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Basics of Economics

Basics of Economics



For new students, a logical place to start would be to ask: What is economics? For the answer to that question, consider these two facts of life: Human wants are unlimited, and resources are finite. This means that not everybody can have everything. This combination of unlimited wants and limited resources is called scarcity. Scarcity, in economics lingo, is not the same thing as shortage. The term shortage is a completely different concept and will be encountered elsewhere in the study of economics. Scarcity is called "the economic problem". How individuals, groups of individuals, and entire societies deal with this economic problem is what economics is all about. So one definition of economics is this:

Economics: the study of how people choose to use their scarce resources in an attempt to satisfy their unlimited wants.



Economics deals with the answers to the what, how, and who questions: WHAT should be produced? HOW should it be produced? WHO should it be distributed to?




As you will figure out, if you haven't done so already, the study of economics involves a certain kind of logic, a unique kind of thinking. This is one of the things that is difficult to define, but you will recognize it when you see it. This form of thinking is called "economic thinking", or the "economic approach".

Economic thinking involves the concept that costs include unintended consequences. Economists attempt to include these costs in the decision making process. This leads to a thoroughness of the thought process not found in all social sciences. When you hear people, especially politicians, discuss economics, you often hear them talk about what should be done, or what course of action should be followed. Such statements are called normative statements. Normative statements are statements about "what ought to be". Other kinds of statements you may hear in relation to economics are called positive statements, which are statements of facts, statements of the results of studies, etc. Positive statements include no value judgements, while normative statements include value judgements. The economic approach requires the avoidance of using normative statements. Only positive statements should be used in applying the principles of economics to real-world situations.


The use of normative statements is one trap to avoid when studying economics. For the economic approach, it might be helpful to note three other common mistakes to avoid:

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  1. Economics involves the study of human behavior. This should be done by assuming that people's behavior is governed by "rational self-interest" (more on that later on this page), instead of assuming that behavior is governed by ignorance. Don't assume that people behave in a certain way because they are too "stupid" to behave rationally. Instead, assume a rational reason for behavior.
  2. Avoid the fallacy of composition. This is the fallacy of saying that what applies to one will apply to many. For example, one person might be better off by saving more and spending less, but the consequences are different if everybody makes that choice at the same time.
  3. Just because an association between events can be found does not mean that one event caused the other. Two things happening together could be a coincidence. Or there may be a provable statistical connection between two events. But just because the events can be linked does not in any way imply that one caused the other.





I mentioned the term "rational self-interest". This is the assumption that economists make that states that the choices people make are done rationally, based on the information known at the time, in an attempt to maximize their satisfaction. This satisfaction is known in economics lingo as utility (the term "utility" will come up often in the study of economics). "Rational", in this sense, does not imply that everybody would make the exact same decision when confronted with the same choice, using the same available information. Different people can make different decisions and each can still be rational. Different people have different goals, different attitudes, and different costs.

Some economists use the term "bounded rationality" instead of "rational self-interest", in order to emphasize the fact that people do not have perfect knowledge at the time that they make decisions. But the terms are interchangeable. Also, it is important to note that "self-interest" is not the same thing as "selfish". People who are acting in rational self-interest, and are trying to maximize their satisfaction, can very well do so by helping others, giving to charity, and making numerous sacrifices.




A very important concept that is involved in all areas of economic analysis is the concept of equilibrium. I have found that while textbooks and classroom instruction generally explain this concept well as it relates to many economic principles, the concept of equilibrium is still often under-emphasized. If you keep in mind that if forms the basis for ALL areas of analysis, you should be able to have a clearer understanding of economic analysis.

The definition of equilibrium as it relates to the study of economics:

Equilibrium: a situation in which no forces exist to create changes



This definition can be applied to all areas of life, not just the areas normally associated with the study of economics.

The opposite of equilibrium is disequilibrium. When disequilibrium exists, the current situation is not sustainable in the long run and will change, - with changes moving towards a situation of equilibrium.

The following terms all terms that refer to the same thing: the terms are interchangeable.


Firm
Business Firm
Company
Enterprise
Business
Seller
Producer



They all refer to an organization that is controlled by one management structure and offers goods or services for sale in the hopes of earning a profit.



On the subject of economic analysis, the study of economics necessarily involves learning many different topics and concepts. This site is divided into various topics accordingly. In order to fully understand and analyze real life situations, knowledge of many different topics must be understood and incorporated into the analysis. Most topics are taught in terms of specific relationships, with assumptions made in order to isolate these relationships. These assumptions include one involving ceteris paribus, or "everything else held constant or equal". This assumption allows for a better understanding of the concepts being studied. It is necessary to make this assumption for studying concepts, but it is an assumption that does not hold true in the real world and must be relaxed when applying these concepts to real-life situation. In the real world, everything else is not constant or equal. The economy is dynamic, and changes are always occurring. With constant changes, real world analysis means that disequilibrium of some kind is always involved with any situation. Knowing which relationships are in equilibrium and which are in disequilibrium for any given situation is a key to proper economic analysis.

Since the real world economy is dynamic, composed of many different inter-relationships, the concept of equilibrium is actually more of a process or a direction of movement, rather than a state of being.




Goods and services



In the study of economics, the term "goods and services" is often encountered. Some comments about terminology would be appropriate at this time. "Goods" refers to physical products, while "services" refers to non-physical products. In terms of what is available for sale, an example of a good is a new car on a car lot. An example of a service is a housecleaning service. For many types of economic analysis, these terms are used together to indicate that the analysis applies to both together; thus the term "goods and services". Because this is used so often in economics, it becomes somewhat cumbersome to continuously repeat this term. Sometimes, in order to avoid this repetition, economists and economics textbooks may use the term "goods" to refer to "goods and services". This second meaning of the term "goods" may seem at times to be confusing, but the context that it is used in should allow you to know which meaning is being used in each instance.

Some other terminology to be familiar with:

Economic good: Something that wouldn't exist in sufficient quantities if it were free. This covers the vast majority of goods.

Free good: Something that there would be enough of even if it were free. It is very difficult to find a real-world example of a free good. Some people say that air is a free good, but in some locations, "clean air" is not free; there is a cost involved.

Economic bad: Something that people pay to have less of: pollution, for example.

Resources or economic resources: Anything used in the production of other goods and services. These include land, labor, and capital.

Land: This includes such things as minerals, timber, and water, as well as the actual land itself.

Labor: The physical and intellectual services of people. This includes training, education, and peoples' abilities. Entrepreneurship is a special class of labor, but some economists have classified it as a fourth type of resource.

Capital: Manufactured products such as machinery and equipment that are used in production. Capital in this sense is physical capital - separate from forms of financial backing such as stocks, bonds, etc. Those kinds of assets are known as financial capital, as opposed to physical capital. In terms of factors of production, capital only refers to physical capital.

These different types of resources produce earnings of their own, and these earnings all have their own terminology: land earns rent, labor earns wages, and capital earns interest. If entrepreneurship is listed as a fourth type of resource, then its earnings would be called profit.




The study of economics is generally divided into two broad categories: microeconomics and macroeconomics.

Microeconomics is the study of economics on the individual level: the individual firm, the individual consumer, the individual worker.


Macroeconomics is the study of economics at the level of the economy as a whole, or an entire industry or sector of the economy as a whole. Economic sectors are classified as the consumer, or household sector, the business sector, the government sector, and the international sector.



Graphs are an important part in the study of economics. See Using Graphs in Economics for an explanation of why graphs are not included in this website.


Using Math in the Study of Economics:
Different levels of economic study require different levels of mathematical knowledge. The purpose of this site is to teach basic economic concepts. With that in mind, an attempt is made to include only a minimal level of math. However, some math is included, because it is impossible to get very far in the study of economics without encountering some math. I am using the following rule for this site when it comes to using math: Some math is included, but nothing beyond linear algebra. This will cover the basics, and many students are familiar with the use of such math. For those who are not, much can be learned from reading this site: just skip over the math portions that are not understood. Much can be learned in that manner, but more can be learned if the math is also followed. Any questions involving a higher level of math will not be answered through this site. Also, statistics, important in many areas related to economics, will not be used here.




One last note about the study of economics: it is often talked about, and joked about, the fact that economists tend to disagree on about everything. Since economists, who are supposed to be the experts in the field, cannot agree or come to a consensus, then people, and especially government officials, often suggest that their own instincts and opinions are just as good as anybody else's, including the so-called expert economists. These people often draw erroneous conclusions by making this assumption. The truth is, economists actually agree on almost everything. One thing that economists always agree on is the logic of economics itself, something that often gets excluded by other people, including politicians. The few things open for disagreement are the only things that the public sees regarding economic thought. Since the public sees only the disagreements, they falsely conclude that disagreements among economists is the norm.

There are very good reasons behind the disagreements that do exist. Economies are very complex. They involve literally millions of inter-relationships and transactions every day. In order to be able to draw conclusions, economists develop simplified models to explain these relationships one at a time. Mentioned earlier in this section is the term "ceteris paribus", which is a Latin term meaning "other things being equal". This means that economists assume that the other millions of relationships are irrelevant to the study at hand. But this assumption only holds true within the economic model, the theory being studied. In the real world other things never remain constant. Isolating specific relationships does yield valuable, statistical correlations that aid in the understanding of how things work. Remember, though, that correlation does not prove cause and effect.

Keeping the assumptions in mind, and having the ability to understand what changes from the theory to the real world when the assumptions are lifted, often separates the "good" economists from the rest.

Economists have used many studies to create many simplified models of the complex world. Sometimes, the complexity is compounded by the fact that the relationships studied take time to develop in the real world. By the time they do, other factors will change. The result of all the complexity is that different interpretations of the conclusions that can be drawn from looking at different models will exist. This is one of the causes of disagreements among economists, and has led to different economic schools of thought. These differences often show up in public as being associated with different political philosophies. It doesn't mean that economists cannot agree on anything, and it doesn't mean that economic study is not worthwhile.

Another criticism of economists is that they are not 100% accurate in their predictions. But they are not supposed to be 100% accurate. That is not their jobs, and most of them don't claim that it is. Their jobs are to study the models, the evidence that they have at their disposal, compare that to the current and complex real world situation, and draw conclusions based on what they believe is likely to occur based on the information that they have at hand. These are economic forecasts, not quite the same thing as predictions of the future. But the complexity of the real world, compounded by the fact that future decisions will be made by imperfect humans, means that "results may vary" when it comes to forecasts about the economy.




This section covers the basics. It should give you a background for studying the various topics in economics. Where to begin?

This site is designed for flexibility: different people use it for different purposes. I have included a series of tabs and links to make navigation through the various topics as easy as possible. Many users of this site are looking for an explanation of a specific topic that they are studying in economics class.

Each topic should be relatively easy to find: start with the tabs and links on the home page. Perhaps you are unsure of where a specific topic would be located, or you want an even easier way to jump to a specific topic: start with the glossary section.

The glossary sectionis handy because it lists all of the economics terms that appear within this site, along with a handy definition as used in economics for each term. Perhaps that definition will answer your specific question. If not, or if you want to learn more, each term itself is a link to a page within this site where that term is used in context.

Perhaps you want to use this site for an overall study of economics. In that case, you would want to systematically work through different sections. In that case, keep in mind that the topics build on one another, so you would want to proceed through them in order. Some people prefer to begin with microeconomics; some prefer to begin with macroeconomics. If you begin with macroeconomics, you will want to be aware that it assumes some prior knowledge of some of the concepts involved with the study of supply and demand, which is part of microeconomics. So start with supply & demand, and then jump to macroeconomics.