First principles
First principles
To the world at large economics is often mistakenly thought of as being strictly related to money. Part of that is likely because the origins of the field are connected to thinking about money. The term economics is derived from the Greek word oikonomia, referring to the management of a household.
That does fit into the modern idea of microeconomics, the part of economics concerned with decision-making at a smaller scale. This includes individuals, households, firms and the structure and operation of markets. While these will appear for us in small amounts, they will not be the focus of this course.
In 1776 Adam Smith, a Scottish philosopher considered the father of modern economics, defined economics as “an inquiry into the nature and causes of the wealth of nations.” This definition points towards macroeconomics, which concerns activity at a larger scale and is the focus of this course. Topics will have a heavy emphasis on aggregate activity, the choices of many individual actors added up. This includes national production, income and spending, markets for investment and money, international trade, and international financial flows.
Our first chapter will build up general concepts and pieces of microeconomics that are essential to understand later material, before continuing on to the core topics. To complete our introduction, we will review a small set of fundamental concepts that are critical for deeper understanding of economics in general.
Behind the definition
The modern definition of economics that provides a natural starting point comes from Lionel Robbins, in his 1932 writing An Essay on the Nature and Significance of Economic Science. He defines economics as “the science which studies human behavior as a relationship between ends and scarce means which have alternative uses.”
Many introductory definitions paraphrase this quote, precisely because it gets directly at three fundamental concepts. They are defined below, and we will expand on them in sequence.
Scarcity
Scarcity can be considered the driving force behind economics even existing as a field. Human desires are unlimited, and economics can be viewed as the study of how to use our limited resources to maximize total benefits and satisfy as many of those wants as possible.
This is most easily seen for physical resources and goods. Only one plug can go into an outlet. Even with creative thinking such as adding a surge protector to provide more outlets, there are limits. Goods and services where use by one individual prevents use by another are referred to as rival.
Think of a piece of wood. If it is used as an input for making one good, it cannot be used to make another. Any wood used to make a chair, cannot also be used to make a table.
Even non-rival goods or services, which can be used by multiple people at once, still face scarcity in other ways. A football game can be viewed by many people at once, but only one person can sit in each seat in a stadium. Streaming services, such as Netflix or Spotify, can be used by many people at once but there are still technical limits to how many people can use them at a single time. If you try to use your phone at a football game or a music festival, often the local cell network is overloaded and may be slow or not work at all. Similarly, if everyone in the world tried to go to a single website at once, it would likely crash.
The opposite in terms of physical items primarily exists in science fiction. The setting of Star Trek gives a clear example of a post-scarcity economy. Scarcity does not exist for basic needs, things such as food, clothing and shelter, and thus everyone can be provided with them. It is still not a completely post-scarcity setting, and for that reason jobs still exist and there is still money that can be used. For example to buy higher quality items or things that are scarce, land and works of art. This is because even in a technologically advanced setting such as Star Trek, scarcity still affects time.
Time, particularly in the provision of human labor, is where the impact of scarcity is exceptionally clear. There are limits to the number of tasks a single person can complete in an hour, even if we allow for modern considerations such as the ability to multi-task or use of an AI tool to assist. It also does not need to take the same amount of time for every person to complete any given task.
Scarcity, no matter in what form, leads us to the fact that decisions must be made on how to prioritize the use of resources.
Choice
Choice is an economist’s term for any decision about how exactly to use resources, including the purchase, consumption and production of goods and services. These choices must be made given some sort of budget to spend, for money, resources, or time. In ideal cases it will be possible to have a single budget, for example when every available resource can be given a monetary value. Having separate budgets for items with the same units, such as time or money, may be necessary.
Consumer choice focuses on individuals. The most common example is the choice of a household on how to spend a budget on various needs and wants. A natural start is to assume a known level of income and look at the choice between two goods, say food and shelter. If we know prices and the preferences of the household over the two goods, we can determine the amount of each they would buy.
The firm’s side of choice is about production. What should be made? How should it be made? Who should make it? Where should that be done? One way to take this is to look at how to minimize costs. Put another way, to find the cheapest way to produce a the amount society wants.
Our other major decision-maker is the government. What taxes should be levied? How should they be collected? How should that revenue be spent? We will expand on the complexities of government decisions only when it is absolutely essential. For a large portion of our discussion, we will either assume there is no government or have a government that makes choices without us needing to think much about the element of “why” they choose what they do.
Not all choice questions involve purchases or even money. It can be about how to spend time or picking a specific method to complete a task. The two could even be mixed together. Should you study for two more hours with a group, study by yourself or go see a movie?
To make any choice we need to be able to compare the possibilities. While it may seem overwhelming to have to consider all alternatives, opportunity cost allows us to narrow our focus.
Opportunity cost
Opportunity cost is the next best alternative of any decision. Put another way, it is what was given up in making any choice.
It is one of the most fundamental concepts in all economics and it can be deceptively complicated. It may not always be clear what the second best option is, so we may need some analysis or calculations to cut out options that are clearly worse than others. We also may have limits on the choices we can make, depending on the type of economic actor making the decision and what sort of rules and systems exist to allocate resources.
The easiest trade-offs to think about are ones where options can be directly evaluated in the same units. In advanced applications, economists use the choices made in the real world to model trade-offs and preferences of the decision-makers. To avoid such complexities, we will often measure everything in terms of money or time. We will explore this with some number-based examples in the next subchapter.
Opportunity cost is often connected to marginal analysis. In this context marginal means additional or next, so it will often involve looking at what happens when there is a little more or a little less of any action or activity.
For example we use marginal benefits to consider the value of consuming a good. If we are eating pizza, and we have already eaten two slices, our relevant concern is not the total enjoyment we get from three slices, but rather the additional enjoyment in going from the second to the third slice.
The other common side of marginal analysis is to examine costs. When deciding how many units of a good or service should be produced, total cost is not as important as marginal cost, the additional cost of producing that last unit. Thinking of producing three slices of pizza, the total cost of making three slices is not as important as the marginal cost of producing the third slice.
Rationality
To close out our discussion of fundamental concepts, we have rationality.
Rationality is an underlying assumption behind basically all of our economic structures and modeling. Often if a decision we see does not seem to make sense, what is missing is that we have not considered some factor or aspect of the choice that is important to the decision-maker.
For most of our purposes, rationality will be pretty straightforward. Individuals will pick the option that makes them happiest and in many cases that is just what provides the most monetary benefits. Firms will generally maximize profits. Rationality can be an overly generous assumption for many microeconomic contexts, but we do not give up much in using this assumption in macroeconomics.