EDUCATION NEWS SIMULATOR YOUR MONEY ADVISORS ACADEMY

Advertisement
INVESTOPEDIA ECONOMY Advertisement

How Is an Economy Formed

Table of Contents
What Is an Economy?
Economic Formation
Growing an Economy
FAQs
and Why Does It Grow?
By ADAM HAYES Updated May 15, 2022
Reviewed by SOMER ANDERSON
Fact checked by RYAN EICHLER
Broadly speaking, an economy is an interrelated system of human labor,
exchange, and consumption. An economy forms naturally from aggregated
human action–a spontaneous order, much like language. Individuals trade with
each other to improve their standards of living. Improved standards of living
are made possible when labor is more productive. Productivity is driven by
specialization, technological innovation, and working capital. The only
sustainable way for an economy to grow is through increased productivity.

KEY TAKEAWAYS
An economy is a connected system of labor, exchange, and
consumption, formed from human action, and driven by increased
productivity.
Economies stand distinct from one another as a result of regional
boundaries; they develop distinctly from one another based on
government actions, policies, labor and productivity growth.
Economic growth results when groups of people, so-called economic
actors, are able to produce goods and services with increasing
efficiency.
To produce real productivity, an economy must have better tools and
equipment, namely capital goods, and greater specialization of
laborers.

What Is an Economy?
Most economies are distinguished from one another by regional boundaries
(the U.S. economy, the Chinese economy, the economy of Colorado), although
that distinction has become less accurate with the rise of globalization. It
doesn't take a planned government effort to create an economy, but it does
take one to restrict and artificially mold it.

The fundamental nature of economic activity only differs from place to place Advertisement

based on the restrictions placed on economic actors. All human beings are
faced with resource scarcity and imperfect information. The economy of North
Korea is very different from South Korea, despite a similar heritage, people,
and set of resources. It's public policy that makes their economies so distinct.

Economic Formation
An economy forms when groups of people leverage their unique skills,
interests, and desires to trade with each other voluntarily. People trade
because they believe it makes them better off. Historically, a form of
intermediation (money) is introduced to make trade easier.

People are financially rewarded based on the value others place on their
productive outputs. They tend to specialize in that which will deems them
most valuable. Then they trade the portable representation of their productive
value –money– for other goods and services. The total sum of these productive
efforts is referred to as an economy.

Growing an Economy
An individual laborer is more productive (and worth more) when they can more
efficiently turn resources into valuable goods and services. This could be
everything from a farmer improving crop yields to a hockey player selling more
tickets and jerseys. When a whole group of economic actors can produce goods
and services more efficiently, it's known as economic growth.

Growing economies turn less into more, faster. This surplus of goods and
services makes it easier to achieve a certain standard of living. This is why
economists are so concerned about productivity and efficiency. It's also why
markets reward those who produce the most value in the eyes of consumers.

There are only a handful of ways to increase real (marginal) productivity. The
most obvious is to have better tools and equipment, which economists call
capital goods–the farmer with a tractor is more productive than the farmer
with just a small shovel.

It takes time to develop and build capital goods, which requires savings and
investments. Savings and investment increase when present consumption is
delayed for future consumption. The financial sector (banking and interest)
provides this function in modern economies.

The other way to improve productivity is through specialization. Laborers

improve the productivity of their skills and capital goods through education,
training, practice, and new techniques. When the human mind better
understands how to use human tools, more goods and services are produced
and the economy grows. This raises the standard of living.

What Is Economics?
Economics is the study of how individuals and groups allocate limited
resources to be used for production, distribution, and consumption. It is
usually broken down into macroeconomics, which looks at the broad economy,
and microeconomics, which looks at individual people and businesses.

What Are Economic Indicators?

Economic indicators are reports on how an economy is performing in key
areas. These reports are released periodically and tend to impact stock
performance, interest rate policy and governmental policy. Some examples
include GDP, retail sales, and employment data.

What Are the Types of Economic Systems?

The main types of systems are primitivism, where individuals self-produce
needs and wants; feudalism, where economic growth is driven by production
by social class; capitalism, in which individuals and businesses own capital
goods and production is driven by the supply and demand dynamics of the
market economy; socialism, in which production decisions are made by a
group and many economic functions are shared by all; and communism, a type
of command economy in which production is centralized through the
government.

Compete Risk Free with $100,000 in Virtual

Cash
Put your trading skills to the test with our FREE Stock Simulator. Compete with
thousands of Investopedia traders and trade your way to the top! Submit
trades in a virtual environment before you start risking your own money.
Practice trading strategies so that when you're ready to enter the real market,
you've had the practice you need. Try our Stock Simulator today >>

Compare Accounts Advertiser Disclosure

PROVIDER

NAME

DESCRIPTION

Related Articles
Factory MACROECONOMICS

Why Are the Factors of Production

Important to Economic Growth?

Stats on board ECONOMICS

A Brief History of Economics

ECONOMICS Partner Links

Why Is Productivity Important in

Economics?

Engineers using ECONOMICS

technologies in car Capital as a Factor of Production
plant

ECONOMICS

What Are the Best Measurements of

Economic Growth?

Argentina PODCAST EPISODES

Untangling the Economic Enigma that is

Argentina

Related Terms
What Is Productivity and How to Measure It Explained
Productivity measures the efficiency of production in economics. Read about
productivity in the workplace and how productivity impacts investments. more

Economics Defined with Types, Indicators, and Systems

Economics is a branch of social science focused on the production, distribution, and
consumption of goods and services. more

What Is Capitalism: Varieties, History, Pros & Cons,

Socialism
Capitalism is an economic system whereby monetary goods are owned by individuals or
companies, and where workers earn only wages. more

Pareto Efficiency Examples and Production Possibility

Frontier
Pareto efficiency is an economic state in which resources are allocated in the most
efficient manner. more

Gross Domestic Product (GDP): Formula and How to Use It

Gross domestic product is the monetary value of all finished goods and services made
within a country during a specific period. more

What Is Economic Growth and How Is It Measured?

Economic growth is an increase in an economy’s production of goods and services. more

About Us Terms of Use Dictionary

Editorial Policy Advertise News

Privacy Policy Contact Us Careers

TRUSTe
California Privacy
Notice

# A B C D E F G H I J K L M N O P Q R S T U V W X Y Z

Investopedia is part of the Dotdash Meredith publishing family. We've updated our Privacy Policy, which will go in to effect on September 1, 2022. Review
our Privacy Policy