Andrew Beattie* says economics has an impact on every moment of our lives, so there are some basic concepts that everyone should understand.
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.
Scarcity
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.
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 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 encapsulates the 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.
Costs and benefit
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.
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.
Although people are generally rational, there are many factors that can throw our internal accountant out the window.
Advertising is one that everyone is familiar with.
Commercials tweak emotional centres of our brain and do other clever tricks to fool us into overestimating the benefits of a given item.
So, cost 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 cost and benefit, 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 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 things are going horribly awry, the chances are 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 1 L bottle.
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 1 L 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 organisational goals, however, the benefits can be exceptional.
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 cost 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.
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 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.
* Andrew Beattie is a contributor to Investopedia.com and operates the Wandering Wordsmith blog.
This article first appeared at www.investopedia.com.
