Introduction to Economics
Economics is the study of how a society uses its resources to produce output that it desires. In the beginning, people were hunters and gathers, organized as family units, and, possibly, as larger groups, who expended most of their energy to satisfy basic needs. Through the millennia, people learned to organize their activities and specialize in their activities, so that they could create products and services that were beyond those needed to basically survive.
Although economics can be a complex science, it is based upon a few simple principles. The primary principle is the efficient allocation of scarce resources. Since every economy has only so much of what are called the factors of production—labor, land, and capital—the greatest wealth generated by any society will be achieved through the most efficient and fullest utilization of its resources.
Adam Smith noted in his 1776 publication The Wealth of Nations that people act naturally in their self-interest, which he called the invisible hand, and that the economy can be organized to take advantage of this self-interest. This requires that the people have the freedom to act and to own the factors of production, and to enjoy the profits or suffer the losses of their activities.
Adam Smith also noted the advantages of the division of labor, where the production of goods or services is decomposed into a series of steps, where a person specializes to perform each step, thereby gaining proficiency in accomplishing the task. This greatly increased productive efficiency over craftsmanship where the worker would perform all of the tasks required to provide the good or service.
In deciding how much of a product or service to provide, economics offers the tools of marginal analysis, which is the ratio of the marginal benefit over the marginal cost of providing the benefit. Marginal analysis is necessary because the cost of producing a good or service usually depends on the quantity produced. Within limits, economies of scale generally reduce the cost of production, where the cost of producing an additional unit is slightly less than the cost of the previous unit. However, demand, and the prices that people are willing to pay, usually declines with increasing supply. Hence, there will be a point, known as the supply-demand equilibrium, where the cost of producing an additional unit is equal to the price that people are willing to pay for that unit.
In most sciences, knowledge is advanced by forming a hypothesis to explain observations or experimental data, designing experiments to test the hypothesis, then either accepting the hypothesis if the experiment confirmed it, modifying it with new information from the experiment, then retesting it, or even outright rejecting the hypothesis if the experiment contradicts it.
In most cases, an economist cannot really conduct experiments, because it is not feasible, given the scale of economics and the difficulty of manipulating the economy to test specific hypotheses. Therefore, economics largely depends on statistical analysis of economic events, including the construction of economic models to make testable predictions. These models are further complicated because of externalities, and asymmetric information and imperfect rationality of market participants.
Although economics is a science, most of its principles are gleaned from observing how the world works, forming hypotheses of cause and effect, then seeing if the explanations can account for a wide variety of economic data. Deductive reasoning is used to abstract the basic principles that yield the greatest understanding of the phenomena that can be used to make predictions that can be tested or observed. Additional information will generally result in modifying parts of the hypothesis that are contradicted by the new information or fail to explain it, or even rejecting the hypothesis if it seems clear that the additional information does not support the hypothesis. As a successful hypothesis gains evidence, it eventually becomes a theory, or even a law or principle, where the confidence of its veracity is high.
Theoretical economics uses mathematical models based on these principles to simulate the economy, continually adjusting mathematical parameters to more closely mimic reality. The confidence in a principle is increased by its ability in making accurate predictions and by how well it coheres with other well-established scientific principles.
Because the economy is complex, there are many deviations from predicted outcomes, which must be resolved through statistical analysis. Economists try to abstract the essential principles by simplifying the economy, so that cause-and-effect relationships can be more easily determined. In any case, it is understood that because all causes cannot be accounted for, there will be some variation in the outcomes of even the simplest models.
Policy economics is the application of economics to formulate government policies to achieve particular goals. Because of the many uncertainties in economics or because of the inability to quantify parameters, there is often a trial-and-error method of achieving economic goals. First the desired goal must be clear. Then, it must be determined what policy options are available to carry out the goal. Once decided, the policy should be implemented, and then evaluated to see how successful it was.
People may differ in what they consider to be the most desirable economic goals, but there are a few economic goals that are widely accepted as being desirable, and these include:
- Economic growth, since this allows more goods and services to be produced that can lead to a higher standard of living.
- Full employment, since labor is one of the factors of production, and less than full employment implies that the economy is not producing as much as it could. Furthermore, the quality of life for those who are unemployed will be low.
- Economic efficiency, since this allows the maximum production of desirable goods and services for the least amount of limited resources.
- Price level stability, since it is difficult to plan economic projects or anything else involving a large amount of capital without stable prices. Even falling prices can wreak economic havoc.
- Equitable distribution of income, so that no one has to suffer extreme poverty.
- Economic security, which provides for people who are unable to take care of themselves, such as the chronically ill, disabled, or anyone else unable to earn an income.
Positive and Normative Economics
A distinction is sometimes made between the study of the economy and what its goals should be.
Positive economics focuses on facts and cause-and-effect relationships without regard to economic goals. It strives to understand how the economy works and why it works the way it does. Normative economics, on the other hand, seeks to use positive economics to formulate the most desirable policy objectives and how to achieve them.
So, for instance, positive economics observes the inverse relationship between the cost of labor and the demand for labor. Normative economics, on the other hand, would use that fact to argue that there should be no minimum wage laws, since this lessens the demand for labor and decreases economic efficiency by reducing economic output.
The Benefits of Studying Economics
The study of economics can help a society to achieve its maximum wealth. It also increases understanding of business cycles and the effect of government policies, and how those policies affect the business cycle, which can be enormously beneficial to both business people and investors.
It also provides a blueprint for how the economy can be improved. It can even improve the political process of selecting capable and honest leaders. Especially in democracies, economic knowledge allows people to evaluate politicians and their proposed policies, to prevent their bamboozlement by demagoguery. For instance, although Hugo Chavez was democratically elected in Venezuela, the people were hoodwinked into believing that communism would provide a better standard of living for everyone, when, in fact the exact opposite is taking place. Without any real understanding of how an economy really works, Chavez is literally destroying Venezuela with his policies.
Knowledge of economics even allows people to choose the best political organization of their society to achieve the greatest economic wealth. For instance, history has shown repeatedly that communism simply never works because it is a well-established principal that people work for their own self-interest and not for the common good. It is clear that any political organization that does not heed economic principles is doomed to failure, and society will suffer as a result.