What Is Economics?

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

Note the following Key terms:

• Scarcity — The situation in which unlimited wants exceed the limited resources available to fulfill those wants.
• Resources — Inputs used to produce goods and services, including natural resources such as land, water and minerals, labor, capital and entrepreneurial ability. These are otherwise referred to as the factors of production.

Economics is used to answer questions such as the following:

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:

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.

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

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.

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

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

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

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

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!

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.

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

• The marginal benefit (MB) of watching more television is the additional enjoyment you receive.


• The marginal cost (MC) is the lower grade you receive from having studied a little less.

Should Apple produce an additional 300,000 iPhones?

Firms receive revenue from selling goods.

• Apple’s marginal benefit is the additional revenue it receives from selling 300,000 more iPhones.
• Apple’s marginal cost is the additional cost—for wages, parts and so forth—of producing 300,000 more iPhones.

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?

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.

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.

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