If you ask most people what economics is, chances are you will get a response that has something to do with supply and demand. “You’ve got one line that goes up, another that goes down, and they intersect at some point.” You might get a little word rearrangement with, “It’s the study of the economy.” Both are correct, but surely incomplete. It’s a bit like me asking you, “What is mathematics?” If your response is, “Mathematics is addition,” you would be correct that addition is a part of mathematics, but there is certainly a whole lot more in the world of math than addition. And the same is true with economics. The perception of economics is mainly focused solely on supply and demand. To get you thinking more about the “greater picture”, we need to first start off with what economics actually is and, in general, how it works.
Quickly before we get to that though, I should clarify that this post is part of series that I am calling “Beginnings.” What that means is that this is part one of a series of posts that introduces you the ideas that dominate all the other posts. Going back to the math example, it’s very difficult to understand multiplication if you don’t understand addition, and it’s very difficult to understand addition if the concept of numbers is completely foreign. These posts are going to (cliche alert) set the foundation for all the others. I really recommend you read all the Beginnings posts before diving into the others so that you are able to really comprehend all the ideas instead of only skimming the surface (I have more posts coming, it’s just going to take a while to type them up. So check back often in these early stages for these posts).
Back to the fun stuff…
The Very Technical Answer
First let’s look at what the hardcore, technical definition of economics is and see what we can take away from it. There are probably dozens, heck hundreds, of different definitions but I am going with the one that I was originally taught which seems to me to be the most complete:
Economics is the science of the allocation of scarce resources for the satisfaction of human wants and needs.
Nice fancy definition that surely will impress any dictionary writers reading this post… But what does it mean? The key word that needs to be stressed throughout all the discussions on economics is science. Remember some of the things I mentioned in my introductory post about how there is a perception that economics is a “voodoo” science. The implication is, really, that economics isn’t a science at all; it’s just an association of theories that may or may not hold true in reality. But the real truth is the economics is a science, just a social one. What that means is that the goal of economics is to find an objective result.
I remember when I was sitting in a university lecture hall first learning these concepts, the professor went on and on about defining the difference between a positive statement and a normative statement. To be honest, it all just sounded like a big waste of time trying to make something boring sound very fancy and sophisticated. However, it’s actually pretty important to know the difference because it helps explain why economics is so much a science. A positive statement is one that we can test objectively. “The temperature outside is 102 degrees,” is an example. It’s summer, I am in Phoenix, so this statement is probably true. But the key is that I can test it. I go outside with a thermometer and test what the actual temperature. Whether the temperature is 102 degrees or not is irrelevant to the statement being positive. The fact is that I could test it. “It’s too hot outside,” is a normative statement because I can’t test this. How can I decide, objectively, what “too hot” is? I can’t test it. There is no thermometer that can reliably and objectively say, “Yep, it’s too hot outside.” Thus, in economics, the statements are scientific because they are positive. We can test them, we can model the scenarios and derive an objective result. Ultimately, what economics does not do is say, “The price of gas tomorrow will probably be too high.” We may be able to create a study that brings some results that might lead to this opinion, but, again, we are using objective measures to, at the very least, substantiate the normative statement. This will also become much more clear when you start reading about real world examples and the actual study of economics.
What also needs to be added is that human wants and needs are insatiable. This is an important addition to the definition because it is what keeps economics as a constant presence in every day life. Throughout all life, we will always want something and we will always need something. As a result, there is always going to be a decision that needs to be made as to how we allocate resources to accommodate those wants and needs.
So economics is a science about insatiable wants and needs. Accepting that, we can narrow this definition into a shorter one that might help drive home what economics actually is. Economics is about how people allocate resources. How much do I buy? At what price? How much of X do I buy and how much of Y do I buy? And now we get to the real intuitive concept of economics:
The Real World Intuitive Definition
Economics is the study of human decision making.
Look back at those last example scenarios. All of them are focused on a particular decision. In some scenarios, we can have multiple decisions happening simultaneously to create some particular outcome. But the center of it all is the decision making. This encompasses so many different aspects of life. There are business decisions, personal decisions, strategic decisions, long-term decisions, short-term decisions, decisions solely for you, decisions that involve multiple parties, and so on. And this is why economics is always around in everyday life. Here’s a quick, simple example.
You are at the grocery store and look at the shelf and you see two cases of soda, one is Pepsi and the other is Coke. The Coke case costs 3 dollars and the Pepsi case costs 2.50. What decision you ultimately make is an economic decision. You are weighing the costs and benefits of either product. If you prefer the taste of Coke to the taste of Pepsi, you might be willing to pay the extra 50 cents to get it. On the other hand, you might be completely neutral on the taste of Coke and Pepsi, so you buy the Pepsi since it’s giving you an equal amount of satisfaction at a lower price. That is an economic decision. No matter what product you ultimately bought, you bought based upon an economic thought process.
Rationality
This previous example leads us to an absolutely critical assumption in economics which allows us to make some simple looking results. This critical assumption is the rationality of consumers. To make sense of this, we need to go back a little bit in time and learn about utility. In the early 19th Century, a philosopher named Jeremy Bentham (pictured above) lead the way in the concept of utilitarianism. His idea was that everyone attains a certain level of satisfaction from doing/buying/consuming items. To give a clear numeration of these levels of satisfaction, he formulated the concept of “utils.” A util is a unit of satisfaction determined by me or whoever is consuming the good and attaining satisfaction. That’s a fancy way of saying how happy I am when I consume something. For example, when I eat a hamburger, I get 10 utils of satisfaction. But when I eat a cheeseburger I get 12 utils of satisfaction. Who said a hamburger was 10 and a cheeseburger 12? Me! Don’t get hung up on what the actual numbers are. It really does not matter whether I get 1 util from a hamburger or 100 from a cheeseburger. What matters is the relative nature between them. In the original example, I got a little bit more satisfaction from the cheeseburger than the hamburger. In the extreme example, I got a huge amount of satisfaction from a cheeseburger and nearly none from the hamburger. That’s what is important here and it allows us to make a clear way of saying how much satisfaction a consumer is gaining from the consumption.
What does this have to do with rationality? It means that assuming all other things are equal (this is a big statement that reoccurs in economics a lot), if I have a choice between X which gives me 10 utils and Y which gives me 11 utils, I will pick Y. This is me being rational. If all other things are equal, why would I possibly choose X and get less satisfaction than Y? Because of this rationality, we can conclude what decision people will make. Simply, consumers will make whatever decision brings them the most utility, all other things being equal. (We need to clean this up a little bit, but I will do so in a later post.)
Going one step further, remember the soda example I used a little bit ago. The thought process that goes through your mind (even perhaps subconsciously) was an economic thought process… despite the fact that you probably never studied economics intensely. This allows us to generalize things and say that rationality of the consumers (or decision makers) is the idea that they act like they know economics even if they don’t consciously make an economic analysis of the decision. You won’t buy Coke if you don’t like the taste of Coke. That is a pretty simple story that everyone in that situation will follow. The economics, though, is still there. In economic terms, the person who doesn’t like the taste of Coke achieves no utility from consuming Coke (or 0 utils) and thus chooses a different soda which provides a positive number of utils, clearly preferred to having zero satisfaction (2 > 0, for instance).
One last concept… Opportunity Cost
In a simplified statement, economics really boils down to the costs and benefits of a given scenario. The benefits are relatively easy to conceptually derive. In most of the general scenarios we are just talking about the satisfaction we attain from the decision, but this can also incorporate things like the value of future gains, such as avoiding future costs (very common in environmental economics). The costs should be relatively simple conceptually as well, but there is a problem that almost always needs to be addressed.
Chances are if I ask you what the cost of a product is, you will tell me the price. This is an incomplete answer because the price of the product itself is but a component of the cost. This brings us to the idea of opportunity cost. The cost of anything is what I must give up in order to attain it. This means that things like forgone alternatives, time, effort, etc. are components of the cost. The cost of a ski vacation is not just the price of the airplane ticket and rental car to get there, the price of the hotel, and the price of the lift ticket and ski equipment all added up. The cost of the ski vacation is all those prices plus the time that I sacrificed to have that vacation, among other things. (Think of this as similar to lost wages. On vacation, I don’t work and thus also lose any income I would have gained had I not gone on vacation and stopped working.) This concept of opportunity cost will constantly manifest itself in nearly every discussion that revolves around economics. That’s why I can say things like, “The cost of a Harvard education is low when I am young.” Sure, the tuition is high, but given my young age, things like forgone wages and the value of the next-best alternative is really low. When I get older (which generally means I have more experience, have a better job, and earning more income), I have to give up a lot more to get a Harvard education. Thus, the cost of a Harvard education is much higher (even if the tuition stays the same).
This concept of opportunity cost also helps us explain other decisions that you and I constantly make. Let’s go back to a grocery store example. Say, that at store A, a gallon of milk costs 3 dollars. However, at store B a gallon of milk costs 2 dollars. Why would I ever go to store A to buy milk? The price of a gallon of milk is clearly much lower at store B. But what about the cost? If store A is right next door, but store B is 20 miles away, the cost of the gallon of milk is much lower at store A than it is at store B. I don’t have to drive an hour through rush hour traffic to get to store B, which makes the opportunity cost of store A lower than the opportunity cost of store B. Thus, I will always go to store A even though the price of the milk is higher than the price of milk at store B, again, all other things being equal.
These examples that we used throughout this post are all economics. We are mapping human behavior since we have made some general assumptions that allow us to make these conclusions. We know that, assuming all else is equal, someone will buy milk from store A than from store B. We have successfully derived, objectively, what that person will do based upon the science of economics. In other words, economics is a methodology for determining what decision someone will make. In the supply and demand example that most everyone will be familiar with, the tools of supply and demand allow us to determine how much and at what price consumers will demand and businesses will supply, or what decisions will be made in a market. And this should start to make clear why economics is such a valued tool in the real world. No matter if you operate a business, invest in a market or product, or simply shop in a mall, having a method which determines what decisions will made can help you make a better decision yourself.
What’s important at this point is that, if you haven’t followed me completely to this point, re-read this post again. Going back to the original math example that started this post: If you don’t understand numbers, it’s hard to understand addition. Likewise, if you don’t understand the rationality of consumers, it’s really hard to understand why we can make the conclusions that we will make in economics. Once this post makes sense to you, then you can go on to the next post in this series (I will supply the link below once it is available).
At this early stage, this ends up being a bit like a class lecture, but it is important. I find economics to be very fascinating and very insightful, which is why (once I get the site going at full speed) you will see a lot of posts about a number of different issues and scenarios. But you won’t enjoy this site fully if you don’t have this basic understanding. (Cliche alert) You have to learn to crawl before you can walk. Finally, please ask questions, write comments, or send me an email. Tough these first few posts will be a little dry, I want this to be about discussion more than anything else.
