An understanding of economics isn't seen as being as vital as balancing a household budget or learning how to drive a car. However, economics has an impact on every moment of our lives because, at its heart, it is a study of choices and why and how we make them. In this article, we'll look at some basic economic concepts that everyone should understand.
You implicitly understand scarcity, whether you are aware of it or not. It is the most basic concept in economics, and it is more of a solid fact than any abstraction. Simply put, the world has limited means to meet unlimited wants, so there is always a choice to be made.
For example, there is only so much wheat grown every year. Some people want bread; some people want cereal; some people want beer, and so on. Only so much of any one product can be made because of the scarcity of wheat. How do we decide how much flour should be made for bread? Or cereal? Or beer? One answer is a market system.
Supply and Demand
The market system is driven by supply and demand. Take beer again. Let's say people want more beer, meaning the demand for beer is high. This demand means you can charge more for beer, so you can make more money on average by changing wheat into beer than grinding that same wheat into flour. More people start making beer and, after a few production cycles, there is so much beer on the market that prices plummet. Meanwhile, the price of flour has been increasing as the supply shrinks, so more producers buy up wheat for the purpose of making flour – and on and on.
This extreme and simplified example does encapsulate the wonderful balancing act that is supply and demand. The market is generally much more responsive in real life, and true supply shocks are rare – at least ones caused by the market are rare. On a basic level, supply and demand helps explain why last year's hit product is half the price the following year.
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Costs and Benefits
The concept of costs and benefits encompasses a large area of economics that has to do with rational expectations and rational choices. In any situation, people are likely to make the choice that has the most benefit to them, with the least cost – or, to put it another way, the choice that provides more in benefits than in costs.
Going back to beer: If demand is high, the breweries of the world will hire more employees to make more beer, but only if the price of beer and the sales volume justify the additional costs to the payroll and the materials needed to brew more. Similarly, the consumer will buy the best beer he or she can afford – not, perhaps, the best-tasting beer in the store.
This extends far beyond financial transactions. University students perform cost-benefit analysis on a daily basis, by focusing on certain courses that they believe will be more important for them, while cutting the time spent studying or even attending courses that they see as less necessary.
Although people are generally rational, there are many, many factors that can throw our internal accountant out the window. Advertising is a concept with which everyone is familiar. Commercials tweak emotional centers of our brain and do other clever tricks to fool us into overestimating the benefits of a given item. Some of these same techniques are used quite adeptly by the lottery, showing a couple sailing a yacht and enjoying a carefree life. This image and its emotional message ("this could be you") overwhelm the rational part of your brain that can run the very, very long odds of actually winning.
Costs and benefits may not rule your mind all the time, but they are in charge more than you think – especially when it comes to the next concept. Adam Smith, the father of economics, derived many of his pioneering theories around the analysis of costs and benefits, including his promotion of free trade at a time when governments controlled most commercial interests.
Everything Is in the Incentives
Incentives are part of costs and benefits and rational expectations, but they are so important that they are worth further examination. Incentives make the world go round, and sometimes go wrong. If you are a parent, a boss, a teacher or anyone with the responsibility of oversight, and your situation goes horribly awry, the chances are very good that your incentives are out of alignment with what you want to achieve.
We'll take a safe example, however, of – you guessed it – a brewery. This particular brewery has two sizes of bottles: one 500 ml bottle and a 1L bottle for couples. The owner wants to increase production, so he offers a bonus to the shift that produces the most bottles of beer in a day. Within a couple of days, he sees production numbers shoot up from 10,000 bottles a day to 15,000. However, he is soon deluged with calls from suppliers wondering when orders of the 1L bottles are going to come. The problem, of course, is that his incentive focused on the wrong thing – the number of the bottles rather than the volume of beer – and made it "beneficial" for the competing shifts to cheat by only using the smaller bottles.
When incentives are aligned with organizational goals, however, the benefits can be exceptional. Some incentives have been proven so effective that they are common practice at many firms, such as profit sharing, performance bonuses and employee stock ownership. However, even these incentives can turn disastrous if the criteria for the incentives falls out of alignment with the original goal. Poorly structured performance bonuses, for example, have driven many a CEO to take temporary measures to juice the financial results enough to get the bonus – measures that often turn out to be detrimental in the longer term.
Putting It All Together
Scarcity is the overarching theme of all economics. It sounds negative, and it is one of the reasons economics is referred to as the dismal science, but it simply means that choices have to be made. These choices are decided by the costs and benefits that impact the choice, leading to a dynamic market system where choices are played out through supply and demand.
On a personal level, scarcity means that we have to make choices based on the incentives we are given and the costs and benefits of different courses of action. This is a very broad look at what is, believe it or not, a very compelling subject. These concepts feed into others, like comparative advantage, entrepreneurial spirit, marginal benefit and so on. The world is wide with choices, and so the field of economics is wide with theories, laws and concepts that explore those choices.
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The Bottom Line
These concepts aren't powerful laws that force human interactions into preset patterns. Rather, they are a recognition of the patterns that emerge from hundreds, thousands, millions and billions of individuals making choices with the information they are given. While knowing these concepts may not allow you to fundamentally change the world, it will help explain a lot. To discover the theories that shaped the way we've come to understand economics, see The History of Economic Thought.