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unions, and all other economic institutions) interacting in two kinds of markets — product markets and markets for productive services, or factor markets. Households appear as buyers in product markets and as sellers in factor markets, where they offer men, machines, and land for sale or hire. Firms appear as sellers in product markets and as buyers in factor markets. In each type of market, price is determined by the interaction of demand and supply, and the problem of microeconomic theory is to say something meaningful about the forces that make up demand and supply.
Theory of choice
At first it appears that all one can say is that everything depends on everything else. But firms and households do not behave in a vacuum. Firms face certain technical constraints in producing goods and services, and households have definite preferences for some products over others. It is possible to express the technical constraints facing business firms by writing down a series of "production functions," one for each firm. A production function is simply a kind of equation that expresses the fact that the output of a firm depends on the quantity of inputs it employs and, in particular, that inputs can be technically combined in different proportions to produce a given level of output. A production engineer could calculate, on the basis of existing technical knowledge, the largest possible output that could be produced with every possible combination of inputs and in this way could define a boundary to the range of production possibilities open to a firm. By itself this does not tell how much the firm will produce or what mixture of products it will make or what combination of inputs it will adopt: these depend on the prices of products and the prices of inputs (or "factors of production"), which have yet to be determined. One may assume that the firm is motivated in a particular way: it wants to maximize profits, which are defined as the difference between the sales value of its output and the money outlays required to obtain its inputs. It will, therefore, select that combination of inputs that minimizes the costs of producing any given quantity of output and will select from the range of possible combinations of products that combination that maximizes its revenues. This is to say that it always tries to move along its production function, along the edge of the boundary of technical possibilities. But where it ends depends, in part, on the demand for its products. This leads to the part played by households in the system.
Households are endowed with definite "tastes" that can be expressed in a series of "utility functions," one for each household. A utility function is an equation like a production function, expressing the fact that the pleasure or satisfaction that households derive from consumption depends on the products that they purchase and on the various ways in which they combine these products in consumption to yield a given level of satisfaction. The utility function need not be specified in the
same detail as a production function. One may think of it as a general description of the household's preferences between all the paired alternatives with which it will be confronted. Here, too, it is necessary to assume something about motivation to make any progress: the assumption is that households seek to maximize satisfaction, distributing their given incomes among available consumer goods in such a way as to derive the largest possible "utility" from consumption. Their incomes, however, remain to be determined.
The purpose of production functions in economic theory is to provide an anchor in the bedrock of technology from which to derive the "supply curves" of firms in product markets and the "demand curves" of firms in factor markets. Similarly, the purpose of utility functions is to provide an anchor in subjective "tastes" from which to derive the "demand curves" of households in product markets and the "supply curves" of households in factor markets. All of these demand and supply curves express the quantities demanded and supplied as a function of prices, not because price is the only determinant of economic behaviour but because the purpose is to have a theory of price determination. Much of economic theory is devoted to showing how various production and utility functions, coupled with certain assumptions about behaviour, lead to demand and supply curves in which the quantity demanded is inversely related and the quantity supplied positively related to price. The figure depicts these relationships (curves would be just as suitable as straight lines).
Not all demand and supply curves look alike. The essential point is that most demand curves are negatively inclined, while most supply curves are positively inclined. This may seem a modest result for a great deal of effort, but the argument has powerful implications. The participants in a market will be driven automatically to the price at which the two curves intersect; this price p is called the "equilibrium" price or "market-clearing" price because it is the only price at which supply and demand are equal. If it is a market for butter, any change in the production function of dairy farmers or in the utility function of butter consumers or in the prices of cows, grassland, and milking equipment or in the incomes of butter consumers or in the prices of nondairy products that consumers buy can be shown to lead to definite changes in the equilibrium prices of butter and in the equilibrium quantity of butter produced. Better still, the effects of a government ceiling on the price of butter or of a tax on butter producers or of a price-support program for dairy farmers can be predicted with almost perfect certainty. As a rule, the prediction will refer only to the direction of change (the price will go up or down); but if the demand and supply curves of butter can be defined in quantitative terms on the basis of past data, one may be able to predict the actual magnitude of the change.
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Theory of allocation
This analysis of the behaviour of firms and households is to some extent symmetrical: all economic agents are conceived of as ordering a series of attainable positions in terms of an entity they are trying to maximize. For a firm these attainable positions are essentially input combinations; for a household they are product combinations. From the maximizing point of view, some combinations are better than others; the best combination is called the "optimal" or "efficient" combination. The rule for efficient, optimum allocation may now be stated baldly: an optimum allocation is one that equalizes the returns of the marginal or last unit to be transferred between all the possible uses. In the theory of the firm, an optimum allocation of outlays among the factors of production implies that the "marginal physical product" of an additional dollar devoted to hiring the services of any one of the factors is the same for all factors; the so-called law of eventually diminishing marginal productivity, a property of a wide range of production functions, ensures that such an optimum exists. In the theory of consumer behaviour an optimum situation obtains when the consumer has distributed his given income in such a way that the "marginal utility" of each additional dollar spent on any of the products purchased is equal for all products; the "law of eventually diminishing marginal utility," a property of a wide range of utility functions, ensures that such an optimum exists. These are merely particular examples of the "equimarginal principle," which is not only at the core of the theory of the firm and the theory of consumer behaviour but also underlies the theory of money, of capital, and of international trade. In fact, the whole of microeconomics is nothing more than the spelling out of this principle in ever wider contexts.
The equimarginal principle is, of course, applicable to any decision that involves alternative courses of action. Economics furnishes a technique for thinking about decisions, whatever their character and whosoever makes them. Military planners may, for example, consider a variety of weapons in the light of a single objective, that of damaging an enemy; some of the weapons are effective against the enemy's army, some against the enemy's navy, and some against his air force; the problem is to find an optimal allocation of the defense budget, one that equalizes the marginal contribution of each type of weapon. But defense departments rarely have single objectives; along with maximizing damage to an enemy there may be another objective, such as minimizing losses from attacks. In that case, more than the equimarginal principle is needed for a decision; it is necessary to know how the department ranks the two objectives in order of importance, since different rankings will imply different optima. But a ranking of objectives is simply a utility function or a preference function.
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In other words, when an institution pursues multiple ends, decisions about how to achieve them require a weighting of the ends. Every decision involves a "production function"— a statement of what is technically feasible — and a "utility function"; the equimarginal principle is then invoked to provide an efficient, optimal strategy. This applies just as well to the running of hospitals, churches, and schools as to the conduct of a business enterprise, to the location of an international airport as well as to the design of a development plan for an underdeveloped country. This is why economists crop up in what seem to be the most unlikely places, advising on activities that are obviously not being conducted for economic reasons.
Macroeconomics
There is, however, an approach to economics in which the foregoing considerations do not apply. That is the field known as macroeconomics. In macroeconomics one is concerned with the aggregate outcome of individual actions. Keynes's "consumption function," for example, which relates aggregate consumption to national income, is not built up from individual consumer behaviour; it is simply an empirical generalization. The focus is on income and expenditure flows rather than on markets. Purchasing power flows through the system from business investment to consumption, but it leaks out at two places in the form of personal and business savings. Counterbalancing the savings are investment expenditures in the form of new capital goods, houses, and so forth, which constitute a source of new injections of purchasing power in every period. Since savings and investments are carried out by different people for different motives, there is no reason why "leakages" and "injections" should be equal in every period. If they are not equal, national income, the sum of all income payments to the factors of production, will rise or fall in the next period. When planned savings equal planned investment, income will be at an equilibrium level, that is, a level at which it can sustain itself; when the plans of savers do not match those of investors, the level of income will go on changing until the two do match. One can complicate this simple model by making investment a function of the interest rate; by introducing the government budget, the money market, labour markets, imports and exports, foreign investment; and so forth. But all this is far removed from the problem of resource allocation and from the maximizing behaviour of individual economic agents.
The result is a kind of intellectual schizophrenia in which the techniques of microeconomics do not carry over fully into macroeconomics and vice versa. This is widely held to be an unsatisfactory state of affairs; economists have in recent years sought to build a bridge between the individual consumer and the overall
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consumption function and between the individual investor and the behaviour of aggregate investment. Nevertheless, the bridge remains incomplete, and the student of economics must be prepared to work with two boxes of tools.
Econometrics
Like mathematical economics, econometrics is something economists do rather than a special area of interest. Econometrics refers to the study of empirical data by statistical methods, the purpose of which is the testing of hypotheses and the estimation of relationships suggested by economic theory. Whereas mathematical economics considers the purely theoretical aspects of economic analysis, econometrics attempts to falsify theories that are expressed in explicit mathematical terms. But frequently the two go together.
The classic technique for estimating an economic relationship is that of "least squares," which is a method of fitting a trend line to a scatter of observations that minimizes the square of the deviations of the observed points from the line. To take a simple example: the Keynesian theory assumes that consumers' expenditures depend principally on income; one may interpret this to mean that consumption depends only on income and then test the hypothesis by trying to fit a trend line to a series of observations of income and consumption over a period of time. In so doing, one is really saying that the observations that fall to either side of the line are due either to errors in measuring the variables or to errors in specifying the relationship between consumption and income. It is essential to the method of least squares that these "errors" be randomly distributed or at any rate distributed in known ways. When this condition is violated, least squares estimates are unreliable. It is sometimes difficult to tell with economic data just how the errors are randomly distributed, and it is precisely for this reason that an econometrician is needed rather than an ordinary statistician.
A still more significant trend in recent econometrics is the tendency to move from single-equation estimates (such as the relationship between consumption and income) to systems of simultaneous equations. While consumption depends on income, income also depends on consumption; this kind of interdependence requires two equations rather than one. More generally, most economic variables are the result of demand and supply forces that simultaneously determine quantities and prices. To estimate a demand curve for butter from a single-equation regression (by relating the price of butter to the quantities of butter consumed, the incomes of consumers, and the prices of near substitutes for butter) is likely to produce a biassed answer because the price of butter is also influenced by supply conditions in the dairy industry. This creates the so-called identification problem, namely, the question of whether it is possible to identify a demand curve or a supply curve
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from observed price-quantity data. The use of simultaneous equation models to estimate economic relationships is by now perhaps the best way of distinguishing econometrics from economic statistics.
The foregoing discussion covers only nine major branches of economics. There are many other fields in economics, including economic history, comparative economic systems, business cycles, economic forecasting, national income accounting, managerial economics, business finance, marketing, the economics of natural resources, economic geography, consumer economics, and regional
economics.
Mark Blaug
Growth and development
The study of economic growth and development is not a single branch of economics but falls, in fact, into two quite different fields. The two fields — "growth" and "development"— employ different methods of analysis and are indeed addressed to two distinct types of inquiry. Development economics is easy to describe. It is one of the three major subfields of economics, the other two being microeconomics and macroeconomics. Development economics resembles economic history in that it seeks to explain the changes that take place in economic systems with the passage of time.
The subject of economic growth is not so easy to characterize. It is the most technically demanding field in the whole of modern economics, impossible to grasp for anyone who lacks differential calculus. Its focus is the properties of equilibrium paths, rather than equilibrium states. One makes a model of the economy and puts it into motion, requiring that the time paths described by the variables be self-sustaining in the sense that they continue to be related to each other in certain characteristic ways. Then one can investigate the way economics might approach and reach these steady-state growth paths from given starting points. Beautiful and frequently surprising theorems have emerged from this experience, but as yet there are no really testable implications nor even definite insights into
how economies grow.
Growth theory began with the work of Roy Harrod in England and Evsey Domar in the United States. Their joint product has been known ever since as the Harrod-Domar model. Keynes had shown that new investment has a multiplicative effect on income and that the increased income generates extra savings to match the extra investment, without which the higher income level could not be sustained. One may think of this as being repeated from period to period, remembering that investment, apart from raising income disproportionately, also generates the capacity to produce more output that cannot be sold unless there is more demand,