Understanding the basics of the economy

The role of the economy

People have many needs, such as the need to eat, to live in an apartment or in a house, to move around,  to meet others, to learn new things or to dress as they please. This is why people cook or go to a restaurant, buy a car, a bike or a ticket for public transport, meet up with friends to go to the cinema or to the theater and therefore they attend training or go shopping. People try to meet their needs in very different ways. In most cases, they are unable to fulfill all of them on their own. Often, they will have to rely on others who work in companies and offer different products and services.

When we buy products and services to meet our needs, we pay specific prices for them. We thus exchange our money for products and services.

To do so, we often use money we got for our own contribution to the economy. If we work for a company, for example, we will receive money (a wage or a salary) which we can use to buy things. On top of such paid work, however, there is also a lot of unpaid labor that is equally important to ensure that an economy can function. Such labor includes household tasks, childcare or caring for other relatives. Most of the time there is no remuneration for this kind of work. It is frequently also called care work. 

If we want to buy products or services, money is a means of exchange. Exchanging money for goods is a key mechanism in our economy. 

Our means of exchange are limited, though. The time we can spend working is limited, for example. When we work, our employer pays us money in return. Some people’s income is higher than others’. But no matter how high our income is, it is limited. The resources a company can use for production are limited too. Such limitations come with the challenge of decision-making. We have to decide what we want to spend our money on.

So, we engage in economic activities to meet our needs as best as we can with the limited resources we have. Companies engage in economic activities, to produce their products and services, thereby fulfilling their corporate purpose. 

Economic stakeholders

We enter into an exchange with others to meet our needs. This results in different trade relationships thatwe can image as a cycle. Throughout the so-called economic cycle, households (private individuals), companies as well as the state all enter into different types of relationships with each other.

Trade relationship 1: goods and consumer spending

We refer to private individuals as “households.” Households have different needs and cannot fulfill all of them by themselves. Therefore there is companies that produce and offer goods (products and services) for sale. Each company specializes in the fulfillment of certain needs. While some companies produce food, for example, others develop smartphones or design clothes. Households pay money to companies for the products and services they want. The money that is exchanged in this context is also called consumer spending.

Trade relationship 2: work effort and income 

Companies need different resources in order to produce goods. First and foremost: people to do the work. People work in all kinds of places, for example: in companies, educational institutions, public administration or social institutions. In return, they receive an income in the form of a wage or a salary. They can use this income for consumer spending to fulfill their needs. People's consumer spending enables companies to pay their employees, cover other costs and make profit. 

Trade relationship 3: taxes and public goods 

Money and goods are not only exchanged between households and companies. For example: Private individuals can use a number of services without directly having to pay for them. Think of roads, cycling lanes, sidewalks or assistance from the police, for example. In the domain of health care and education, people in Austria do not have to pay directly for certain services either because everyone should have equal access to them. Households and companies pay a part of their income and consumer spending to the state in the form of taxes and fees. The state then uses these revenues to provide public services. Both households and companies can make use of these services in different ways. Households, for instance, may benefit from family allowances, pension payments or education. Companies may receive subsidies or funding for research. Taxes allow for the provision of various government services. 

The economic cycle shows that private households, companies and the state interact with each other in many ways. Together they shape the economy by exchanging products, services and money. 

It is important to emphasize that we are describing a simplified version of the economic cycle here. In reality, these processes are much more complex, especially due to economic relations with other countries. Legal, political, social and cultural conditions play an important role, of course.

How the market price is determined by supply and demand

The economic cycle reflects many individual decisions: Households decide what they want to spend their income on, companies decide how much they want to produce of which product and the state decides about tax levels, for example. Markets are where all of these decisions intersect. They have a supply side and a demand side. Companies that produce bikes, for example, represent the supply side on the market for bikes. They can set a certain price for their bikes. If the price is very high, potential buyers – households or other companies – might be less willing to buy bikes. As a result, companies might find it difficult to sell their bikes and thus might be forced to lower the price. At a lower price, more households and other companies will probably want to buy bikes. This is likely to increase demand. Increased demand, in turn, could lead to companies raising their prices, so they can benefit from the increase in demand. The interplay between supply and demand on the market will ultimately lead to an equilibrium price. The equilibrium price reflects the price level at which supply and demand match. With changing demand the equilibrium price level will also change. If more people want to buy a product, for example, while its supply remains the same, its price will rise. This also happens if supply goes down (e.g. after a bad harvest) while demand remains unchanged.

The principle of supply and demand is not only valid for bikes, but for a broad range of products and services on various markets in the economic cycle. Next to the market for products and services, there is also a labor market. As employees, private individuals form the supply side and companies, as employers, represent the demand side. There is also a capital market, where the supply of and demand for money and capital come together. All markets follow the principle of supply and demand. 

Households, companies and the state may have different interests regarding the exchange of products, services and money. Households want to buy good products and services at a low price. They also want to receive a fair income for their work which, according to them, should be as high as possible. Companies  want  to make profit by selling their products and services. This could mean, for example, that they want to buy production materials of the desired quality at the lowest possible price. In their view, the labor required for production should not be too expensive either. The price they want for their goods and services, should be as high as possible. Similar conflicts of interest also arise where the state is involved. Households and companies would like to receive as many state-provided services as possible while paying as little taxes as possible in return.