What Is Economics?

Economics is a social science concerned with the use of scarce resources for the satisfaction of human wants.

Economics is the study of the choices consumers, business managers, and government officials make to attain their goals, given their scarce resources.

Note the following Key terms:

Economics is used to answer questions such as the following:

  1. How are the prices of goods and services determined?
  2. How does pollution affect the economy, and how should government policy deal with these effects?
  3. Why do firms engage in international trade, and how do government policies affect international trade?
  4. Why does government control the prices of some goods and services, and what are the effects of those controls?

Economists do not always agree on the answers to every question; they almost always engage in lively debates on many issues.

In addition, economics is a dynamic field with new problems and questions constantly arising. Therefore economists are always at work developing new methods to analyze economic issues Opens in new window.

All the issues that confronts economists reflect a basic fact of life:

People must make choices as they try to attain their goals.

The choices reflect the trade-offs people face because we live in a world of scarcity Opens in new window, which means that although our wants are unlimited the resources available to fulfill those wants are limited.

For example, you might like to own five Mercedes-Benz cars and spend three months each year in five-star European hotels, but unless you are a close relative of James Packer Opens in new window you probably lack the money to fulfill these dreams.

Everyday you must make choices about how to spend your limited income on the many goods and services Opens in new window available.

The finite amount of time available to you also limits your ability to attain your goals.

If you spend an hour studying for your economics test, you have one less hour available to study for your statistics test.

Firms and the government are in the same situation that you are:

They have limited resources available to them as they attempt to attain their goals.

We begin the next section by discussing three important economic ideas that confronts us in real-life situations: people are rational; people respond to incentives; optimal decisions are made at the margin.

Three Key Economic Ideas

As you try to achieve your goals, whether buying a new computer or finding a part-time job, you will interact with other people in markets.

A market is a group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade. Much of economics involves analyzing what happens in markets.

Economics is concerned with how people make choices and interact in markets.

We will now turn to the three important economic ideas:

  1. People are rational.
  2. People respond to economic incentives.
  3. Optimal decisions are made at the margin.

1.   People are Rational

Economists generally assume that people are rational.

This assumption does not mean that economists believe that everyone knows everything or always makes the ‘best’ decision.

It does not mean that economists assume that consumers and firms use as much of the available information as they can to achieve their goals.

Rational individuals weigh the benefits and costs of each action, and they choose an action only if the benefits outweigh the costs.

For example, if a computer store charges a price of $520 for a copy of Windows, economists assume that the managers at the store have estimated that a price of $520 will earn the most profit.

The managers may be wrong; perhaps a price of $550 would be more profitable, but economists assume that the managers have acted rationally on the basis of the information available to them in choosing the price.

Of course, not everyone behaves rationally all the time. Still, the assumption of rational behavior is very useful in explaining most of the choices that people make.

2.   People Respond to Economic Incentives

Human beings act from a variety of motives, including religious belief, envy and compassion.

Economists emphasize that consumers and firms consistently respond to economic incentives.

This fact may seem obvious, but it is often overlooked as the following example illustrates.

The Pharmaceutical Benefits Scheme (PBS) Opens in new window is an Australian government initiative under which around 80 per cent of prescriptions are dispensed in Australia. At 1 January 2012 patients pay up t0 $35.40 for most PBS Opens in new window medicines or $5.80 if they have a concession card. The Australian government pays the remaining cost. Under current arrangements these amounts are adjusted in line with inflation on 1 January each year.

The government’s expenditure on the PBS—currently over $10 billion annually—is increasing rapidly, mainly due to the high cost of subsidizing new and expensive prescription medicines to make them available at prices people can afford.

The government paid part of the price of over 200 million prescriptions for subsidized medicines supplied up to the year ending June 2011. That’s around nine prescriptions every year for each Australian. The scheme accounts for around 20 percent of the total Australian government’s health budget and continues to grow.

For a medicine to be available on the PBS it must not only satisfy the criterion that it has a significant impact on patient health but also be cost-effective in that the extra benefit to patients must be worth the cost to government (the taxpayer).

Many Australians do not fully understand this second criterion and believe that if a medicine improves your health it must be worth taking no matter what the cost!

Some also think that it is unfair to pay for something as important as medicine as it is vital for one’s health.

However, economists argue, and this is accepted by government, that if medicines were free there would be little incentive for patients or doctors to use medicines wisely.

3.   Optimal Decisions are Made at the Margin

Some decisions are ‘all or nothing.’

For example, an entrepreneur decides whether or not to open a new restaurant: they either start the new restaurant or they don’t.

You decide whether to enter university or to take a job. But most decisions in life are not all or nothing.

Instead, most decisions involve doing a little more or a little less. If you are trying to decrease your spending and increase your saving, the decision is not really a choice between saving every dollar you earn or spending it all.

The choice is actually between buying a cappuccino at a café everyday or cutting back to three times per week.

Economists use the word marginal to mean an extra or additional benefit or cost of a decision.

Should you watch another hour of television or spend that hour studying?


Should Apple produce an additional 300,000 iPhones?

Firms receive revenue from selling goods.

Economists reason that the optimal decision is to continue any activity up to the point where the marginal benefit equals the marginal cost—in symbols, where MB = MC.

Often we apply this rule without consciously thinking about it.

Usually you will know whether the additional enjoyment from watching a television program is worth the additional cost involved in not spending that hour studying without giving it a lot of thought.

In business situations, however, firms often have to make careful calculations to determine, for example, whether the additional revenue received from increasing production is greater or less than the additional cost of the production.

For fruit growers, do they need to change their expansion plans for their orchards if the price of water rises Opens in new window, or is the additional amount they must pay for water less than the additional revenue they would receive from selling more fruit?

Economists refer to analysis that involves comparing marginal benefits and marginal costs as marginal analysis.

Economics As a Social Science

Because economics studies the actions of individuals and societies it is a social science. Economics is therefore similar to other social science disciplines, such as psychology, political science and sociology.

As a social science Opens in new window, economics considers human behavior — particularly decision-making behavior — in every context, not just in the context of business.

Economists have studied such issues as how families decide the number of children to have, why people have difficulty losing weight or attaining other desirable goals and why people often ignore relevant information when making decisions.

Economics also has much to contribute to questions of government policy. Economists have played an important role in formulating government policies in areas such as the environment, health care and poverty.

The best way to think of economics is a group of useful ideas about how individuals make choices. Economists have put these ideas into practice by developing economic models Opens in new window.

Consumers, business managers and government officials use these models every day to help them make choices.