While having a basic understanding of economic theory isn't perceived as being as important as balancing a household budget or learning how to drive a car, the forces that underpin the study of economics impact every moment of our lives. At the most basic level, economics attempts to explain how and why we make the purchasing choices we do.

Four key economic concepts—scarcity, supply and demand, costs and benefits, and incentives—can help explain many decisions that humans make.

Key Takeaways

  • Four key economic concepts—scarcity, supply and demand, costs and benefits, and incentives—can help explain many decisions that humans make.
  • Scarcity explains the basic economic problem that the world has limited—or scarce—resources to meet seemingly unlimited wants, and this reality forces people to make decisions about how to allocate resources in the most efficient way.
  • As a result of scarce resources, humans are constantly making choices that are determined by their costs and benefits and the incentives offered by different courses of action.

Scarcity

Everyone has an understanding of scarcity whether they are aware of it or not because everyone has experienced the effects of scarcity. Scarcity explains the basic economic problem that the world has limited—or scarce—resources to meet seemingly unlimited wants. This reality forces people to make decisions about how to allocate resources in the most efficient way possible so that as many needs as possible are met.

For example, there is only so much wheat grown every year. Some people want bread and some would prefer beer. Only so much of a given good can be made because of the scarcity of wheat. How do we decide how much flour should be made for bread and beer? One way to solve this problem is a market system driven by supply and demand.

Supply and Demand

A market system is driven by supply and demand. Taking the example of beer, if many people want to buy beer, the demand for beer is considered high. As a result, you can charge more for beer and make more money on average by using wheat to make beer than by using wheat to make flour.

Hypothetically, this could lead to a situation where more people start making beer and, after a few production cycles, there is so much beer on the market—the supply of beer increases—that the price of beer drops.

Although this is an extreme and overly simplified example, on a basic level, the concept of supply and demand helps to explain why last year's popular product is half the price the following year.

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5 Economic Concepts Consumers Need To Know

Costs and Benefits

The concept of costs and benefits is related to the rational expectations and rational choices of consumers. In every situation, people try to maximize their benefits while minimizing their costs.

If demand for beer is high, breweries will hire more employees to make more beer, but only if the price of beer and the amount of beer they are selling justify the additional costs of their salary and the materials needed to brew more beer. Similarly, the consumer will buy the best beer they can afford to purchase, but not, perhaps, the best-tasting beer in the store.

The concept of costs and benefits is applicable to other decisions that are not related to financial transactions. University students perform cost-benefit analyses on a daily basis by choosing to focus on certain courses that they've deemed more important for their success. Sometimes this even means cutting the time they spend studying for courses that they see as less necessary.

Although economics assumes that people are generally rational, many of the decisions that humans make are actually very emotional and do not maximize our own benefit. For example, the field of advertising preys on the tendency of humans to act non-rationally. Commercials try to activate the emotional centers of our brain and fool us into overestimating the benefits of a given item.

Everything Is in the Incentives

If you are a parent, a boss, a teacher, or anyone with the responsibility of oversight, you've probably been in the situation of offering a reward—or incentive—in order to increase the likelihood of a particular outcome.

In the example of a brewery, the owner wants to increase production so he decides to offer an incentive–a bonus–to the shift that produces the most bottles of beer in a day. The brewery has two sizes of bottles: one 500 milliliter bottle and a one-liter bottle. Within a couple of days, he sees production numbers shoot up from 10,000 to 15,000 bottles per day. The problem is that the incentive he provided focused on the wrong thing—the number of bottles rather than the volume of beer. He begins receiving calls from suppliers wondering when orders of the one-liter bottles are going to come. By offering a bonus for the number of bottles produced, the owner made it beneficial for the competing shifts to gain an advantage by only bottling the smaller bottles.

When incentives are correctly aligned with organizational goals the benefits can be exceptional. These practices include profit sharing, performance bonuses, and employee stock ownership. However, these incentives can go awry if the criteria for determining if an incentive has been met falls out of alignment with the original goal. For example, poorly structured performance bonuses have driven some executives to take measures that improve the financial results of the company in the short-time—just enough to get the bonus. In the long-term, these measures have then proven detrimental to the health of the company.

Economics Is the Dismal Science

Scarcity is what underpins all of economics, which is why economics is sometimes referred to as the dismal science. Humans are constantly making choices that are determined by their costs and benefits. On a personal level, scarcity means that we have to make choices based on the incentives we are given according to different courses of action. On a market level, the impact of millions of people making choices creates the forces of supply and demand.