How economies work

Getty Premium images

An economy consists of all the wealth and resources of a society. Within this society, individuals and businesses interact daily--buying, selling, working and producing. Understanding how an economy works is a central task of economics, which studies how societies allocate scarce resources to satisfy wants and needs.

Economists believe understanding the ways in which different societies allocate scarce resources helps to explain why some nations are prosperous and others are not. To explain how economics and economies work, economists rely on economic models, which represent in mathematical or graphic forms a simplified version of real-life economic activity.

The Economic Circular Flow

A favourite model among economists for explaining how economies work is a circular flow diagram. This simplifies the overall economy by reducing it to two basic economic actors: consumers and companies. The circular flow depicts an ongoing process of buying and selling among these two classes. Companies use factors of production, or inputs, such as land, labour, and capital (production facilities and machinery, for example) to manufacture goods and services. They offer these products for sale, and consumers buy them. Meanwhile, consumers sell inputs, such as their labour, to companies, for which they receive money, which they then use to purchase the goods and services they want and need.

Standard of Living

Economists believe that a society's living standard depends on its productivity, or ability to produce. Improving productivity means deciding the optimal way to allocate resources for helping a society prosper. Societies make different decisions about how to allocate their resources to produce goods and services. Economists believe a market economy, a decentralised system in which consumers and firms are free to interact with each other, is the best way to organise economic activity.

Market Economy vs. Central Planning

Communist countries of the Cold War era believed that government was the best means for organising economic activity for the benefit of all. The collapse of many communist economies, including the Soviet Union, demonstrated that government planning often distorts outcomes and does not provide the optimum allocation of resources. Many countries that rely on government planning have since introduced market characteristics into their economies. In contrast to economic systems led by government planners, market economies rely on government to act as a referee rather than an active participant. Governments administer systems of justice and enforce contracts and property rights to protect the market-based economy. Under such a system, government intervenes in the economy only when the market fails to allocate resources efficiently. Well-designed and implemented government policy can help improve outcomes in the market economy.