Economic Principles

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Economic Principles Economic Principles

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Table of contents

    Principles of economics definition

    The principles of economics definition can be given as a set of rules or concepts that govern how we satisfy unlimited wants with limited resources. But, first, we must understand what economics itself is. Economics is a social science that studies how economic agents satisfy their unlimited wants by carefully managing and using their limited resources. From the definition of economics, the definition of the principles of economics becomes even clearer.

    Economics is a social science that studies how people satisfy their unlimited wants by carefully managing and using their limited resources.

    Economic principles are a set of rules or concepts that govern how people satisfy their unlimited wants with their limited resources.

    From the definitions provided, we can learn that people do not have enough resources to match all their wants, and it gives rise to the need for a system to help us make the best use of what we have. This is the fundamental problem economics seeks to solve. Economics has four main components: description, analysis, explanation, and prediction. Let's cover these components briefly.

    1. Description - is the component of economics that tells us the state of things. You can look at it as the component that describes the wants, the resources, and the outcomes of our economic efforts. Specifically, economics describes the number of products, prices, demand, spending, and Gross Domestic Product (GDP) among other economic metrics.

    2. Analysis - this component of economics analyzes the things that have been described. It asks why and how things are the way they are. For example, why is there higher demand for one product over the other, or why do certain goods cost more than others?

    3. Explanation - here, we have the component that clarifies the outcomes of the analysis. After analysis, economists have the answers to the why and how of things. They now have to explain it to others (including other economists and those who are not economists), so action can be taken. For example, naming and explaining relevant economic theories and their functions will provide the framework to understand the analysis.

    4. Prediction - an important component that forecasts what may happen. Economics studies what is happening as well as what is observed to usually happen. This information can also provide estimates of what may happen. These predictions are very helpful for economic decision-making. For instance, if a decline in prices is predicted, we may want to save some money for later.

    Principles of microeconomics

    The principles of microeconomics focus on small-level decisions and interactions. That means that we will focus on individuals and their outcomes rather than a population of people. Microeconomics also covers individual firms rather than all firms in the economy.

    By narrowing the scope in which we analyze the world, we can better understand minute changes and variables that lead us to certain outcomes. All living creatures naturally practice microeconomics without even realizing it!

    For example, have you ever combined morning activities to get ten more minutes of sleep? If you answered yes, you have done something that economists call: 'constrained optimization.' This happens because the resources that surround us, like time are truly scarce.

    We'll cover the following foundational economic concepts:

    • Scarcity

    • Resource Allocation

    • Economic Systems

    • Production Possibilities curve

    • Comparative Advantage and trade

    • Cost-benefit analysis

    • Marginal analysis and consumer choice

    The economic principle of scarcity

    The economic principle of scarcity refers to the difference between people's unlimited wants and finite resources to satisfy them. Have you ever wondered why individuals in a society have wildly different means and standards of living? This is a result of what is known as scarcity. So, all individuals experience some form of scarcity and will naturally attempt to maximize their outcomes. Every action comes at a trade-off, whether it's time, money, or a different action we could have done instead.

    Scarcity is the fundamental economic problem that arises due to the difference between limited resources and unlimited wants. Limited resources can be money, time, distance, and many more.

    What are some of the key factors that lead to scarcity? Let's take a look at Figure 1 below:

    Economic Principles Diagram showing the causes of scarcity StudySmarterFig. 1 - Causes of scarcity

    To varying degrees, these factors combined affect our ability to consume everything we wish to.

    They are:

    • Unequal Distribution of Resources
    • Rapid Decreases in Supply
    • Rapid Increases in Demand
    • Perception of Scarcity

    For more on the topic of scarcity, check out our explanation - Scarcity

    Now that we've established what scarcity is and how we must shape our decisions in response to it, let's discuss how individuals and firms allocate their resources to maximize their outcomes.

    Principles of resource allocation in economics

    To understand the principles of resource allocation in economics, let's first describe an economic system. Groups of individuals living together naturally form an economic system in which they establish an agreed-upon way of organizing and distributing resources. Economies typically have a mix of private and communal production, which can vary how much of each takes place. Communal production can provide a more equitable distribution of resources, whereas private production is more likely to maximize efficiency.

    How resources are allocated between competing uses depends on the type of economic system.

    There are three main types of economic systems: command economy, free-market economy, and mixed economy.

    • Command Economy - Industries are publicly owned and operations are decided by a central authority.

    • Free-market Economy - Individuals have control over operations with little government influence.

    • Mixed Economy - A wide spectrum that combines free-market and command economy to varying degrees.

    For more information on economic systems, check out this explanation: Economic Systems

    Regardless of the type of economic system, three basic economic questions need to always be answered:

    1. Which goods and services should be produced?

    2. What methods will be used to produce those goods and services?

    3. Who will consume the goods and services that are produced?

    Other elements can be included in decision-making, such as natural resource advantages or trade proximities. Using these questions as a framework, economies can design a clear path to establishing successful markets.

    Consider the economy of candy-topia, a newly established society with abundant candy natural resources such as cacao, licorice, and sugar cane. The society has a meeting to discuss how to allocate its resources and develop its economy. The citizens decide they will produce candy using their natural resources to their advantage. However, the citizens realize that everyone in their population has diabetes and can't eat candy. Thus, the island must establish trade with someone who can consume their goods, so they'll need to establish their oceanic trade industry or hire one to facilitate trade.

    For more information on resource allocation, check out our explanation - Resource Allocation

    Next, we will cover how individuals and firms optimize their choices by analyzing different possible outcomes.

    Marginal analysis and consumer choice

    At the core of every economic analysis is the structure of viewing decisions and outcomes at the margin. By analyzing the effect of adding or taking away a single unit, economists can better isolate and study individual market interactions.

    To optimally use marginal analysis, we choose to make decisions whose benefits outweigh the costs and continue making those decisions up until the marginal benefit is equal to the marginal cost. Firms seeking to maximize their profits will produce a quantity where marginal cost equals marginal revenue.

    Marginal Revenue/Benefit is the utility received from producing/consuming one additional unit.

    Marginal Cost is the cost of consuming or producing one additional unit.

    All consumers face constraints of time and money and seek to receive the largest benefit for the lowest cost. This occurs every time a consumer goes to a store. Naturally, we seek the product that provides the greatest benefit at the lowest cost.

    Have you ever stopped to buy a meal or a snack? How do you determine how much to eat?

    You will, without realizing it, determine how hungry you are relative to the cost and purchase a quantity of food that satisfies your hunger.

    You could buy more snacks, but by this point, you are not hungry, and they provide less value, specifically less value than the cost.

    Economists count on this, as to make models, they must assume that market actors will maximize their total utility. It is one of the core assumptions that economists make when modeling behavior. Therefore, for the most part, it is assumed that market actors will always try to maximize their total utility.

    To learn more about this topic, why not read: Marginal Analysis and Consumer Choice?

    Now that we have established how economies allocate their resources in different systems we will analyze how they maximize their production and determine how much to produce.

    Economic Principles and the Production Possibilities Curve

    One of the most useful economic models for efficient production is the production possibilities curve. This model allows economists to compare the trade-off of producing two different goods and how much can be produced by dividing resources between them.

    Consider the graph and adjoining example below:

    Candy Island has 100 production hours and is trying to determine how to allocate its hours to its two industries - Chocolate and Twizzlers.

    Economic Principles Production possibilities curve example StudySmarterFig. 2 - Production possibilities curve example

    In the graph above we see the production output possibilities of Candy Island. Depending on how they distribute their production hours, they can produce X amount of Twizzlers and Y amount of chocolate.

    An effective method to interpret this data is to look at increases in one good and how much you must give up of the other good.

    Say Candy Island wanted to increase chocolate production from 300 (point B) to 600 (point C). To increase chocolate production by 300, Twizzler production will decrease from 600 (point B) to 200 (point C).

    The opportunity cost of increasing chocolate production by 300 is 400 Twizzlers foregone - a 1.33 unit trade-off. This means that at this exchange, to produce 1 chocolate, Candy Island needs to give up 1.33 Twizzlers.

    What other information can economists analyze from the PPC?

    What does it mean if production occurs to the left or inside the PPC? This would be an under-utilization of resources, as there would be available resources that were left unallocated. In that same mindset, production can't occur past the curve, as it would require more resources to be available than the economy can currently sustain.

    To learn more about the PPC, click here: Production Possibilities Curve

    Principle of comparative advantage in economics

    When countries are establishing their economies, it is paramount to identify their comparative advantages. Comparative advantage occurs when one economy has a lower opportunity cost of production for a specific good than another. This is demonstrated by comparing two economies' productive capacity and efficiency in producing two different goods.

    Check out this example below for how comparative advantages can occur.

    Imagine Candy Island at maximum production can produce either:

    1000 Chocolate bars or 2000 Twizzlers.

    This means that the opportunity cost of a Chocolate bar is 2 Twizzlers.

    Imagine there is a similar economy - Isla de Candy determining which of the two goods they want to specialize in producing. 800 Chocolate bars or 400 Twizzlers.

    Isla de Candy struggles to be as efficient as Candy Island in Twizzler production as they have a higher opportunity cost of making Twizzlers.

    However, Isla de Candy determined its opportunity cost of making a Chocolate bar to be 0.5 Twizzlers.

    This means that Isla de Candy has a comparative advantage in Chocolate bars production, whilst Candy Island has a comparative advantage in Twizzler production.

    The ability to trade changes economic options greatly, and it works hand in hand with comparative advantage. Countries will trade for a good if they have higher opportunity costs for production than another; this trade facilitates efficient use of the comparative advantage.

    Therefore, assuming free trade, Candy Island would be better off producing Twizzlers and trading exclusively for Chocolate, as Isla de Candy has a lower opportunity cost for this good. By engaging in trade, both islands will be able to specialize, which will result in both of them receiving a higher quantity of both goods than would be possible without trade.

    Dive in deeper in our article - Comparative Advantage and Trade

    Comparative advantage occurs when one economy has a lower opportunity cost of production for a specific good than another.

    To make effective economic decisions, it's important to have a complete analysis of the costs and benefits of any action. This will be covered in the subsequent section.

    Economic Principles and Cost-Benefit Analysis

    For an economic analysis of decision making a particular set of assumptions must hold. One assumption is that economic actors will consider opportunity costs and then determine the total economic cost of an outcome.

    This is done through a cost-benefit analysis, where all the possible costs are weighed against the benefits. To do this properly, you must measure the opportunity cost and include that in the cost-benefit analysis. The opportunity cost is the utility or value that would have been provided by the next best option.

    Imagine you have $5 to spend and can only spend it on one thing. How would you decide if you were to consider the full opportunity cost? What is the opportunity cost if you were to buy a cheeseburger for $5?

    You could have bought a winning scratch card or lotto ticket with that $5. Maybe you could invest it in an emerging business and get your money multiplied 1000-fold. Perhaps you could give the $5 to a homeless person, who later would become a billionaire and buy you a house. Or maybe you could just purchase some chicken nuggets because you are in the mood for them.

    The opportunity cost is the most valuable alternative choice you could have made.

    This example may seem a bit overwhelming, but we often analyze decisions and try to make the best one by assigning them some value, which economists call 'utility'. Utility can be described as the value, effectiveness, function, joy, or satisfaction we receive from consuming something.

    In the example above, we would compare the two best options to spend $5 on and decide on the utility they provide. While the wild opportunity costs in the example may seem overwhelming, we know that many of them are highly unlikely. If we quantify the utility with a likelihood of occurrence, we'll have a balanced utilitarian view. The equivalent of this for firms and producers is how they make decisions to maximize total revenue.

    If you are still hungry for knowledge at this point check out our article: Cost-Benefit Analysis

    The opportunity cost is the utility or value that would have been provided by the next best option.

    Utility can be described as the value, effectiveness, function, joy, or satisfaction we receive from consuming something.

    Principles of economics examples

    Shall we present some principles of economics examples? Kindly consider the example below for the concept of scarcity.

    A family of 6 only has three bedrooms, 1 already taken by the parents. The 4 kids then have only 2 rooms left, but each person would ideally like to have their own room.

    The above scenario describes the scarcity of bedrooms for the family. How about we build on it to provide an example of resource allocation?

    A family has 4 kids and only two rooms available for the kids. So, the family decides to put two of the kids in each room.

    Here, the resources have been allocated in the best way possible for each kid to get an equal share of a room.

    All the basic economic concepts laid out in this explanation form a structure of economic thinking and analysis for individuals and firms to maximize their benefits while minimizing costs.

    Economic Principles - Key takeaways

    • Scarcity is the fundamental economic problem that arises due to the difference between limited resources and unlimited wants.
    • There are three main types of economic systems: command economy, free-market economy, and mixed economy.
    • Marginal Revenue/Benefit is the utility received from producing/consuming one additional unit. Marginal Cost is the cost of consuming or producing one additional unit.
    • A PPF is an illustration of all the different production possibilities an economy can make if both its products depend on the same limiting factor of production.
    • Comparative advantage occurs when one economy has a lower opportunity cost of production for a specific good than another.
    • The opportunity cost is the utility or value that would have been provided by the next best option.
    • Utility can be described as the value, effectiveness, function, joy, or satisfaction we receive from consuming something.
    Frequently Asked Questions about Economic Principles

    What are the main Principles of Economics?

    Some principles of economics are scarcity, resource allocation, cost-benefit analysis, marginal analysis, and consumer choice.

    Why are principles of economics important?

    The  principles of economics are important because they are the rules or  concepts that govern how people satisfy their unlimited wants with their  limited resources.

    What is economic theory?

    Economics  is a social science that studies how people satisfy their unlimited  wants by carefully managing and using their limited resources.

    What is the cost benefit principle in economics?

    The cost benefit principle in economics refers to the weighing of the costs and benefits of an economic decision and undertaking that decision if the benefits outweigh the costs.

    Which President believed in the principles of trickle-down economics?

    United  States president Ronald Regan announced plans to revitalize the economy  through trickle-down economics. A theory that believes that by giving  benefits to top earners and businesses, the wealth would trickle down  and help the everyday worker. This theory has been disproved, yet it is  still believed and practiced by many.

    Test your knowledge with multiple choice flashcards

    Total utility decreases as the units of consumption increases.

    Marginal utility and total utility have the same curve.

    Marginal utility decreases as the units of consumption increase.

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