, whether the entity is a nation or a small town.

No two economies are identical. Each is formed according to its own resources, culture, laws, history, and geography. Each evolves according to the choices and actions of the participants.

These decisions are made through some combination of market transactions and collective or hierarchical decision-making.

Capitalism requires a market-based economy. Communism requires a command-based economy.

Types of Economies

In the modern world, few nations are purely market-based or purely command-based. But most lean toward one or the other of these models.

Market-Based Economies

Market-based or "free market" economies allow people and businesses to freely exchange goods and services according to supply and demand.

The United States is mostly a market economy. Producers determine what’s sold and produced, and what prices to charge. If they expect to succeed, they will produce what consumers want and charge what consumers are willing to pay.  

Through these decisions, the laws of supply and demand determine prices and total production. If consumer demand for a specific product increases, production tends to increase to satisfy the demand. The increased demand causes prices to rise until consumers balk and cut back on their purchases. Demand for the product will then decline and prices will decline with it.

This constant tug of supply and demand allows a market economy a tendency to naturally balance itself. As the prices in one sector rise with demand, the money and labor needed to fill that demand shift to those places where they're needed.

Command-Based Economies

Command-based economies depend on a central government that controls the production levels, pricing, and distribution of goods.

In such a system, the government owns industries deemed essential on behalf of the consumers who use them. Competition among companies is discouraged or banned. Prices are controlled.

Communism requires a command-based economy. Contemporary examples include Cuba and North Korea.

A command-based economy attempts to supersede the workings of supply and demand.

Mixed Economies

Pure market economies rarely exist in the modern world since there's usually some degree of government intervention or central planning. Even the United States could be considered a mixed economy. It may not mandate production but it has ways to influence it. For example:

  • In late 2021, President Joe Biden ordered 50 million gallons of oil released from the nation's Strategic Oil Reserves with the stated aim of forcing gasoline prices lower by increasing its supply.
  • In 2022, the Federal Reserve imposed a series of interest rate increases on the nation's banks. The purpose was to raise interest rates throughout the economy in order to reduce demand for loans and therefore reduce inflation in the costs of goods and services.

In truth, most of the world's developed economies mix market-based and command-based models.

China had a command economy only until 1978 when it began a series of reforms that encouraged private enterprise.

Studying Economies

The study of economies and the factors affecting economies is called economics. The discipline of economics can be broken into two major areas of focus, microeconomics, and macroeconomics.

Microeconomics

Microeconomics studies the behavior of individual people and businesses in order to understand why they make the economic decisions they do and how these decisions affect the larger economic system.

Microeconomics studies how a particular value is attached to a product or service. It examines how individuals coordinate and cooperate with each other in business.

Microeconomics tends to focus on economic tendencies, such as how individual choices and actions impact changes in production.

Clearly, principles of psychology and marketing influence microeconomics.

Macroeconomics

As the name implies, macroeconomics studies the big picture.

Macroeconomics includes the study of economy-wide factors such as the effect of rising prices or inflation on the economy. It seeks to track and understand the financial indicators that clarify an economy's success or failure over time, such as gross domestic product (GDP), changes in unemployment, and consumer spending.

In short, macroeconomics studies how the economy as a whole behaves.

Economic Indicators

As noted above, macroeconomics is the study of the big picture and that picture is incomplete without a set of economic indicators. These are some of the most closely-watched of those indicators.

Gross Domestic Product (GDP)

Gross domestic product is the total value of all of the completed goods and services produced by an economy during a period of one year.

The gross domestic product of the United States was about $23 trillion in 2021.

Unemployment

The Unemployment Report estimates the number of people who are working for pay during a given period. More importantly, the number is tracked over time in order to determine whether unemployment is worsening.

In the U.S., the Bureau of Labor Statistics (BLS) publishes a monthly unemployment report that breaks down how many people are working, the average number of hours they are working, and their average earnings. This is used to produce the unemployment rate.

Inflation (or Deflation)

Inflation in consumer prices is measured and tracked so that problems in the economy can be pinpointed. If the rate of inflation is outpacing the rate of income growth, the economy is in trouble. Inflation can be negative, too, but overall deflation is relatively rare.

The BLS also publishes a key inflation report for the U.S. The Consumer Price Index tracks the costs of goods and services from month to month. It breaks down its report into the vital areas of consumer spending, such as food, energy, and rent costs.

Those numbers determine the rate of inflation.

Balance of Trade

An economy's balance of trade is a comparison of the amount of money that is spent on imports of goods and services and the amount of money it earns on goods and services it exports. It is measured primarily by recording all of the products that pass through the Customs office of a country.

A nation achieves a positive balance of trade when it exports more than it imports. It has a negative balance of trade when it buys more than it sells.

Neither is necessarily good or bad. A nation may have a negative balance of trade because foreign businesses are heavily investing in its future. A nation with a positive balance of trade may have protectionist policies in place that could hurt it in the long run.

The U.S. had a balance of trade deficit in 2021 of about $859.1 billion, up $182.4 billion from the previous year, according to the U.S. Bureau of Economic Analysis.

History of the Concept of Economy

The word economy derives from the Greek term for household management and the word is still used in that context.

Economics as an area of study was touched on by philosophers in ancient Greece, notably Aristotle, but the modern study of economics began in 18th century Europe, particularly in Scotland and France.

Development of Modern Economics

The Scottish philosopher and economist Adam Smith, who in 1776 wrote a landmark book called The Wealth of Nations, was thought of in his own time as a moral philosopher. He and his contemporaries traced the evolution of economies from prehistoric bartering systems to money-driven and eventually credit-driven economies. 

During the 19th century, the development of technology and the growth of international trade created stronger ties among countries, a process that accelerated into the Great Depression and World War II. After 50 years of the Cold War, the late 20th and early 21st centuries have seen a renewed globalization of economies.

What Is Economics?

Economics is a branch of the sciences that seeks to understand the way a population functions by studying the way its economy functions. Every group of people develops a survival plan based on shared labor and resources. How they do that, and how well they succeed at it, is the study of economics.

What Is Macroeconomics vs. Microeconomics?

Macroeconomics is the study of the overall performance of an economy. It evaluates the stability and progress of an economy over time by analysis of key indicators. These include gross domestic product (GDP), employment, inflation or deflation, and the balance of trade.

Micronomics is the study of the behavior of the individual consumers and businesses that make up the economy. Their motivations, habits, and behaviors are studied to determine whether an economy is functioning in their best interests.

What Is Economics in Real Life?

All of us participate in an economy, with the possible exception of a hermit living on a desert island. We contribute something to the whole, by producing or helping to produce a product or offering a service. In return, we receive money that allows us to buy the goods and services that we can't produce for ourselves.

The Bottom Line

An economy is a community that is observed by an analysis of its allocation of resources. Every individual and family in the community has a contribution to make. In return, each expects a share of the goods and services provided by other members of the community.

In modern times, the functioning of an economy is analyzed and quantified by economists.

Article Sources
Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.
  1. The White House. "President Biden Announced Release from the Strategic Petroleum Reserve as Part of Ongoing Efforts to Lower Prices and Address Lack of Supply Around the World."

  2. CNBC. "Fed hikes interest rates by 0.75 percentage point for second consecutive time to fight inflation."

  3. World Bank. "The World Bank in China."

  4. Statista. "Gross domestic product of the United States at current prices from 1987 to 2027."

  5. BEA. "U.S. International Trade in Goods and Services, December 2021."

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