Guide to Economics: Basic Concepts You Need to Know

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What is economics?

Social science is not only political science, psychology, sociology, anthropology, and history. For example, economics is also a social science.

Economics is a social science dealing with scarcity and choice. It studies humans and their behavior. The focus is on how they allocate resources to satisfy their needs and wants.

Economics is an important social science discipline. Learning about economics doesn’t mean you have to be an economist. By studying it, you will know the everyday phenomena around you. For example, what happens to employment if the government raises taxes? You will also know when you have to save more than you consume?

If you are a business owner, economic knowledge is important in making decisions. For example, what happens to the demand for your product if you increase the selling price? How sensitive will your customers be to respond? How much do you have to sell the product for to make a profit? At what price?

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Guide To Understanding Economics

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What are the basic concepts in economics?

Ceteris paribus assumption

In studying economic phenomena, economists also apply the social scientific method. Thus, they combine theory, tools, and techniques to analyze qualitative or quantitative data.

Economic models can be mathematical equations or curves. They’re usually simpler than in real situations.

Because human behavior is complex, they use the ceteris paribus assumption when developing the model. They assume other factors other than those being studied are constant or unchanged. That’s important because they can’t fit all the variables into the model.

Positive economics vs. normative economics

In analyzing economic phenomena, economists also depend on positive and normative approaches. Positive economics concerns what has been, is, or will happen. It explains cause and effect relationships, is theoretically based, and can be tested by looking at the data. For example, if interest rates rise, aggregate demand will fall. It is a positive statement and can be proven using data and theory.

Meanwhile, normative economics is all about what ought to be. It involves a value judgment about what is good and what is bad. It makes a recipe for how the economy should work. Normative statements often include words such as “should” or “must.” For example, global economic growth should increase to 6% after COVID-19.

Needs, wants, and scarcity

In fulfilling our needs and wants, we face scarcity. Why? We have limited resources. Meanwhile, our needs and wants are unlimited. That means, we cannot use the available resources to fulfill all our needs and wants.

Needs are essential to us. Foods and drinks are examples. You can’t live without both.

Meanwhile, wants represent non-essential needs. It’s often unlimited. For example, you currently own a car, but you may also want a private jet. Or, you may also want to buy a house even though you currently don’t have enough money.

Resource

Resources represent inputs for the production of goods and services. It is also often called the factors of production. Economists divide them into four categories:

• Land represents the various natural resources available on earth, land, underground, above ground, or the sea. That includes oil, water, wood, and metallic minerals.
• Labor represents the physical and mental effort of an individual. They are employed to help produce goods or services.
• Capital is a man-made tool used to assist the production process. They include machinery, equipment, and buildings. It excludes financial capital such as money because it does not contribute directly to the production process.
• Entrepreneurship is about taking risks to set up a business to produce goods and services. Entrepreneurs combine the other three factors, hoping to make a profit.

Each supplier of those resources is compensated. For example, rent and wages are compensation for land and labor. Meanwhile, for capital and entrepreneurship, suppliers earn interest and profit. The sum of the four is called factor income. In aggregate, they make up the national income.

Resource allocation and economic system

Since they are scarce, we must allocate resources to their best use. It requires choice and involves opportunity costs. We must make choices and answer three basic economic questions:

• What goods and services are produced?
• How to produce?
• For whom the production?

Each decision to answer the three questions above raises an opportunity cost. If we have chosen something, we give up the alternative.

The way we allocate resources also depends on what economic system we adopt. That answers the question of who should allocate resources? To what extent should the government and the private sector intervene?

The system chosen can ultimately have an impact on economic efficiency and welfare. This is because it coordinates choices about production and consumption.

We recognize three main systems:

1. Free market economy
2. Command economy
3. Mixed economy

In a free-market economy, the free private sector plays a major role in allocating resources. Property rights create incentives for the private sector to produce things of value and make the best possible use of resources.

In contrast, such incentives do not exist under a command economy. The government determines everything. Producers cannot set their own prices to maximize profits. The private sector cannot operate, and market mechanisms cannot work to allocate resources efficiently.

Rational choice and marginal analysis

Economists assume individuals are rational. So we consider costs, both implicit and explicit, in every decision we make. Then, we compare it with the benefits. That’s what we call marginal analysis.

The best option is when the difference between total benefits and total costs is maximum. Or, in other words, the marginal benefit equals marginal cost.

Comparing the marginal benefit with the marginal cost helps us to make the right decision. With it, we can decide whether to increase, decrease or maintain the current level of consumption (production).

Consumer choice

Consumers want to maximize their satisfaction in consuming goods and services. However, they face limitations. They have limited resources. They don’t have money to buy all the goods and services they want. So, they have to make a choice.

As I said, economists assume consumers are rational. To explain how they behave, they introduce a consumer choice theory. It deals with how consumers make choices to maximize their total utility. Utility represents the personal satisfaction obtained from consuming goods and services.

If resources (money) were not limited, consumers would want a lot of goods and services. But, being limited, they cannot buy all the goods and services they like. Therefore, when buying, they should consider their income.

Finally, to satisfy needs and wants, they must be selective. They choose the best combinations of goods and services tailored to the available budget.

Usually, economists will simplify the number of goods selected to just two goods. Then, consumers choose various combinations of the two goods (called consumption bundles). Combinations that give equal total utility form an indifference curve.

Meanwhile, consumers’ income represents the budget line (budget constraint). Optimal choice if they get the best combination of goods and within budget. Or, in other words, they get maximum satisfaction and fit the money in their pocket. That is what we call consumer equilibrium. In a graph, it occurs when the indifference curves and the budget line intersect.

Production possibilities curve

The production possibilities curve is an example of how producers deal with trade-offs in allocating resources. They cannot produce all the goods the market likes. Instead, they must choose which goods to produce, considering the available resources, technology, and production techniques.

Again, for ease of explanation, economists use two products. The points along the curve indicate the optimal combination of quantities of the two products a business can produce. The trade-off occurs because if they produce more of the first product, they must produce less of the second product and vice versa.

Can’t businesses produce more of both? The answer is yes. But, again, it depends on the available resources and technology. If they had more resources or efficient technology, they could do it.

If that happens, the production possibilities curve will shift outward. And, if it is associated with the economy as a whole, the shift indicates the economy is growing.

Efficiency

Efficiency is about how well we use resources at their maximum potential. Since they are scarce, of course, we must allocate resources efficiently. But, how efficiently we have done it, there are two efficient concepts in economics:

• Allocative efficiency – when price equals marginal cost. Consumers and producers get the maximum benefit. It is equilibrium under perfect competition, where the total welfare or economic surplus is maximized.
• Productive efficiency – producing the cheapest goods. It is achieved when production is at the minimum average total cost.

Market

A market is a place where sellers and buyers transact. It can refer to a physical or virtual location. It can also:

• Factor market
• Product market
• Financial market

Factor markets transact production inputs – and because of that, we also call them input markets. An example is the labor market. In this market, businesses buy from households and turn those services into products. Households use their income to purchase goods and services in product markets.

Product markets transact business output. It could be durable goods, non-durable goods, or services markets. In this market, businesses and households act as buyers. Businesses buy goods and services for inputs in producing other goods and services. Meanwhile, households buy final goods and services.

Furthermore, in financial markets, the supply and demand for money meet. If the product is long-term financial capital, such as stocks and bonds, we call it the capital market. Meanwhile, if the financial instrument is short-term, we call it the money market.

Financial markets are increasingly strategic in the modern economy. Here, companies raise funds to expand their businesses. Meanwhile, households, the main source of loanable funds in this market, can make more money.

Goods and services

In economics, you may come across the following terms:

• Free goods. They are available indefinitely, so they are never rare. For that reason, they have no price. Fresh air is a great example. Their consumption does not involve an opportunity cost.
• Economic goods. They are scarce, and their consumption involves an opportunity cost. Consumer goods and capital goods are examples.

Another classification is based on whether the goods are rivalrous and excludable or not?

• Rivalrous indicates their consumption by one person reduces their availability to another.
• Excludable indicates the producer can prevent non-payers from getting the goods.

If we make it in a matrix, this classification results in the following four categories:

	Excludable	Nonexcludable
Rivalrous	Private goods	Common goods
Nonrivalrous	Club goods	Public goods

1. Private goods. Once consumed, their availability decreases. In addition, producers can prevent non-payers from consuming them by charging a price. Most of the items fall into this category.
2. Common goods. Once consumed, their availability also decreases. But, we cannot prevent others from consuming them. Examples are wood in the forest and fish in the sea. Their exploitation can give rise to the tragedy of the commons.
3. Club goods. They are non-rivalrous and excludable. Examples are cinema and cable TV. When you buy cinema tickets at a location, other people can do it too. But, for that, you have to pay.
4. Public goods. Their consumption by one person does not reduce their availability to others. And, companies cannot prevent non-payers from using them. Examples are national defense and street lights.

Economic sector

The economy involves various economic activities and actors. They can be grouped into sectors of the economy in several ways. For example, economists classify them as:

• Primary sector involves extracting natural resources and producing raw materials. It covers sectors such as agriculture, fisheries, forestry, and mining.
• Secondary sector involves converting natural resources into goods. That includes manufacturing and construction.
• Tertiary sector involves the production of services. Examples are financial services, trade, transportation, and tourism.
• Quaternary sector also offers services. But, it involves knowledge-based services such as technology, information services, and education.

Furthermore, in macroeconomics, economists classify economic actors into four sectors:

• Household sector consists of various individuals.
• Business sector comprises a wide range of businesses, whether incorporated or incorporated.
• Government sector includes various government institutions such as national, regional and government agencies.
• External sector consists of three other sectors but is located outside the country.

Or, under the classification of the two groups, the economic sector consists of:

• Private sector consists of various households and businesses. They become consumers and producers of goods and services in the economy. Their role is significant under a free market economy.
• Public sector comprises the government sector plus state-owned companies. Its role is significant under a command economy.

Comparative advantage and absolute advantage

Two basic theories for starting the topic of international trade: absolute advantage and comparative advantage. A country should focus on products in which they have an advantage. For other products, they can buy them from other countries.

Absolute advantage bases its idea on the production cost. Specifically, a country gains an advantage when producing goods and services at a lower cost than others.

Meanwhile, comparative advantage bases its explanation on opportunity cost. Each country has different endowments and technological advances. Both factors contribute to explaining the comparative advantage in each country.

Another concept related to both is specialization. Since a country cannot produce all the goods its citizens need, it must trade with other countries. When each country specializes, there are gains from trade. They can gain more choices than they can by being self-sufficient.

Economic growth vs. economic development

Economic growth is about how the economy’s output grows over time. With more output, we can enjoy various goods and services. As a result, we can fulfill our various needs and wants. The economy also provides more jobs and income. Finally, it leads to high per capita income.

But, why, even though the income per capita is high, poverty still exists? Why in some countries must the government provide health insurance for the poor?

Such questions then give rise to another discipline of economics, development economics. It discusses not only how to grow the economy. But, it also discusses how economic growth contributes to people’s welfare.

Economic development is about increasing the income of the population by considering factors such as education and health. To measure the progress in a country, economists formulate the Human Development Index.

Another important topic is sustainable development. It is about how the economy develops without compromising the needs of future generations. The increasing destruction of the environment around us reminds us of that.

What are the two important branches of economics?

Broadly speaking, economics is divided into two main branches: microeconomics and macroeconomics. In discussing the two, economists usually start by discussing the basic concepts of economics. Then, they discuss why economics emerged? What assumptions do they use? It became the basis for explaining the concepts in the two branches.

Apart from these two, there are various branches of economics:

• Behavioral economics
• Business economics
• Development economics
• Financial economics
• Industrial economics
• International economics
• Managerial economics
• Econometrics
• Urban economics

Microeconomics

Microeconomics centers on the individual consumer and business. It answers questions such as what is the purpose of consumers buying goods? What is the purpose of producers producing goods? And how do they make decisions to maximize their respective goals?

Then, you will also learn about how consumers and producers interact in the market. Consumers represent demand, and producers represent supply. Both act in their respective best interests. If the two agree on the best price and quantity, it results in equilibrium. It was the best outcome for both of them.

Demand and supply will adjust to market conditions. If prices rise, consumers decrease demand. Declining demand threatens producer income. So, finally, they lowered the price. That is the market mechanism, the system in which supply-demand will work towards equilibrium.

Such a mechanism is important for allocating resources efficiently. But, that only happens under ideal conditions when the market operates under perfect competition. In other markets, these market mechanisms do not always work. There may be external intervention causing disequilibrium, which leads to market failure.

Macroeconomics

Macroeconomics concentrates on the economy as a whole. You will find topics such as economic growth, unemployment rate, inflation, and exchange rates here. Economists also discuss how the economy can affect these variables.

You will also learn about demand, supply, and equilibrium. But, it is different from what you learn in microeconomics.

Macroeconomics studies economic actors, goods, services, and prices in the aggregate, not individually. Economists divide economic actors into four macroeconomic sectors:

• Household
• Business
• Government
• Foreign

The spending of the four sectors on goods and services represents demand in the economy. But, then, economists specifically use the term “aggregate demand” to represent it.

The aggregate demand curve is downward sloping, similar in microeconomics. But, the reason for the slope is not the diminishing marginal utility. Instead, it occurs because of the real wealth effect, the interest rate effect, and the exchange rate effect.

Meanwhile, for supply, they use the term aggregate supply. It is the sum of all goods and services produced in the economy. It is divided into two: short-run and long-run aggregate supply. Hope you remember. The terms short-term and long-term here are also different from those you find in microeconomics.

Furthermore, in macroeconomics, equilibrium is divided into two: the short run and the long run. Short-run equilibrium is reached when the aggregate demand curve intersects with the short-run aggregate supply curve. That yields output (measured in real GDP) and actual price levels. It may lie exactly on the long-run aggregate supply curve, which means that real GDP equals potential GDP.

But, often, the short-run equilibrium fluctuates around potential GDP. It forms what we call the business cycle. During the cycle, real GDP rises and falls, forming two main phases: expansion and contraction. Between the two phases, there is a highest (peak) and a lowest (trough). These fluctuations also affect other economic variables such as inflation and unemployment.

Furthermore, in macroeconomics, you will also find the topic of money. It’s on the monetary topic. How does money affect interest rates and economic activity? You will find the answer in this section.

The next topic is about the global economy. The interaction between economic actors does not only take place within the country but also with economic actors abroad. They may transact goods and services (international trade). Or, they invest abroad. Some companies may acquire companies overseas. Or, domestic investors buy stocks and bonds in foreign markets.

Such transactions are recorded in the balance of payments. Moreover, transactions involve two different currencies. So, in the end, it also affects the exchange rate.

Trading and investing do not always run smoothly. As a result, some countries may adopt trade protection policies and capital flow controls. To reduce such restrictions, they finally made a pact and began to integrate their economy.