Economic behaviour involves the exchange of one scarce resource for another. When people engage in paid work, they exchange their scarce time, effort, and skill for income, and, when people make purchases, they exchange their scarce income for scarce goods and services. Economic activity is driven by the need to exchange.
Wants and needs
The need to exchange has its roots in human biology. All humans are born with basic needs, including the need to eat and drink, the need to keep warm, and the need to be protected. These result in a sustained demand for food, drink, clothing, and shelter.
In addition, the human species has wants, which also have a strong influence on behaviour. iPads, smartphones, designer clothes and foreign holidays are all examples of wants. As incomes rise the relative importance of wants increases in relation to needs. In a modern and affluent economy, the satisfaction of wants frequently dominates economic activity, while in less developed economies the satisfaction of basic needs remain the overwhelming goal.
The process of satisfying needs and wants is called consumption. The need and desire to consume drives individual economic actions and provides the motive for engaging in an exchange of scarce resources. To be able to consume, individuals need to exchange their skill and effort, or their enterprise, land or capital, for an income. They can then exchange this income for the products they need or want. Through exchange, consumption is satisfied by a process called production.
Factors of production
Production involves the creation of goods and services by using scarce resources. Producers must exchange the income they earn for the scarce resources they need to enable them to produce. Therefore, both parties, producers and consumers, must exchange something they have for something others want.
There are four types of scarce resource used in the process of production.
Land and natural resources
This includes the land on which production is located as well as the resources contained within the land, such as metals, minerals, and oil. The environment – the air, sea, rivers, and forests – is also a scarce resource.
This includes the value of human skill and physical effort that is available to an economy, and is more commonly referred to as labour.
This includes all man-made assets which have been created to help produce goods and services, such as machinery and equipment. Capital also includes stocks of raw materials waiting to be used before they become goods and serves. The creation of capital is called investment.
Enterprise is supplied by entrepreneurs, who have two crucial roles:
Combining the other factors in such a way that goods and services can be produced in the most efficient way.
Taking risks associated with the potential loss of assets or with making commercial losses.
Types of production
Production is undertaken by firms, also known as enterprises, or businesses. There are three main stages of production, corresponding to three economic sectors:
- Primary production, which involves the extraction of resources from the earth, such as agriculture, fishing, and mining. Land and natural resources are the main resources used in primary production.
- Secondary production involves the manufacture of semi-finished and finished consumer goods, such as computers, motor vehicles, and clothing. Labour and capital are the main resources used in the secondary sector.
- Tertiary production involves the distribution of products and the creation of services, such as road haulage, financial services, and healthcare. Human capital is usually the most essential resource used in tertiary production. The tertiary sector is sometimes sub-divided into tertiary, quaternary and quinary sectors. The quarternary sector of an economy includes the infrastructure of information technology and knowledge that enables an economy to produce successfully. The quinary sector is defined at the not-for-profit aspect of the economic, political and social infrastructure which supports economic activitiy, including universities, charities and government activity. Sophisticated quaternary and quinary sectors are commonly viewed as essential to economic development in a globalised economy.
In addition, two other sectors have been identified in a modern economy:
- The quaternary sector of an economy includes the infrastructure of information technology and knowledge that enables an economy to produce successfully.
- Finally, the quinary sector is defined as the not-for-profit aspect of the economic, political and social infrastructure which supports economic activity, and includes universities, charities and government activity. Sophisticated quaternary and quinary sectors are commonly viewed as essential to economic development in a globalised economy.
The role of money in exchange
Money occupies a central role in market economies because it acts as a medium of exchange. The advent of money replaced the need for exchange through barter and enabled producers and factor owners to specialise. For example, without money, a hairdresser would have to accept another good or service as direct payment for a haircut. However, if the hairdresser is paid in potatoes, it means that he must pay for his assistant in potatoes, as well as pay himself in potatoes, and his suppliers. However, what if another client wants to pay in rice, and yet another in wheat? What is a haircut worth in terms of rice or wheat? Exchange through barter is very complex, and barter economies tend to remain highly undeveloped because direct trade is extremely difficult.
Money allows complex trade and exchange
Money is any asset that is generally acceptable in the settlement of a debt incurred in an exchange. For an asset to be widely used as money, it must have certain properties, including that the asset is portable, divisible, durable and stable in value. Some assets fulfill the role of money much better than other ones. Potatoes, for example, would not make a good medium of exchange because they are not durable, nor do they have a stable value. Throughout history, gold and silver have frequently been used as money, given their divisibility into bars and coins. The introduction of paper money by the Chinese in the 9th Century AD marked a significant development in the evolution of money, especially given the ease with which different denominations could be created, and the portability of paper money in comparison with gold or coinage. It is said that the Chinese invented paper money because there was a shortage of metal to make coins.
It is clear that the evolution of money as a medium of exchange, and as a store of wealth, had a considerable impact on the development of modern commerce, international trade, and global prosperity.
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