The Basics - Three Insights
In his Student's Guide to Economics, the late Paul Heyne wrote of three insights that underpin all modern economic thinking:
1. The Mutual Determination Insight. Everything depends on everything else, and everyone depends on everyone else where economics is concerned - we also refer to this as interdependence.
2. The Subjective Insight. There are no objective costs; "things" cannot have costs, only actions can have costs. These costs accrue to the actor.
3. The Marginal Insight. Which has more value - a glass of cool water, or a glass of sparkling diamonds? That depends on whether you are dying of thirst in the desert or sitting beside a water cooler. The value of everything and anything depends on the situation. The only value relevant to a situation is the marginal value - that is, the addition to or subtraction from a value that results from a specific situation - that is to say, on a specific margin.
1. The Mutual Determination Insight. Everything depends on everything else, and everyone depends on everyone else where economics is concerned - we also refer to this as interdependence.
2. The Subjective Insight. There are no objective costs; "things" cannot have costs, only actions can have costs. These costs accrue to the actor.
3. The Marginal Insight. Which has more value - a glass of cool water, or a glass of sparkling diamonds? That depends on whether you are dying of thirst in the desert or sitting beside a water cooler. The value of everything and anything depends on the situation. The only value relevant to a situation is the marginal value - that is, the addition to or subtraction from a value that results from a specific situation - that is to say, on a specific margin.
The Basics - Scarcity and The Economizing Problem
We live in a world of unlimited wants and needs (can we tell the difference?); but unfortunately, we also live with scarcity. We therefore have to decide what to produce, how to produce it, and for whom to produce it. By scarcity, we mean limited availability of the means of production - land, labor, capital, (entrepreneurial ability, for those who prefer to add it), and not to a lack of riches.
The Basics - Incentives Matter
Out there on the margin of whatever situation with which we are faced, rational actors choose between different alternatives. If we perceive that one choice is more beneficial to the rest, or that fewer costs accrue to that choice than to the others, then that is the choice we will make. In other words, an incentive is a cost or benefit that motivates economic actors (consumers, firms, etc.) to act. Much of economic planning is about getting the incentives right.
The Basics - Opportunity Cost
This is one of those ideas that is pretty simple, but causes economics students all sorts of trouble. Opportunity cost is the next-best choice available to someone who has chosen between two or more mutually exclusive options. Let's say, for example, that you decide to go to college full time. Well, if you hadn't made that choice, you most likely would have decided to go to work instead. You have made a trade-off, sacrificing the enjoyment of present income for the chance to get an education. So,we can say that the opportunity cost of your choice to go to college is the money you could have made if you had gone to work.
The Basics - Utility
The worth of one choice to another is determined by assigning to them and comparing their value. Value can be expressed as an amount of money (price) or in terms of what must be given up to get it (cost). Value is a function of utility, or the usefulness of something to a person. We usually speak of marginal utility (see The Marginal Insight) because things have different values to different people under different circumstances. It is that utility that allows us to assign prices to goods and services, whether in terms of money prices or opportunity cost.
The Basics - The Price System. It is the price system that makes a market economy successful. The famed economist Milton Friedman stated that it is the price system which has enabled the United States to develop. Producers use it to note a change in the demand for a product and to raise or lower their asking prices accordingly, and consumers use it to note a change in the supply of a product and to raise or lower their bid prices accordingly. This is the "Invisible Hand" of Adam Smith, an incredibly complex, automated system of signals flying throughout the marketplace, 24-7-365. Although we speak of Equilibrium (Market Clearing Price), a point at which the intersection between suply and demand intersect at a particular price, such an equilibrium point really can exist only on a graph. Have you ever gone to the store to discover that they are out of your favorite cereal? Have you ever seen a producer suddenly lower the price of an item suddenly and drastically? These are the little burps and hiccups of a system that is not perfect. On the other hand, what results when central planners try to take over the function of a free market, substituting their own ideas for the autoomation of the price system, we see very soon what is meant by the term "fatal conceit" - in such a system, people die of starvation.
The Basics - Factors of Production (Economic Resources)
Land (natural resources), labor (human resources), capital (capital resources) - and entrepreneurial ability (entrepreneurship) for many modern economists. Put all these things together, make a useful product or service, and you will have created wealth! And, after all, we measure wealth in terms of our productivity, so it all makes sense. Watch out, though: natural resources aren't factors of production unless there is payment made for their use (exchange). And, nobody will pay for it unless it is scarce (don't confuse scarce with rare!). Ah, and a note on capital resources: they include capital goods as well as the money used to purchase them. Capital goods are the buildings, structures, machinery, and tools used to produce the goods and services demanded by consumers. So, you might wonder, what is the difference between labor and entrepreneurial ability? Well, labor is any human effort exerted during the production process. It can be either physical or intellectual. Entrepreneurship, however, combines organizational skills and the willingness to engage risk in order to bring together the other factors of production to produce something of value. One last thing... I promise! Labor, Capital and Entrepreneurial ability are called ACTIVE factors of production, while land is considered PASSIVE. The first three are actively engaged to produce goods and services, but land (natural resources) just sits there until the other factors act upon it.