Chapter 1: Basic Concepts, Scope and Methodology of Economics

Introduction

It is not possible to produce all the goods and services people desire because of limited resources. Therefore, people have to prioritize their needs. Economics studies how individuals and societies prioritize their needs and choose to use scarce resources at their disposal. In other words, economics is the study of how society manages its scarce resources.

In economics, decision makers need to compare marginal benefit and marginal cost of his/her action. Only if the benefit is greater than the cost, any action should be undertaken.

Microeconomics and macroeconomics are two major branches of economics study. While microeconomics examines the decision-making behavior of the smallest decision-making units such as the individuals, or households and the business firms, macroeconomics examines the aggregate behavior of economic agents and the government on a national scale.

What is economics?

In general, people do the things they do for two main reasons: either they like to do it or they need to do it. What they need to do may not match what they like to do; thus, people have to make choices considering the limited time they have. Besides time, money is another limited resource, which compels people to make choices regarding how to use their scarce resources.

Scarcity arises from the limited nature of society’s resources compared to unlimited needs and desires.

As material inputs and factors of production needed to produce goods are not available in unlimited quantities, it is not possible to produce all goods and services in sufficiently large quantities. The economic problem arises due to this scarcity, so economics studies individuals’ and societies’ priorities in handling scarce resources.

Interaction between consumers and producers determines the prices of various goods and services, and how much of each will be produced and sold.

Hence, economists examine the whole process of the allocation of society’s limited resources between different goods and services needed by different sections of the society, and analyze the effects of the government’s actions on the economy as a whole. Such factors as growth rate of total income, unemployment rate and inflation rate are also in the scope of economists’ studies.

Although study of economics is divided into subcategories focusing on different specializations, there are basic concepts that are common in each field.

Basic concepts

What a person has to give up to get an item or to achieve an outcome is called the opportunity cost. Opportunity costs of each action should be recognized while making choices. In some cases, the nature of opportunity costs may change over time or depending upon alternative outcomes resulting from an action.

The locus of all output pairs that could be produced with the available production technology when the firm uses all its scarce resources fully and efficiently is called production possibilities frontier (PPF). In other words, it is a graph showing various combinations of output that the firm can produce in its factory with the available workforce and other inputs by using the available production technology.

Basic economic concepts such as scarcity, efficiency, tradeoffs and opportunity cost can be illustrated effectively on a PPF.

Efficiency is closely related to PPF, and it refers to the ability to put a given amount of scarce resources into use in such a way to produce the highest level of output that could be produced with the available production technology.

Equity, on the other hand, is related to the distribution of resources fairly among the members of a society.

Efficiency and equity are often in conflict. The government should give proper weights to these often conflicting goals in order to set its priorities.

Many of our decisions in life are not binary; that is, our decisions involve more than two alternatives.

The term marginal is often used in economics, and it can be defined as small incremental adjustments made on an existing plan of action. Therefore, marginal changes are adjustments made to add to the total achieved so far.

People may have to think at the margin to be able to make the best decision. Thinking at the margin while taking an action indicates that the rational decision makers such as individuals, firms, and students, take an action if and only if the marginal benefit of the action is greater than the marginal cost.

The continuous interaction between the actions of firms and households in a market economy affect market prices, and get affected by changes in those prices. Even though the actions of self-interested actors are often completely uncoordinated, market economies have proven remarkably successful in matching what consumers want with what producers are willing to supply in such a way to promote overall economic well-being of the society.

A Market Economy allocates resources through the decentralized decisions of many producers and households that interact in various markets.

Considering certain social or policy goals, the government may intervene in markets even though government interventions sometimes prevent prices from responding naturally to changes in supply and demand.

When the market fails to allocate resources efficiently market failure occurs. Presence of externalities may be a reason of market failure. An externality is the one that has often unintended impact that an economic actor’s actions has on the well-being of another actor who stands by.

Market power, which is the ability of a single actor (or a few actors) to control or substantially influence market prices, may also cause market failure.

Although a market economy rewards individuals by their ability to produce things that others are willing to purchase, this may not always mean that each individual will have enough food to eat, a decent shelter, or access to health care.

Contrary to zero-sum game, in which one of the parties wins when the other loses, international trade is a positivesum game, which means both parties are winners. Trade, whether domestic or international, contributes to wellbeing of all participants since it allows countries to exchange what they produce most efficiently for what they cannot produce quite as efficiently.

Economywide outcomes and the difference between microeconomics and macroeconomics

Microeconomics studies the behavior and decisions of the smallest decision units such as individuals or households and firms. Collective behavior of these smallest decision units produces economywide outcomes, which is the subject matter of macroeconomics. That is, macroeconomics study how a country’s economy as a whole is structured and works, by paying particular attention to the effects of monetary and fiscal policies pursued by the government. Standards of living; for instance, is a topic discussed in macroeconomics.

A country’s standard of living depends on the economy’s ability to produce goods and services; therefore, it may change dramatically from one country to another. Differences in living standards among countries are mainly due to the differences in worker productivity across countries. People enjoy a higher standard of living in countries where workers can produce a larger quantity of goods and services per hour or per day.

Another factor that affects standards of living is the prices as they determine the actual purchasing power of a given level of income. Inflation is the increase in the general price level (or overall level of prices) in the economy within a given period of time. It must be kept under control because high inflation enforces certain economic and social costs.

As economic policy choices may lead to conflicting outcomes, it is necessary for policymakers to attribute different weights to desirable and undesirable outcomes by prioritizing economic policy goals. Hence, economists study how such policy instruments as tax collection and the quantity of money put in circulation could be used to achieve different goals.

Methodology of economics

In scientific method, economists develop theories after carefully observing the relevant behavior of economic agents and real world phenomena, and then they put those theories to test by using data. This method follows a sequence starting and ending with observations. While initial observations help formulate the theory, following observations continuously test the validity of that theory.

However, experiments are often difficult to conduct in economics. In order to overcome these difficulties, economists study history or closely watch current developments in the world to identify natural experiments that might have occurred.

The real world, which is too complicated to fully understand, is simplified through assumptions in economics. Even though different assumptions can be used to answer different questions, the main purpose of assumptions is to simplify the analysis.

Primarily, economists offer solutions to economic problems. In order to achieve this, they first explain the causes of economic events by answering questions. Then, they need to fully understand the causes of relevant economic outcomes, and they recommend policies to fix those outcomes.

There are two types of statements in the study of economics: positive statements and normative statements. Positive statements in economics are statements that intend to describe how things are and how things actually work. A normative statement is a prescriptive statement, like the ones expected to be made by a policy adviser, involving normative judgements and prescriptions about how the world should be.

While it is in principle, possible to confirm or refute positive statements based on available evidence, using data alone is not adequate to decide on the validity of normative statements. This creates a crucial difference between positive and normative statements. Moreover, ethical judgements, religious or political views are involved in deciding on good or bad policies.

On the other hand, positive and normative statements are connected in that our positive views about how the world works affect our normative views about the desirability of various policies. Normative conclusions cannot be solely based on positive analyses, though.

Generally, how the economy works is explained in economics; however, the goal of economics is often to improve the way the economy works.