The Magic of the Economy

The field of economics is a social science. This means that economics has two important attributes. Economics studies human activities and constructions in environments with scarce resources, and uses the scientific method and empirical evidence to build its base of knowledge.

Figure 1 Circular Flow of the Economy

The evaluation of human interactions as it relates to preferences, decision making, and constraints is a significant foundation of economic theory. The complexity of the dynamics of human motivation and systems has led to the establishment of assumptions that form the basis of the theory of consumer and firm behavior, both of which are used to model circular flow interactions within the economy (Figure 1).

Economics provides distilled frameworks to analyze complex societal interactions, as in the case of consumer and firm behavior. An understanding of how wages and consumption flow between consumers and producers provides agents with an ability to understand the symbiosis of the relationship rather than fixating on the contentious components that surface from time to time.

Economics also allows individual agents to balance expectations. An understanding of the ebb and flow of the economy through the boom and bust of the business cycles, creates the potential for emotional balance by reminding agents to limit desperation in downturns and exuberance in expansions.

By developing an understanding of the foundations of economics, individuals can become better decision makers with respect to their own lives and maintain a balance with respect to an externality that has the potential to supplement or deter their plans. Since economic theories are a basis of decision making and regulatory policy, being knowledgable about economics foundations allows an individual to be an active and aware participant rather than a passive economic agent.

Is Economics a Science?

Economics is a social science that assesses the relationship between the consumption and production of goods and services in an environment of finite resources. A focus of the subject is how economic agents behave or interact both individually (microeconomics) and in aggregate (macroeconomics).

Microeconomics examines the behavior individual consumers and firms within the market, including assessment of the role of preferences and constraints. Macroeconomics analyzes the entire economy and the issues affecting it. Primary focus areas are unemployment, inflation, economic growth, and monetary and fiscal policy.

Figure 1 Founders of Economics

The discipline of economics evolved in the mid-19th century through the combination of political economy, social science and philosophy and gained entrenchment with the increased scrutiny of the asymmetric financial and welfare distribution attributed to sovereign rule. Early writings are attributable to Jeremy Bentham, David Ricardo, John Stuart Mill and his son John Mill and are focused on human welfare and benefits rather than capitalism and free markets (Figure 1).

As in other social sciences, economics does incorporate mathematics in the theoretical and analytics framework of the discipline. Formal economic modeling began in the 19th century with the use of differential calculus to represent and explain economic behavior, such as utility maximization, an early economic application of mathematical optimization in microeconomics. Economics utilizes mathematics to assess the relationships between economic actors in environments in which resources are finite.

The use of mathematics in economics increased the quantitative analysis inherent in the discipline; however, given the discipline's essentially social science roots, many economists from John Maynard Keynes to Robert Heilbroner and others criticized the broad use of mathematical models for human behavior, arguing that some human choices can not be modeled or evaluated in a mathematical equation.

Economic theory and analysis may be applied throughout society, including business, finance, health care, and government. The underlying components of economic theory can also be applied to variety of other subjects, such as crime, education, the family, law, politics, religion, social institutions, war, and science.

Scarcity Leads to Tradeoffs and Choice

A fundamental concept in economics is that of scarcity. In contrast to its colloquial usage, scarcity in economics connotes not that something is nearly impossible to find, but simply that it is not unlimited. For example, the number of available hours in a day is a scarce resource: there is a finite amount of time available to you to do work, hang out with friends, and relax. Most resources are scarce in most situations.

Figure 1 Tradeoffs

Since resources tend to be scarce, anyone that uses the resource has to make a decision about how to use it. Suppose, for example, that you are a drink manufacturer. To produce a beverage, you have to use some scarce resources: the plastic for the bottle, the workers' time, a machine to fill the bottles, etc. If you choose to make one bottle of water, you have chosen to not make a bottle of soda (Figure 1). Your scarce resources force you to make a choice and a trade-off producing one product or another.

Like producers, consumers also have to make choices. Often, consumer must choose between current consumption ("I want to buy an ice cream") and future consumption ("I should rather save my money so I can buy an ice cream tomorrow"). Since consumers' resources such as time, attention, and money are limited, they must choose how to best allocate them by making tradeoffs.

The concept of trade-offs due to scarcity is formalized by the concept of opportunity cost. The opportunity cost of a choice is the value of the best alternative forgone. In other words, if you can only produce bottles of soda and water, the opportunity cost of producing a bottle of water is the value of producing a bottle of soda. Similarly, there is an opportunity cost in everything: the opportunity cost of you reading this is what you could be doing with your time instead (say, watching a movie). When scarce resources are used (and just about everything is a scarce resource), people and firms are forced to make choices that have an opportunity cost.

Individuals Face Opportunity Costs

When individuals make decisions, they are necessarily deciding between taking one course of action over another. In doing so, they are choosing both what to do and, by extension, what not to do. The value of the next best choice forgone is called the opportunity cost. In other words, the opportunity cost of a course of action is the value the option that the individual chose not to take.

Figure 1 Opportunity Cost

Individuals face opportunity costs in both economic and non-economic decisions. One of the easiest way to imagine an individual's opportunity costs is to imagine a student who decides to study. By choosing to study, the student is implicitly choosing to not go to a party, hang out with friends, or catch up on some much-needed sleep (Figure 1). In this example, the opportunity cost is not easily expressed in dollars and cents, but is just as real.

Rational individuals will try to minimize their opportunity costs. By doing so, individuals are maximizing the amount that they can get out of their resources (time, money, effort, etc.). This makes sense: individuals should seek to get the most and give up the least.

As economic actors, individuals face opportunity costs as well. For example, suppose you decide to purchase a new computer. You could have chosen to spend your money on books or rent or a spring break trip; whichever one of those options is most valuable to you (beside purchasing a new computer) is the opportunity cost.

Such logic applies for every economic decision: purchasing one good means that an individual has chosen to spend resources one way instead of another. Opportunity costs are an important consideration for economists and busnesspeople, but are faced by individuals even when they are not making classically economic decisions.

Individuals Make Decisions at the Margins

Figure 1 Marginal and Total Utility

When individuals make decisions, they do so by looking at the additional cost and benefit of the decision. The cost or benefit of the single decision is called the marginal cost or the marginal benefit. This is different from the total or average: net marginal benefit (marginal benefit minus marginal cost) is the amount that total benefit will change due to the single decision. In theory, individuals will only choose an option if marginal benefit exceeds marginal cost (Figure 1).

Let's take an example. Suppose you are buying a car and have three choice: Car A, which costs $10,000; Car B, which costs $12,000; and Car C, which costs $15,000. The prices represent the marginal costs of each car; purchasing the car will add the cost of the car to your total costs. Also suppose Car A provides you $15,000 worth of utility, Car B provides $15,000, and Car C provides $25,000. Those utilities, in dollar terms, are the marginal benefit of each car.

In order to make the decision, you look at the marginal cost and marginal benefit of each car. By subtracting the cost from the benefit, Car A offers $5,000 of marginal benefit, Car B offers $3,000, and Car C offers $10,000. Obviously, Car C is the best choice because, at the margins, it offers the most benefit to you.

Note that you care concerned not with your total or average cost and benefit (assuming no resource or other external restrictions), but with the marginal cost and benefit. As a decision maker, you want to know how much the decision will change your current state, so you look at the margins, not the overall picture. That is not to say that things like the total cost are unimportant, but that, assuming there are enough resources, individuals will look at the marginal change each option will provide to his/her life or to the firm and chose the one with the greatest net marginal benefit.

Individuals Respond to Incentives

An incentive is something that motivates an individual to perform an action. The study of incentive structures is central to the study of all economic activities (both in terms of individual decision-making and in terms of cooperation and competition within a larger institutional structure).

Figure 1 Sales are Incentives

Perhaps the most notable incentive in economics is price. Price acts as a signal to suppliers to produce and to consumers to buy. For example, a sale is nothing more than a store providing an incentive to potential customers to buy (Figure 1). The lowering of the price makes the purchase a better idea for some customers; the sale seeks to persuade individuals to change their actions (namely, to buy the product).

Similarly, the increase in price acts as an incentive to suppliers to produce more of a good. If suppliers think they can sell their products for more, they will be more inclined to produce more. The price acts, therefore, as an incentive to customers to buy and suppliers to produce.

Types of Incentives

Incentives come in many other forms, however. Broadly, most incentives can be grouped into one of four categories:

• Remunerative incentives: The incentive comes in the form of some sort of material reward – especially money – in exchange for acting in a particular way. Wages, prices, and bribery are all examples of remunerative incentives. This is the type of incentive that is typically associated with economics.
• Moral incentives: This occurs when a certain choice is widely regarded as the right thing to do, or as particularly admirable, or where the failure to act in a certain way is condemned as indecent. Societies and cultures are two main sources of moral incentives.
• Coercive incentives: The incentive is a promise of some sort of punishment if the wrong decision is made. For example, the promise of imprisonment is a coercive incentive for people to not steal.
• Natural Incentives: Things such as curiosity, mental or physical exercise, admiration, fear, anger, pain, joy, or the pursuit of truth, or the control over things in the world or people or oneself cause individuals to make certain decisions.

Economics is mainly concerned with remunerative incentives, though, when discussing government regulations, coercive incentives often come into play. By manipulating incentives, individuals (and businesses and government) hope to encourage some behaviors and discourage others.

Incentives and Performance

Companies leverage incentives-based strategies to drive performance and optimize employee decision-making and behaviors through meaningful reward systems. While there are both advantages and drawbacks to this type of approach, remunerative (financial) incentives are highly attractive options for employers in a variety of industries and businesses. Providing incentives such as variable income, where an individual can obtain more personal rewards for successfully creating a product or making a sale, often drives up production for highly motivated employees.

An example of this would be a manufacturing facility making widgets. The floor manager shifts the wage system from an hourly wage perspective to a straight piece rate system. Under this system, the more widgets a worker creates the higher his or her prospective income will be. In this situation less productive workers may stay the same but highly productive workers will increase their production as a result of this incentive system.