How Is an Economy Formed and Why Does It Grow?

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.

Defining 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 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.