What is Economics? - Definition & Principles

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  • 0:01 What Is Economics?
  • 0:56 Key Principles of Economics
  • 2:28 Incentives, Markets, & PPF
  • 4:17 Opportunity Cost &…
  • 6:15 The Value of Money
  • 7:09 Lesson Summary
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Lesson Transcript
Instructor: Kallie Wells
Why do we buy more when something goes on sale? At what point does one stop consuming a good they love to consume? All of these can be addressed by the principles of economics, which are discussed in this lesson.

What Is Economics?

Economics is the science of analyzing the production, distribution, and consumption of goods and services. In other words, what choices people make and how and why they make them when making purchases.

The study of economics can be subcategorized into microeconomics and macroeconomics. Microeconomics is the study of economics at the individual or business level; how individual people or businesses behave given scarcity and government intervention. Microeconomics includes concepts such as supply and demand, price elasticity, quantity demanded, and quantity supplied. Macroeconomics is the study of the performance and structure of the whole economy rather than individual markets. Macroeconomics includes concepts such as inflation, international trade, unemployment, and national consumption and production.

Key Principles of Economics

There are several main principles of economics that every theory and concept is based upon. Here is a description and quick application or example of those principles that apply to the study of production, distribution, and consumption of goods and services.

Scarcity is the basic economic problem that exists because we as humans have unlimited wants that cannot be met by the limited amount of resources our world has. Any good or service that has a non-zero price is considered scarce. It will cost you something to consume that good or service. Without scarcity, there would be no reason to study economics. People would consume everything they could possibly consume and not have to make choices or trade-offs between goods and services.

In economics, marginal means the impact of a small, or one-unit, change. How much better off will you be with one additional unit? As a rational thinker, you will continue to increase the variable until the additional (marginal) benefit gained from the last small increase is no less than the additional (marginal) cost of the last small increase. Consider your favorite dollar menu item from your preferred fast food restaurant. Each additional one you consume costs you $1. And with each additional one you eat or drink, you are satisfying a want. At some point, you will stop consuming that item. The point at which you stop consuming is the point at which the additional benefit you gained by eating or drinking that item is valued no more than $1. That is the point at which the marginal benefit equals the marginal cost.

Incentives, Markets, & PPF

It's no surprise that people respond to incentives. Incentives in economics are typically always financial and can take on several forms, such as prices, taxes, and fees. When you see your favorite item go on sale, you typically buy more. There was an incentive, such as a lower price, and you responded by consuming more of that good or service. We naturally respond to incentives, so therefore, incentives are created to influence the behavior of consumers for a particular good or service.

Markets are places where goods and services can be exchanged between buyers and sellers. Each market has a demand and supply curve; the quantity of the good they are willing and able to purchase or sell at varying price points. The graph below is an example of typical supply and demand curves. The demand curve is generally downward sloping, showing more of the good will be demanded as the price of that good decreases. The supply curve is upward sloping. As the price increases, sellers are willing and able to sell more of the good. The point at which the two curves intersect is called the market equilibrium.

Example of a typical supply and demand curve
Supply and Demand Curve

The Production Possibility Frontier (PPF), also called the Production Possibility Curve, is a graphical representation showing all possible combinations of two goods a nation can produce given the limited resources in a limited time frame. Below is a PPF between food and computers. Any point along the PPF - points A and B - represents maximum utilization of resources; the nation cannot be better off given the limited resources. Any point inside the PPF represents underutilization of resources and any point outside the PPF represents the idea of scarcity; the nation has limited resources and cannot meet unlimited demand that occurs outside the curve.

Example of a Production Possibility Frontier (PPF)

Opportunity Cost & Diminishing Returns

When making decisions, we have to give up something. The benefit or value of the next best alternative is called the opportunity cost. What did you have to give up to sleep in an extra hour? If you were headed to work, you gave up an additional hour of pay. Therefore, the opportunity cost of sleeping in one hour was your hourly wage. The concept of opportunity cost is illustrated on the below Production Possibility Frontier for food and computers. Moving from point Q to R will require one less food unit to produce one more computer. Therefore, the opportunity cost for one more computer is one food unit. Moving from point T to V requires three less food units to produce one more computer.

A PPF that illustrates opportunity cost
Opportunity Cost

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