When the price of something falls people usually demand more of it. This happens because you can now afford to buy more of it and also more people can afford it now. This is called the law of demand.
This means the higher the price, the lower the demand is, and the lower the price, the higher the demand for any normal good or service. Undeniably, a change in people’s tastes, income, and preferences can affect the demand for something, but we will assume that these other factors don’t change, so we can only focus on the relationship between price and quantity demanded.
The Law of demand is a key economic concept and has many uses and implications in our daily lives. The demand curve slopes downward when you plot the price on y-axis and the quantity demanded on the x-axis.
But does it happen to every single item and is there a way to find out by how much?
The answer to this is yes, and this brings us to another important topic, which is the price elasticity of demand.
By how much does the demand change with a change in its price?
The answer to this question depends on how responsive or sensitive the demand is to a change in price.
Economists call it elasticity of demand. Similar to the concept of a stretch of an elastic, we can look at how much does the demand stretches (changes) in response to a change in the price.
Many factors affect the elasticity of demand. Whether there are any substitutes for that good, if the good is a necessity or not, loyalty to a specific brand of good, time duration, and how much income you spend on that good all play a role in determining its elasticity.
In economics, if the percent change in the quantity demanded is more than the percent change in the price, we call it elastic. Going with the same logic, if the percent change in the quantity demanded is less than the percent change in the price, we call it inelastic.
Just if you are interested, here’s the formula to calculate elasticity.
So if the value is greater than 1, it means the good is elastic and is sensitive to price change.
So, those goods where a small change in price creates a big change in the quantity people demand, we call them having an elastic demand.
Similarly, those goods and services, where a change in price do not cause a change in demand, have inelastic demand.
Who uses this calculation anyway?
Businesses and corporations use this calculation to see whether their total revenue will increase or decrease, due to a decrease or increase in price. This also helps them in deciding how much discount to give you during the holiday season.
The government also uses price elasticity to select goods and services on which to impose excise duty for maximum revenue.
If you are interested in knowing more uses, here is another article that lists some other ones.
Let’s look at some real-life goods and services to understand this concept better.
Inelastic goods
A classic example of inelastic demand is gasoline in the short run. Anyone going to work every day needs gasoline to drive. Even if there is a rise in the price of gasoline, people will still need it. Some of us might find a carpool or use public transport, but for most of us, we will still need to fill up our gas tanks despite the high price.
Addictive things like tobacco have inelastic demand as well. Smokers still use it even if there is rise in its price. Similarly, certain prescription drugs, like insulin, because of their limited substitute availability also have inelastic demand.
Elastic goods
Now, let’s look at some things which have elastic demand. If the price of Pepsi goes up, a lot of people can switch to a close substitute like Coke, unless they are die-hard Pepsi fans. So Pepsi has a very elastic demand. So any item that has a perfect substitute, will have an elastic demand.
The duration of a price change and the category of the good or service also makes it more elastic. Too complicated! Let me example this with an example.
In my example above, over the short run, people may not find alternatives to going to work if the gas price goes up, so the demand is inelastic in the short run. However, over the long run, people can find alternative options, like using electric cars or working from home. Thus, the demand for gas will be elastic in long run.
A specific brand of milk can have elastic demand if people can substitute it with other brands, but milk in general will have more inelastic demand, as there are not many substitutes for dairy lovers. So here you saw the broad category of food has inelastic demand, meaning its demand won’t change if the price of milk goes up. However, a specific brand of milk can see a decrease in demand if its price increases.
The first chart shows price elasticity > 1, the second shows price elasticity < 1, and the third shows price elasticity close to 1.
Are there other types of elasticities as well?
Yes, there are two other types – cross elasticity, which looks at the effect of a change in the price of a substitute or complementary good or service), and income elasticity (which looks at the effect of change in income on quantity demanded. These are important because changes in demand can also happen due to changes in income level and price of other supplements or complementary goods.
But to not make the post overly long, I only focused on price elasticity in today’s post, as we wanted to see the effect of a change in price only.
Hope you found this microeconomics post helpful, to see my other microeconomics posts, please click here. And, yes, if you can think of another elastic or inelastic good or service, please write in the comment below.
These are all examples of externalities. Sorry, if this sounds too complicated at the beginning, it will all make sense as you read along. Externalities can happen when the after-effects of certain actions can spill over to other people not directly involved in it. These could be either positive or negative spillovers.
Externalities can arise between producers, between consumers or between consumers and producers. Externalities can be negative when the action of one party imposes costs on another, or positive when the action of one party benefits another.
Let’s look at an example of a positive externality. Vaccination for any infectious disease would be a positive externality because vaccination will reduce the overall severity, symptoms, and thus the possibility of spread of infection of that particular disease. This will also benefit people who are not vaccinated through positive spill overs by others who are. People who didn’t receive the vaccine are less likely to get an infection if more and more people around them are vaccinated. Vaccination also reduces the burden on a country’s healthcare and benefits society. Most recent example of this is the Covid 19 vaccine, which was provided mainly by the government in many countries to stop the spread of infection.
In both positive or negative externalities, government intervention is required to make sure the businesses that create externalities get the benefits for positive externalities or pay the price for negative externalities.
If a factory is producing toys but at the same time polluting the environment, people are bearing the cost of pollution. This is a negative externality. From an economic perspective, the business is transferring some of its cost of production to society. Without any tax on pollution, that business factory’s actual cost of production is less than what it should be, so it can charge lower prices from the people for the toys it produces. This reduced price creates more demand for toys, making the business produce more and more toys and thus polluting the air more.
In our first example above, the factory will find ways to reduce its chimney smoke from polluting air if it has to pay the price for its pollution. Government can impose taxes in these cases. Tax will also increase the overall cost of production for the business. The business will be forced to charge higher prices from the consumers, which will, in turn, reduce the demand for it and the over-pollution problem will be solved to some extent. Similarly, water pollution that is caused by industrial effluents can harm ocean life, other plants, animals, and humans. The government imposing a tax on factories creating water pollution can limit it to some extent. In economics, the use of tax to limit negative spillovers is known as internalizing the externality.
Another type of negative externality is caused by smoking. The government wants to discourage smoking and thus impose heavy duties and taxes on cigarette manufacturers because active or passive smoking both are harmful to society. Thus, cigarettes sell at a fairly expensive price. People who can’t afford to buy can refrain from consuming it. Also, smoking is banned in public places and to minors, these are all attempts to reduce the consumption of smoke.
Similarly, to encourage businesses with positive externalities, government can provide subsidies to those producers. When producers get subsidy it lowers their cost of production and it encourages them to produce more. Also, the subsidy is a government expenditure, which government meets through taxation on general public. This taxation on general public is either form of direct tax (like income tax) or indirect taxes (like those paid on goods and services when we buy them.) Thus, the society who is reaping the fruits of a positive externalities ultimately ends up paying the price of subsidy.
One example of this is public (government funded) education, when the government subsidizes public education, a greater quantity of education (more schools and colleges) is made and the society as a whole reaps the spillover benefits of more educated people. Also, parks, the police force, and public hospitals provided by the government provide benefits to any person who lives in the neighborhood. These are called public goods with positive externalities that are nonexcludable and benefit the larger public who indirectly pay for them through taxation.
How do we grow our money? We all know that unfortunately, we can’t grow our money on trees. But there’s a way to have more money in the future. If we start saving early and make regular contributions to it each month in an interest-bearing account with a bank, our money will grow. I will prove how an economist would do it- you guessed it right, by using graphs and numbers!
For the younger generation, this post might be particularly useful. As soon as you start getting paid from your first-time job, whether it is a part-time job, or your first full-time job after college, you must learn to save for your future. American economy and many other economies nowadays are very consumption-based economies. People tend to live above their means and take loans to buy luxury things early on in their lives instead of saving money for the future. Our current generation needs to understand that there is no shortcut way to getting rich. Saving a portion of your income every month is key to having a secure financial future.
A very important factor for anyone’s wealth creation is to learn to start budgeting. Before you spend money on any of your expenditures, you must set aside some money to pay yourself first. By paying yourself, I mean depositing a fraction of your income in a bank account that pays you some interest.
Banks are considered low-risk and safe places to save your money. In the US, deposits at banks are insured by the Federal Deposit Insurance Corporation, FDIC. Deposits held at credit unions is administered through the National Credit Union Administration, NCUA. Your money is very safe in a savings account and is almost risk-free, hence the return paid on savings is not very high. Risk and return move together. It means higher the risk, higher the return, the lower the risk, the lower the return.
Inflation erodes money’s purchasing power, so keeping extra money sitting idle at your home is not a good option at all. A portion of your money should be either saved in a savings or time deposit account in a bank and some portion should be invested in high-return, high risk assets. In another post, I will go over where you can invest your savings besides keeping them in a bank. For now, our focus here is to understand how money grows with compound interest over time.
Just with the power of compounding, you can grow your money by a lot and a few years by just keeping it in a time deposit in a bank. Compound interest, or compounding, means that interest is earned on both the amount you initially deposit, which is called Principal, as well as on the interest you earn each day until you withdraw your deposits.
The rate of interest that the bank pays us is expressed as a percent. Two main factors will determine how fast money has grown when you withdraw your savings deposit. The first is the time component and the second is the rate of interest.
Mathematically, we can express this as
= P (1+i)t/ 100
Where P is called the Principal amount that we deposit initially in a bank
i is the nominal interest rate that the bank pays
t is the time period for how long we’re saving
I will explain this with a simple example. Let’s assume that I started saving at the age of 17 and initially deposited $1000 in a savings account with a bank at 3% interest rate and kept it for 20 years. Now each month, I started depositing $50 into my account. This means I have deposited $1000 + $12000 during the 20-year period. Are you curious to see what happens to my money in 20 years? With the power of compounding, my money has grown to be at $18,235.85. I magically made an extra $5235, which is $18235.85-$13000.
If I didn’t make a monthly contribution to my savings of $50, my money would have only grown to $1820.75 in 20 years. Thus, we see that the regular savings contribution is a very important factor in growing your money. Simply putting a certain amount of money into a bank savings account before you pay any bill or buy anything, will help a great deal in growing your money.
Now, if we assume that this time duration increases from 20 to 50 years with the same monthly contribution of $50 per month and the same initial deposit of $1000 when I retire at the age of 67, I will get $73,939.46. If I add my monthly contribution of $50 each month for these 50 years with the initial deposit of $1000. I would have contributed a total of $30,950 by age 67. This $43,000 got created just with the power of compounding.
If the interest rate goes up from 3% to 5%, and I keep saving $50 a month with the same initial deposit of $1000, my total money would become $145,551.98 at the end of 50 years. And I will be so happy.
Now, let’s change one variable of the equation, our time duration t. Let’s assume that instead of starting to save at the age of 17, I started saving at the age of 30. I want to show you the exact figure of how much less money I would be able to collect after 37 years. In this case, the total time is reduced from 50 years to 37 years and even though the rate of interest is higher at 5%. I will only have $70,360.49 instead of $145551.98.
Thus, by looking at all these examples, we understood that it is just not how much you save but also how early you start that will help your money to grow. The power of compound interest is making your money grow exponentially, doing the job for you. * For our math-savvy readers, did you notice that the time variable t appears as an exponent in the equation above and thus, shows the exponential rather than linear growth.
You just have to put your saving in a safe interest-bearing account such as CDs or time deposits with a bank and make routine contributions to it, and please start early. Once you have the job, you can get the money directly deposited from your paycheck each month into your account.
So yes, always remember to pay yourself first.
As I wrote earlier in my post, there are a few other options available in the market to save and invest your money. Some of these options can give us higher returns than banks do but they also pose higher risks as well. A recent article by Bankrate lists some savings and investment options in the US with no to very low risk. We will go over those in my next post.
The answer to this complex question is simpler than you might think.
Do you think a business can charge whatever price it wants, to get the highest possible profit? But consumers who demand those products would like to buy them at the cheapest price, so how do they come to a consensus? In markets that are highly competitive (see footnote)*, meaning there are many producers and consumers of a specific good or service, the price of that product or service gets determined by the interaction of supply and demand forces. These forces work together in the same manner as the blades of the scissors cutting the paper.
Wait, but what are these supply and demand forces?
First, let’s understand them individually, and later we will see how they interact to set the “right” price.
Demand
In economics, we assume that people buy more of something when its price is lower. This negative or inverse relationship between price and quantity demanded is called the law of demand. This means the higher the price, the lower the demand is, and the lower the price, the higher the demand is for any normal good or service. Undeniably, a change in people’s tastes, income, and preferences can affect the demand for something, but we will assume that these other factors don’t change, so we can only focus on the relationship between price and quantity demanded.
Let me explain this with a simple example of the demand for bread. The prices are shown on the Y-axis and the quantity that people are demanding is on the X-axis. You can see this inverse relationship in the graph below that slopes downward.
If the price of one loaf of bread is $10 there is going to be very less demand for it, let’s say only 10 loaves of bread will be demanded. Once the price is lowered to $6, a few more people will be willing to buy it, so the quantity demanded increases to 20. And if the price is further lowered to $2, more people would be willing to buy it, as more can afford it, so the quantity demanded now is 40.
Supply
Now let’s look at the supply pattern. For a producer, if he gets a higher price for bread, he will be willing to make more bread and supply more of it. A higher price or reward encourages producers to supply more, and you can see this positive relation in the graph below as an upward-sloping supply curve. So, the law of supply states that there is a positive relationship between the price of a good and quantity supplied. This means the higher the price, the more businesses or producers are willing to supply, and the lower the price, the less they would like to supply. In the graph below, we can see at $2, producers are only willing to supply 10 loaves of bread, at $4, 20 loaves, and at $10, 40 loaves of bread will be supplied.
Now when we plot both of them together in one graph, we will see there is one price, where both these curves meet. In economics, we call it an equilibrium point, where the price is just right for the producer/seller and the consumers. In the graph below, this happens at point A, where demand and supply meet or cross each other. The price is set at $4 and the quantity demanded and supplied is 25 loaves of bread. Thus, we saw no one individually impacted the price, but producers’ supply and consumers’ demand worked together to set the price that makes everybody happy.
You understood how prices can influence how much people want to buy and produce. Now, let’s understand also, how it works the other way round, meaning how much people demand and businesses supply can influence the prices as well.
If there’s more demand than supply for something (such as point B above), this will send a signal to the producers to increase the price from $2 to $6, because they understand that people are prepared to pay more to receive that good or service. In this case, there is an incentive for the producers to increase the price. If the price goes up to $6, some consumers will drop out as they won’t be able to afford bread at price $6.
On the other hand, if there is more supply than demand (shown as point C above), this is a signal to the producers to lower the price from $6 to $2, because the price at $6 was too high and there is a very limited number of people who are willing to buy it. Now some producers, might drop out and can’t lower the price to $2, because they can’t cover their cost of production.
Over time the price will keep moving upwards or downwards until it reaches a point where demand is equal to the supply, at point A ($4).
Today, you learned two fundamental concepts in economics: the law of demand and the law of supply.
If you are wondering about whether it is possible to plot these demand and supply curves in real life, the answer is, yes? In economics, a graph is just a simple representation of economic principles or behavior observed. Economists survey people and collect data and plot that data using easy-to-understand graphs. In the demand and supply curves we looked at today, the slope could be steeper or flatter. In order to learn what decides how steep or flat (demand or supply) curve will be, we will have to look into another important principle in economics called elasticity. More on that will be in my future posts. For now, if you just want to know why economists use models and graphs to solve real-world economic problems, please read my post here.
*In non-competitive markets, like monopolies, where one company controls the market, it gets more control in setting the price. The demand and supply forces don’t work very well here. Producers want to get the maximum profits by setting the price higher and can do that as well. In the absence of other competing businesses, consumers who want to buy their product or use their service, don’t get other options. Hence, they end up paying a higher price than they would have paid if more companies were in the market for that product or service. Usually, to prevent businesses from exploiting consumers, some government intervention is required so these monopolies don’t create artificial barriers to entry.
It is worth noting that, some monopolies can happen naturally and not all monopolies are bad. We will look at this more in detail with real-world examples in another post.
We know economics is all about putting resources to their best use, so we get the most out of it. Economists use a fancy term called “allocative efficiency” to describe it. By resources, we mean land, labor, capital, entrepreneurial ability, and time.
Now, you may ask could there be different types of economies or economic systems to make the best use of limited (scarce) resources? Yes, indeed. These economic systems help to answer the three essential economic questions of what to produce, how to produce, and for whom to produce?
Let’s take a quick look at the three most common economic systems around the world: they are 1. free market, also called the market economy, 2. centrally planned economy also called the command economy, and 3. mixed economy or Keynesian economy
I don’t want to bore you with lots of text, so briefly I will explain these. But before you leave, make sure to scroll down to check an interesting chart comparing different countries in 2022. I know we all like visuals to better understand something.
So here are the three famous systems:
Market economy: In this type of economy, goods and services exchange freely through market supply and demand forces. In economics, it’s called Laizzes Faire, which means a policy of letting things happen their way, without interference. So, in this system consumers and firms interact freely and maximize their incentives without government intervention. Now, you as a consumer should typically act to satisfy your utility by demanding products you want or need. Similarly, all consumers will do the same. So, consumers signal the producers in the market about what to make and what not to make based on their demand. This helps to answer the question of what goods and services to produce.
Firms act to satisfy their profit motives by producing products at a minimal cost. Because businesses want to get maximum profits, they will adjust the production process to minimize costs so there’s less wastage of resources. This helps to answer the question of how to produce goods and services. Also, no single producer is required to know all the information in terms how many competing producers are there, and what is alternative use of his resources. Prices set by demand of consumers, and supply of every other producer can give him that signal to produce in the best possible way. Because if he charges more than others or don’t make the products people demand, people will not buy his product and go to the one next to him, given the other producer is local and they sell identical products. This has become easier with so many online shops now a days. Thus, the invisible hand or natural market forces will answer the question for whom goods and services are produced.
Let’s take an example, if more people demand more of a specific good, like iPhone, its price tends to rise as well. This happens because we as consumers are willing to pay more for that good. Acting in response, producers wanting more profit, will increase production to satisfy the demand of people. As a result, a market economy tends to naturally balance itself.
Whenever we see a rise in prices in one sector of an industry due to high demand, the scarce resources, such as land, labor, capital, and entrepreneurship shift to those areas where they’re needed the most. In the free market economy., the role of the government is only limited to protecting property rights, this way there is a guarantee of fair competition in the marketplace. People can protect their ideas through patents and copyrights, and this encourages innovation. Thus, a free-market economy is the one with the least amount of government intervention.
Command economy: On the opposite spectrum is the command economy, where the entire price set up and distribution of goods and services are controlled by a central planner or the government. All economic and political decisions are taken by the government or a central committee of very limited people. They decide how to allocate the country’s limited resources. North Korea is one example of this type of economic system. This type of economy is commonly seen in communist countries. Natural market forces of supply and demand can’t decide the price and quantity of goods and services produced and consumed.
Generally, people living in these countries don’t have a high standard of living and don’t enjoy economic freedom. By “economic freedom” we mean the ability to choose to produce something or consume something based on your ability and need. Since the government fails to collect all the information correctly about what to produce and how to produce, a lot of wastage happens. People who advocate a command economy think this system is more equitable because everybody gets an equal share. But at the core of economics is the belief that people want to act for their self-interest. As a result, there is less incentive for businesses to work hard and employ better production techniques to maximize profits. Because if someone doesn’t get to keep the extra share, why work hard for it?
There are flaws in both pure market economy and command economy
Let’s investigate, why both these economic systems are not perfect. We just discussed why the command economy is not a great system, but we also need to know what the limitations of a free-market economy are as well.
In a free market, sometimes, markets can waste scarce resources by producing products at higher than necessary costs. This usually happens when there is very less competition or if one producer displays a monopoly. Due to a lack of competition, there’s no real pressure to bring down costs as a result, prices are inflated. The second type of market failure happens in the case of public goods. Private businesses don’t want to produce these public goods, even though we all collectively enjoy these, and are very necessary for the safety and well-being of our people. Since these types of investments are usually not profitable for private firms to produce, they don’t do that. Services like infrastructure or military, police services or fire departments, parks, basic k-12 education and healthcare for the poor. So, if we are only left to the free market, the people would go without these goods and services and not have basic needs and wants met. Also, there will be more unequal distribution of income and people may have extreme inequalities. So, to solve this problem, some role of government is vital. This type of system is called a Mixed economy.
Mixed economy: Thus in the real world, pure market economies rarely exist because there is usually some government regulation or intervention needed for smooth function. In most countries, like the US, public education, security, law and order, nuclear energy, social security benefits, public goods like parks, and defense are provided by the government. The government also provides regulation, so businesses don’t create monopolies and exploit people by charging very high prices. The government also invests in scientific research to develop future businesses and industries. Additionally, when the economy is not behaving optimally, ie. when a lot of people are unemployed (as in a recession) or if the prices are too high (inflation), government intervention is needed to get the economy back to full employment and achieve stable prices.
How much role the government plays in an economy can vary between countries, but in countries with higher real GDP per capita, there has been less government intervention and more free-market play. In this economic system, the government or the public sector and the free market also known as the private sector, work together to meet social needs. The free-market system is allowed to work independently, but the government intervenes to avoid market failures. Thus, we see this mixed economic system as the most common economic system around the world today.
Here’s a chart from Heritage Index showing how different countries enjoy economic freedom. In their study, they used twelve economic freedom categories. Within these categories, they graded the freedom of doing it on a scale of 0 to 100. It’s interesting to see the twelve economic freedom indicators, which they use to calculate a country’s overall score. Here is the list, I got from their website. https://www.heritage.org/index/about
Rule of Law (property rights, government integrity, judicial effectiveness)
Government Size (government spending, tax burden, fiscal health)
Open Markets (trade freedom, investment freedom, financial freedom)
The study gives equal weight to each of the above factors.
Economic systems and economic freedom experienced in countries of the world
As you can see, countries with the highest score in economic freedom from 80-to 100, are in darker green. Countries with the least economic freedom are in red.
From the chart, you can see China, North Korea, Zimbabwe, Cuba, and Venezuela have the least economic freedom because of a command economy.
On the other hand, Singapore, New Zealand, Ireland, Switzerland, Luxembourg, Taiwan, and Estonia have the most economic freedom. When we look at the real GDP per capita of these countries, the people living there mostly have a higher standard of living. All these countries are highly advanced, free-market economies, mainly because of their open and corruption-free business environment. In all these countries, there is a well-secured property right to stimulate entrepreneurship and innovation. There is also a very high level of transparency and government accountability.
Many other countries, like India, Mexico, Brazil, and Russia show poor to moderate levels of economic freedom. Even though countries like India are opening from their initial planned structure, there is still a lot of bureaucratic red tape that hinders setting up new businesses easily there. In addition, there is a lot of political corruption and scandals. Unfortunately, many of them are not even reported.
Originally from India, I can’t stop noticing the score India got in this ranking. Unfortunately, it still got very low score in the economic freedom index. Despite considerable liberalization since 1990s, India still has a lot of government controlled sectors and capital market. International participation in many industries is still limited compared to many other countries that rank higher in the economic freedom index. Also, In India, property rights are not very well established, which hinders free enterprise and technological innovation. Reservation system based on cast, instead of socio economic status is another deterrent in its economic performance. All of this combined has caused the infamous brain-drain, where a lot of highly skilled class move to other countries for a better lifestyle. Unless all these changes are made, India is still has a long way to catch up in the economic freedom score.
The US and the UK and many advanced countries are mixed economies. They are under the “mostly free category” denoted in the light green color. According to their report, the US economic freedom score is 72.1, which makes it the 25th freest country in the world to do business in. The US private property rights are secured, and contracts are protected and enforced.
It’s interesting to note that countries with higher economic freedom also have higher GDP per capita and higher happiness indexes. So, we can conclude that, overall, less government intervention (only limited to areas where the market fails), is needed for countries to do better economically.
Has it ever happened to you while listening to the news that there is some big scary vague thing called the economy that’s just out there? You might think you have no control over it, as most of it is based on business and government decisions. You are wrong here!
You are also a very important player in the economic game. The economy is just all of us together, acting in our own individual best interests, deciding how to use the limited resources we have, to get the maximum happiness. By pursuing our selfish interests, we indirectly contribute to the growth of society, by the magic of some invisible hand.
We all are in the economy as everyday people, who are going about everyday tasks and decisions. The main point is that we’re all actors in the economy rather than spectators. So, we are not passively looking at this thing called economy but taking an active part in the economy all the time.
In other words, an economy is a large set of interconnected production, consumption, and trade of goods and services that help in determining how scarce resources are allocated. I know in economics some fancy words are often used, such as “scarce”. By scarce we mean limited, something that we don’t have an infinite amount of.
It is true that in the news, macroeconomic indicators are discussed more often, like inflation, GDP, unemployment, etc. But believe it or not, a lot of times, the decision-makers behind these big indicators are millions of small entities like you and me. In microeconomics, we look at how people can make the best decision they can to make their lives better by making good choices.
We apply an essential economic tool called “thinking on the margin” in our daily lives. It essentially means evaluating the benefit of one extra unit of something vs. the cost of one extra unit of the same thing.
For example, should I spend one more hour studying? Should I eat one more pizza slice? Small decisions like that are also economic decisions. Households, businesses, and governments all think about tradeoffs and marginal cost vs marginal benefit analysis while taking many decisions in life.
For an individual, it is a personal decision like should I spend a few additional minutes reading this article or should I switch to some other activity that may give me more marginal benefit? Similarly, firms must decide whether to hire additional labor to increase production and by how much? Will the extra revenue generated from hiring that extra labor to be enough to cover his cost of wages?
Lastly, on a macro (aggregate) level, governments make the monetary and fiscal policies to make more significant decisions by doing the same marginal analysis. Should they build an extra park or use the money on healthcare? We need to remember that the principles of economics can provide guidance across all sectors, be it at the micro-level or macro level.
A lot of people think economics is all about money, banks, complicated graphs, and mathematical modeling, but truly speaking it is much more interesting than that.
So, what exactly is Economics?
Economics is a study of human behavior, understanding the choices people make with their limited resources. By resources, we mean the tools needed to produce goods and services for humans consumption for a comfortable life. These resources are usually classified into 1)land, 2)labor, 3)capital such as tools and machinery, 4)human capital or entrepreneurship, and 5)our precious time.
We don’t usually have an infinite amount of these resources, so how do we allocate the limited resources to make us better off and happier? In short, Economics deals with our struggle to achieve happiness in a world full of constraints and limitations.
The word Economics comes from the Greek word oikonomia, which means household management. It starts with an individual making a tradeoff, choosing the best option that satisfies their wants, and forgoing the other best alternative use of their resources. From individual households, it moves to businesses, deciding what and how much to produce and sell. And lastly, government and the central bank decide when and how to intervene to ensure maximum happiness for its citizens.
We are making choices every single day. For example, if you are reading this, you have chosen to gain some knowledge vs. maybe, watching a TV Show or doing something else.
While reading this, you think you are making the best use of your time. (or at least I hope you do 😉 In short, you apply economics every minute (even when you don’t know it).
What does the field of Economics cover?
As you learn Economics, you can find answers to some fascinating questions such as:
How the price of anything is set?
How do we measure a country’s prosperity?
Why are some countries rich, while others are still poor?
What is inflation?
How do we understand business cycles?
What tools do the central bank and government use when the economy is facing inflation or a recession?
Is international trade a good thing?
And is reading this article even worth my time?
Trust me, the list is endless. There is a wide variety of areas that economics can cover. Economists try to solve many of these problems our world is facing today by simply understanding human behavior and the choices people make. I might have used the word choice a lot here, but hope you got the idea?
You will understand our rapidly evolving complex economies and how the economic fundamentals can still explain the changes.
You can apply Economics in your day-to-day life, such as while analyzing the cost and benefits of a particular decision you are going to make and managing your finances.
Similarly, you will also understand how economic principles apply to the businesses around us from a small local donut shop to a big company like Apple.
Understanding economics will enable you to evaluate the feasibility of promises made by politicians to get your vote.
Believe it or not, Economics can also help us understand the best strategy to deal with environmental issues, such as global warming and pollution.
Last but not least, since Economics is based on human behavior, there can be more than one view on any economic issue. It’s not an absolute science and many times economists differ on how a certain situation should be handled.
When you study Economics, you can acquire the necessary skills to argue why a specific viewpoint makes more sense to you.
Some key principles of economics are:
Everything has an opportunity cost and experiences diminishing returns.
People are rational (for the most part) and act in their self-interest (even charity is considered self-interest since it gives you some happiness).
Supply and demand interact through an invisible hand.
Comparative advantage fosters trade.
People think on the margin.
I will explain the above points in detail in my other posts. We will also dig into the two main subdivisions of economics: macroeconomics and microeconomics. We are only getting started!
