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Economics

Ten fundamental principles of economics

Introduction to Economics

Economics is defined as a scientific way of allocating resources in such a way that can optimize the production, consumption, and distribution of goods and services.

The principles of economics are based on three major questions:

  • How people make decisions
  • How people interact
  • How the economy as a whole works

The 10 fundamental principles try to answer these questions in the following way:

How people make decisions:

  1. People face trade-offs:

Trade-off means that people have to give up something to avail the other thing. This is because the resources are limited whereas the wants are unlimited. An economy faces trade-off while deciding which good to produce. For example, producing food or producing defense equipment. Even an individual faces trade-offs like working 12 hours a day to earn more or working 8 hours a day and having some leisure time. An individual cannot have both. If he chooses to work 12 hours a day, he cannot have leisure time. Whereas, if he works only 8 hours a day, he can have leisure time but he cannot earn more.

Similarly, a country has limited resources (of labor and capital) to produce defense equipment and food. Currently, if it is allocating its resources in such a way that the country produces 100 units of food and 50 units of defense equipment; it would require them to give up some units of defense equipment to allocate those resources in producing more food. Thus, an economy faces a trade-off between producing food to feed its people and producing defense equipment to protect them.

Of course, this theory has assumptions like there is no change in technology in short term and there is resource constraint.

  1. The cost of something is what you give up to get it

Opportunity cost is the cost of giving up the next best alternative to make the optimal decision. This cost can be in terms of money, effort, or utility. For example, you order a dress online. The other alternative was to go out and buy it from the store. Now you would consider various factors before deciding to order online. For example, the dress you order online was on discount. Even if it were for the same price, you would have to put your time and effort into taking a cab to go to the store, try it, and then return home. Thus, the best decision was to order it online which would have saved your time, effort, and money.

Similarly, when a business owner decides to put a factory on a piece of land, the other alternatives for which the land could have been utilized were growing crops or building a park for recreational purposes. Thus the cost of the next best alternative that is foregone is the crops that could have been produced on that piece of land.

  •  Rational people think at the margin

People make decisions by comparing costs and benefits at margin. This is a major assumption on which economic theories are based. Let us try to understand this with the help of two cases:

Case 1: Suppose there are two shops A and B near your house. Shop A sells an egg for Rs.6 whereas shop B sells an egg for Rs.5. Of course, you will buy the egg from shop B even though shop A sells for a marginally higher price.

Case 2: Suppose shop B is situated a little away from your house and the traveling cost comes to Re.2. Shop A and B sell eggs for Rs.6 and Rs.5 respectively. Now, if you were to buy a single egg, would you still buy it from shop B? If we add the traveling cost, the total cost incurred is Rs.7 from shop B. So in this case, you will be inclined towards buying from shop A since it’s cheaper. The marginal cost of buying from B (Rs.2) exceeds the marginal benefit (Re.1)

  1. People respond to incentives

Incentives are defined as the additional benefits which trigger a specific action to be taken. However, the decision to choose one alternative over the other depends on whether the alternative’s marginal benefit exceeds the marginal cost. Again, this benefit can be in terms of money, effort, time, and utility. Also, incentives can be positive as well as a negative incentive. For example, when people speculate that the price of a commodity is going to fall in the coming future (can be due to offers like end season sale), they wait till its price drops. Even a marginal fall in the price of that commodity will lead to a sharp increase in its demand and people will rush to buy that product.

Similarly, when the government imposes a higher tax on cigarettes and alcohol, its consumption falls. Only people who can afford to buy it will purchase it. The overall consumption will drastically reduce since people who used to buy 1 pack a week might buy 1 pack in two weeks now. This can improve the lifestyle of people as well as reduce chronic diseases. Understanding response to incentives is important to frame a public policy for the well-being of society.

How people interact:

  1. Trade can make everyone better off

Competition results in gains from trading. In other words, people gain from their ability to trade with one another. This generally happens between capital and labor-intensive economies. Trade is possible when one economy specializes in producing a particular type of good and the other economy specializes in another type of good. Now there can be various reasons for specialization. It can be due to the abundance of resources in a particular economy in terms of capital, labor, land, skill set, etc.

Let us try to understand this with a simple example. India has an abundance of labor and a large area of agricultural land. Thus, it can produce a huge quantity of agricultural produce like rice, nuts, essential oils, fruits, spices, etc. Similarly, USA is equipped with the latest technology and capital resources which allows it to manufacture capital equipment like turbojets, gas turbines, instruments, and appliances used in medical and surgical sciences. Since both the countries specialize in their respective products, trading can make both of them better off as they can consume both the products at a better price and better quality. If USA allocates some of its land and labor to produce spices, it will not be able to supply the same quality of produce at a lower cost to its people since labor is expensive in USA. Also, India is not as advanced in research and development as USA. So it cannot produce and supply the highest quality of instruments to its people.

Thus, the trade makes both the economies better off as it allows specialization and economies of scale- where the average cost of production falls with more production.

  1. Markets are usually a good way to organize economic activity

The market is a platform where buyers and sellers can interact. Developed countries generally have an organized market system since people are more rational there. When households and firms interact in markets, they are usually guided by the price mechanism of the market without government intervention. This is because when firms and households look at the prices while deciding what to buy and sell, they take into account the social cost of their action unknowingly.

When consumers (the demand side) purchase a product, they try to maximize their utility for the price they pay. When producers (the supply side) sell a product, they try to maximize the profits from their sale. The market acts as a mediator by transferring the value/commodities from producers and consumers. Thus, when there is no third party intervention, the market forces determine the price of a commodity.

  • The government can sometimes improve economic outcome

The market failure or market inefficiency is a result of market power or externalities. A firm gains market power when they have a high market share. In a competitive market, the producers are the price takers which means that they can increase the quantity they sell to generate higher revenue. However, if a firm has market power, it can create a price for their commodity instead of becoming the price taker. When such a firm increases its price, the purchasing power of people falls which leads to a fall in the standard of living of the economy. Now if you are wondering how a price rise can deteriorate the standard of living, here is an example. Suppose there is a single firm in India that manufactures medicines. If the firm increases the price of medicines by 30%, a major section of India will not be able to buy it. Their purchasing power will fall. They will either suffer from the illness, or they will spend a major portion of their income on medicines and spend less on education, a better quality of food, sanitation, etc. Thus their standard of living falls.

Externalities are defined as third part cost or benefit who is not involved in the economic transaction. There can be negative as well as a positive externality. For example, the increased education level of an individual leads to a lower unemployment level in the economy as that individual has higher chances of getting employed, or running a business thereby generating more employment opportunities for others. This is an example of a positive externality. When a factory manufactures goods on a large scale, it is exposing the residents in that area to an increased level of air and water pollution. This is an example of a negative externality.

Now in the above examples of market power and negative externality, a few individuals are made better off at the cost of the well-being of a large section of the society. Thus, in such cases, the government needs to intervene. For example, the government came up with the MRTP Act to restrict monopoly and regulate market prices. Pigovian tax was implemented in the form of various policies where the producers had to pay higher taxes for a higher level of pollution. This tax can be used to compensate for the cost of the negative externality. Thus, the government can sometimes improve the economic outcome.

How the economy as a whole work:

  • A country’s standard of living depends on its ability to produce goods and services

The standard of living of a country includes indicators like health, education, and per capita income. One way of looking at health indicators is life expectancy at birth and access to healthcare facilities. Quality of education can be measured by the expected wage rate. The skilled workforce has a higher wage rate expectancy whereas the unskilled workforce has a low wage rate expectancy. The per capita income is an indicator of the ability to fulfill the materialistic requirements of life.

When productivity in a country increases, the employment rate also increases. This means that the returns on the factor of production will also increase- rent, wages, interest, and profit. Higher returns indicate that the marginal productivity of the factors of production is rising- land, labor, capital, and entrepreneur. This leads to an improvement in the purchasing power of the economy since they are more efficient and getting higher returns. The real income will also increase which refers to the buying power of the money in your hand. You can now buy more number of goods and services from that money. This leads to a further rise in the demand side for goods and services which improves the standard of living of people in an economy as now they have access to a higher number of commodities.

  1. Prices rise when the government prints too much money

Have you ever wondered why the government doesn’t simply print loads of money to end poverty or pay off their debt? Well, there is a reason behind that. Printing too much money can lead to inflation in the long run. This is because the amount of goods and services is not changing, but the supply of money in the market is rising. So people will have higher purchasing power in the short run. The cash in hand has increased but the collective amount of commodities in the economy is the same. So when people are buying the same amount of goods and services with more money in hand, the suppliers will increase the price to match the demand. This causes an increase in the general price level of all the commodities over the period which is referred to as inflation.

There are other problems related to printing too much paper money. It leads to a devaluation of the currency. Devaluation refers to a fall in the value of your country’s currency against foreign currency. Also, the value of total savings in the economy will fall in the long term as people will have to spend more to buy the same number of goods and services. When the government prints excess money to pay off the national debt, the prices can increase further which will make the government holdings and bonds less attractive. This will make borrowings more difficult for the government. Thus, printing excess money will worsen the situation rather than solving it.

  1. Society faces a short-run trade-off between unemployment and inflation

In the short run, when the price rises, the producers have an incentive of generating higher profits. So they invest more to produce a higher number of goods and services. This requires hiring more labor and generating more employment opportunities for them. When the income rises due to higher employment, the purchasing power of people increases, and the aggregate demand also increases. This leads to a rise in the general price level- inflation in the economy.

Thus, if the government wants to control inflation, they can do it at the cost of higher unemployment in the economy. This short-run relation between inflation and unemployment is also depicted by the Phillips curve which is L-shaped showing the inverse relationship between the two variables. However, in the long run, there is only a natural rate of unemployment which means that there is no relation between inflation and unemployment. The Phillips curve is vertical in the long run at the natural rate of unemployment.

Conclusion:

In conclusion, these ten principles are the basis on which various theories and concepts have been formed. There will always be an exception to these principles since a majority of them is about the way humans make decisions. While individuals react differently, these principles help in forming a generalized perception about them and giving the optimal solution to three economic questions: What to produce, how to produce, and for whom to produce.

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