It seems like there is always much to do about it: the economy. And, for good reason: the economy is something that has an impact on all of our lives. It influences the salary you get, how much taxes the government demands, what they spend the tax money on, what kind of companies tend to flourish in countries/regions and much more.
But, let’s take a step back. What actually is the economy? What are people referring to when they talk about ‘the economy’? How do you know when something is good or bad for the economy and what are the main concepts of economy?
In this article we will go over some of the key concepts that shape what the economy is.
What does the economy mean?
Let’s first take a look at what we mean when we talk about the economy. To figure this out, here are two definitions:
‘’An economy is the large set of interrelated production and consumption activities that aid in determining how scarce resources are allocated. The production and consumption of goods and services are used to fulfill the needs of those living and operating within the economy, which is also referred to as an economic system.’’
‘’An economy is an area of the production, distribution and trade, as well as the consumption of goods and services by different agents.’’
Looking at these two definitions there are some concepts that are important to understand. We will take a look at goods and services, consumption, production, labor, distribution and resource allocation. Take note that these are far from in-depth explanations. They will help you understand the basics, but there is much more to say about these concepts than we can cover in this article.
What are goods and services?
Goods and services are the items/experiences that the economic system provides for people to use/enjoy. Goods are usually tangible things, (things you can physically touch) like a table, a phone, a book or toothpaste. Services are usually things that are provided to you by others, like getting a haircut, going for a checkup at the doctor, calling a support desk and getting an eye measurement.
What is consumption?
Consumption is the act of spending some of your resources (time, money, expertise) in order to get something you want (like goods or services). Consumption is driven by the needs and wants that people have; you need to eat, so you consume food. You want to go to ibiza, so you consume an airplane ticket that will get you there. Some needs are more physiologically rooted (like food, shelter and safety) while others are more luxurious (like buying a nicer car, the latest iPhone or an automatic robot vacuum.
What is production?
Production is what an actor (a company, a person, an organization) does to create the things that people want and need. For example, if people want more electric scooters, there needs to be a company or organization that will produce those scooters before people can actually get them.
What is distribution?
Distribution is the way in which the goods and services that people want to consume are actually distributed among all these people. For example, a company that produces luxury mattresses needs a way to distribute these mattresses to people that want them. They might do this by advertising and getting people to visit their warehouse, or they might offer people an option to buy the mattresses online and ship it to them.
What is labor?
Labor is the driving force behind the ability of organizations to produce and distribute whatever it is that people want to consume. Without labor, a company can’t produce or distribute anything. For example, if people want organized stores that have shelves stocked with plenty of food, the company will make sure to hire people (or in jargon: allocate resources) to make sure this happens. Or, if a company wants to open a webshop, it needs to get the labor required to build and maintain one.
What is resource allocation?
Each person, company or organization has resources; things that you possess (or can control) that can serve a use. For example, if you want to eat food, your time, your money and the ingredients you have in your home are resources. You can use these resources to achieve a certain goal: I want to eat a pizza. The choices you make with regards to the allocation of resources decides how you’re planning to get to a certain goal. So, you might say: I’ll spend 12 euros on Thuisbezorgd and order a pizza online. You would be allocating your money to achieve the goal of eating a pizza. Another option might be to use the ingredients you have at home and spend some time making the pizza. The way you allocate your resources show you how you’re planning to achieve a certain goal.
Knowing these concepts will make it much easier to step into the world of economics without getting totally lost. They will also help you expand your knowledge further, if that is something you’d like to do.
Knowing these concepts, we will now look at ways in which the economy influences your life
How does the economy influence me?
It might be better to ask how it doesn’t influence your life: the economy lies at the heart of our society and has huge implications for everyone that lives on earth.
That said, we will take a small subset of all the possible implications the economy might have on your life to better tell you what it actually is that the economy does. We will do this by talking about the way your salary is decided, what inflation is and what interest is.
How is a salary decided?
I won’t have to explain to anyone reading this that having money is at the least essential, and at the best a way to increase your well being dramatically. One of the most common ways to get money is to work for a company or organization that will pay you a salary. But how do you know how much salary a certain job is worth? And how can you increase your salary?
The price for anything that exists (goods, services, labor) is formed based on the relationship of two simple principles: supply and demand. Supply is related to production, which we discussed earlier. Supply is the combined production of a certain good or service in a given timeframe. Demand is related to consumption, which we also discussed. Demand arises through people (i.e. consumers) expressing their needs and wants.
The balance between supply and demand decides how valuable something will be. A low supply and a high demand means something will increase in value, while a low demand and a high supply means something will decrease in value.
Take Pine, an 800 year old bonsai tree. In the bonsai world it is regarded as one of the most impressive trees of them all. This popularity means there is a lot of demand for the tree; how cool would it be if you’re into bonsai and you had this tree in your house?! However, there is only one Pine, meaning, there is a very high demand, and a very limited supply. What do you think will happen to the price of this tree? It becomes incredibly expensive! This was confirmed when it was sold for $1,300,000, making it the most expensive bonsai tree ever.
The same principle works the other way around. Say a car manufacturer like Volkswagen decides to make 1.000.000 cars of a new model. However, when it is introduced to the market it appears to be completely unsafe and full of design flaws. This leads to a high supply, and a very limited demand; the price will drop.
The same principle works in deciding how much salary a given job is going to be worth. If the job is easy and there are a lot of people that can do it (supply is high), the price will be low. However, if the job is hard or requires specific knowledge that not many people have (low supply), the price will be higher.
The trick to increasing your salary is then to find or cultivate something you can do that a lot of people want (high demand), but not a lot of people can do (low supply). When you position yourself in this way, the salary companies are willing to pay you will dramatically increase.
After getting paid a nice salary, you now have some money. But, there are two important things you need to know about money: inflation and interest.
What is inflation?
Inflation is the general increase in prices of goods and services over a given timeframe. This happens when the amount of money rises quicker than the amount of things you could buy with the money.
This might sound a bit vague, so we’ll try to elaborate with an example.
Let’s say you have $100, which is all the money in the world. You want to buy all of Europe from the person that currently owns it. That person says okay, and agrees to sell you Europe for $20, because you both agree that Europe is worth 20% of all the money in the world.
Now, a year goes by and you still haven’t made the deal. However, your neighbour found your money printer and printed $10 for himself. This means that the total amount of money in the world is now $110.
You go to the person that owns Europe, and ask them if you can still buy Europe for $20. The person says no: Europe is worth 20% of all the money in the world, so he now wants not $20 (20% of $100) but $22 (20% of 110). This means Europe just got more expensive.
This is the basic principle of inflation: as more money gets made, things will get increasingly more expensive. Every year the inflation rate is calculated and it will show you what has happened to the value of your money of the last year.
So we know that your money decreases in value, but can it also increase in value?
What is interest?
Interest is money that someone else pays you if you allow them to use your money for a while, in addition to paying you back all of the money you borrowed them some time in the future. What this means is that you can put aside money you don’t urgently need by giving it to someone that uses it (a bank, a company, a friend) and they will pay you back a little more than it would otherwise be worth.
Let’s say you have a friend that wants to buy a pair of shoes worth $100, but he’s strapped for money right now. He knows he’ll have enough money in the future, but he really wants these shoes right now. You decide to borrow your friend $100 so he can buy the shoes right now, on the condition that he pays you back a little more than $100 in the future. To be precise, he will pay you 10% interest over the amount that you borrowed him in 1 year. This means your friend will pay you $100 + 10% of $100 = $110. By doing this, your money has increased in value (if the interest was higher than inflation).
A lot was discussed in this article, and we hope it helped you broaden your understanding of what the economy actually is. Of course, there is so much more to be said about the topics that we discussed and there are many, many more topics that we didn’t even touch on. However, we hope that these insights give you some more confidence when matters related to the economy are discussed and that they might help you in your personal life in some way.
Let us know in the comments what your thoughts are regarding this article and if you have any further questions, we’re always happy to help!