Understanding economic theory is often overlooked as a life skill, in contrast to the ability to balance a family budget.
However, economics as a topic of study is inextricably linked to our daily lives, as it is essentially the study of the decisions we make and why we make them. You don’t need to dig into an economist’s theoretical depths to enrich your life. Still, five economic fundamentals underpin all economic theories that everyone should know.
The Principle of Limited Resources
The principle of limited resources is the most fundamental economic concept and is far from abstract. There is a finite quantity of resources globally, and we must use them to meet infinite demands. As a result, one must always decide which needs to be addressed with limited resources.
Let’s look at a simple scenario. Wheat can only be grown in small quantities each year. The demand for wheat goods differs from person to person: some people require bread, others like pasta, and others enjoy wheat beer. However, due to the limited amount of wheat available, producers may produce only a tiny amount of each product. How do you determine how many wheat grains should go into flour for baking bread? What is the price of pasta? Or is it for a beer? The market system is one solution.
Law of Supply and Demand
The supply and demand mechanism is what drives the market. Let’s stick with the beer example. Let’s imagine that people desire more beer, indicating a tremendous demand for beer. High demand means that the price of beer can be raised, which means that the benefits of using wheat in beer production are greater than those of processing wheat into flour. As more people begin to make beer, the market becomes saturated, and prices plummet. Meanwhile, flour prices rise as supply shrinks, and producers respond by buying more wheat to make flour — and so on.
Although this is a very ordinary example, it visually depicts how the market process for balancing supply and demand works. In reality, the market is usually considerably more responsive, and genuine supply crises (where the collection of an item or service abruptly increases or decreases) are uncommon. A basic comprehension of the supply and demand market mechanism is sufficient to understand why a top-rated product was sold at half the price the following year.
Costs, Benefits, and the Relationship Between Them
Much of the financial information connected with rational forecasting and rational choosing comes from these notions. People favor the most helpful alternative that has the lowest cost.
Let’s return to our previous example of beer. If the demand is high, breweries will only hire more workers to manufacture more beer if the beer’s price and the sales volume cover the higher labor and material costs. The consumer is in a similar situation: he will buy the best beer he can afford but not the most delicious beer in the store.
This guideline isn’t just for money transactions. Our perceptions of what constitutes a benefit and what we record as a cost are frequently subjective. When faced with several possibilities, we always select the best cost–benefit ratio.
Although most people act sensibly, many factors can switch off our internal “accountant.” Advertising is one of these variables. It manipulates our emotions and employs other deceptive tactics to persuade us to overestimate the advantages of acquiring a thing. The sights and messages these approaches attempt to imprint on our minds overwhelm our reasoning minds.
So, while a genuine awareness of our advantages, costs, and the relationship between them does not always rule our consciousness, the importance of these concepts is relatively high. Many of Adam Smith’s views come from a cost–benefit analysis, and he is sometimes referred to as the “Father of Modern Economics.”
Everything Is an Incentive
Incentives are vital in estimating costs and benefits, but their significance is so great that it warrants its discussion. Incentives keep the world turning (sometimes in the wrong direction). Suppose you’re a parent, supervisor, teacher, or someone else in a position where you’re in charge of other people’s activities and things aren’t going well. In that case, it’s most likely due to improper incentives that don’t align with your desired outcomes.
Consider the brewery once more as an example. The brewery’s goods are available in 500 mL and 1 liter. The brewery’s owner wants to boost output, so any shift that produces the most bottles daily gets a bonus. He reports that production has increased from 10,000 to 15,000 bottles per day a few days later. Suppliers began calling him soon after, asking when orders for liter bottles would arrive. Of course, the issue was that the incentive he was using was misdirecting workers. Instead of encouraging the volume of beer produced, the number of bottles produced was encouraged, creating a situation where competing shifts could profitably deliver only little bottles.
Some incentive programs have been beneficial throughout history and are now standard practice for many businesses. Employee participation in the company’s earnings, bonuses for productivity, and the distribution of company shares among employees are examples of such initiatives. However, even time-tested incentives might have fatal consequences if the reward circumstances diverge from the original incentive goals. Poorly constructed performance bonuses, for example, have encouraged some CEOs to make questionable actions to enhance financial statements and earn a reward. However, organizations can obtain significant gains when incentives align well with the organization’s goals.
The Need to Connect Concepts
All economic research revolves around the issue of limited resources. This term has a negative connotation, which is why economics is called the “dark science.” Still, it implies that the selection process is essential for economic activity. The decision is based on the cost-benefit ratio of one or more investments of forces and resources. As a result, we have a dynamic market system, a complex, linked system in which our choices are mirrored in supply and demand axes.
On a personal level, limited resources mean we’ll have to make decisions based on existing incentives and awareness of the specific costs and rewards of certain activities. The universe is an entire of options we can (or must) choose from. The subject matter of economics, which analyzes these alternatives and the methods for choosing between them, is replete with theories, laws, and concepts. All of the principles covered, including “comparative advantage,” “entrepreneurial spirit,” “marginal gain,” and many others, are vital to others.
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