Every day, billions of dollars of shares change hands on stock exchanges worldwide. The United States alone produces $34.5 trillion worth of output daily. The social science economics concerns the use of scarce resources to maximize satisfaction of unlimited wants.
What is scarcity? Scarcity, also known as the basic economic problem, is a law of nature. All resources, even those which seem to be in complete abundance (such as water), are scarce. The principle of scarcity operates on two assumptions:
- Natural resources are finite and extinguishable
- Seemingly limitless resources are hampered by our inability to utilize them
Because of scarcity, every person, business, and government in the world must make choices concerning the use of limited resources. However, we have limitless wants since we will always demand more gold, oil, or water. Economics deals with how to use these resources to make maximum efficient use to satisfy the maximum number of these wants.
The choices people make when addressing scarcity are known as opportunity costs. An opportunity cost is the next best alternative that could have been chosen. Suppose that Company A makes 10,000 pillows per day and 4,000 mattresses. Company A decides to make another 1,000 mattresses per day. However, it is forced to cease production of 2,000 pillows. The opportunity cost of producing 1,000 extra mattresses per day was 2,000 pillows per day. If you choose to go to your college's football game and could have been doing laundry instead, then that task is the opportunity cost of your attending the football game.
Opportunity costs are an important part of economics that require further inspection. Suppose that instead of producing 1,000 mattresses per day Company A could also choose to produce 3,000 blankets for the same lost production of 2,000 pillows. What is the opportunity cost of producing the 3,000 blankets? It is still 2,000 pillows. It is not 2,000 pillows and the 1,000 mattresses which Company A could have produced. Opportunity costs are thought of only as the single next-best alternative. The economic perspective focuses on the marginal analysis, or only the immediate effects, of the costs.
Marginal analysis underlies much of economic thought. Governments and businesses usually make decisions based on the marginal cost and marginal benefit. Marginal analysis deals heavily with utility, or the satisfaction received from use of something. Suppose you choose to buy a sports car from Company B. Company B offers several options packages for that sports car. The packages include: an upgraded radio; the radio and a navigation system; the radio, navigation system, and heated seats. If you choose to buy the radio and navigation system package over simply the upgraded radio, your marginal cost is the extra dollar value you must pay. Your marginal benefit is the utility you derive from having the navigation system. If you decide the utility, and therefore the marginal benefit, is greater than the cost of the radio, and therefore the marginal cost, you should buy the radio. If not, you should choose the less expensive package instead.
Economics evaluates mostly the marginal costs and benefits because the entire picture is often irreducibly complex or irrelevant. You will later learn that in the short run a tradeoff (opportunity cost) exists between unemployment and inflation. When one is low the other is high. In the long run, however, there is no tradeoff between unemployment and inflation because unemployment will return to a natural level. Despite this, a problem exists: the long run may well be ten to fifteen years. Therefore, governments cannot simply afford to do nothing because they are confident unemployment will return to its natural level. Instead, they use the short run model to decide what to do and evaluate the actual change which will affect people in the immediate time period.
This idea leads into another basic tenet of economics. In any economic analysis, we usually assume that everything outside of the problem at hand remains constant. For instance, some variables in our unemployment and inflation model will actually erase the tradeoff. This happened in the 1980s and 1990s in the United States, where there was low unemployment and low inflation at the same time. However, for the most part the model is almost always correct. Thus, for the purposes of examining those two variables, economists usually assume that all of the other possible variables affecting those remain the same. Economists call this ceteris paribus or the other things being equal assumption. When considering economics, it is helpful to first evaluate only two variables, and then to examine the effects of other upon the model.
As a science, economics follows the scientific method. Hypothesis are developed from observations, and are tested to ensure validity (usually in economics this simply involves more observation). For results to be valid, a hypothesis must be able to predict an outcome more than once.
Economists are usually involved in theoretical economics and use their observation of facts to interpret them in a meaningful way. They use cause and effect relationship to establish economic theories or principles. Over time, a theory or principle may become accepted as universally true, at which point it becomes a law. A law is generally always considered to be true. A caveat to all of this is that all economic theories, principles, and laws are generalizations or abstractions. They simplify the actual picture, even more so because of ceteris paribus. A law, though almost always true, may prove false under special circumstances. Like other social sciences, economics cannot apply universal rules because humans sometimes act irrationally.
Positive and normative economics
The act of establishing cause and effect relationships to create theories is known as positive economics. Once positive economics establishes the rules, normative economics seeks to apply it. Sometimes economists refer to this as policy economics. Thus, they act to apply economic theories to policy. This is where economists usually differ with each other. Almost all economists, and virtually all capitalists, accept economic laws as true; however, it is their interpretation of what to do about them that brings them into conflict. The chapters on Fiscal and Monetary policy provide examples of the competing points of view.
Economics is divided into two portions: macroeconomics and microeconomics. This text deals with macroeconomics, the study of an economy as an aggregate, or as a whole. Macroeconomics deals with problems exclusively at a very large scale, usually the national level. Economics concerns itself with several basic goals. These can only be met at the macroeconomic level. They will be discussed in the chapter concerning the market economy.
Karl Marx, who wrote The Communist Manifesto, stated that history is the sum of economic factors. Largely, this is the case. As such, economics is a much more controversial field than most people think. This is because economics effects everyone equally, personally, and intimately. Economics is the only science which touches us in a way we can relate to every day. There are a few problems which people may fall victim to when assessing economics. These include biases, "loaded terminology", and jargon. A few are more serious and harder to spot.
The Broken Window Fallacy
The following is an excerpt from Henry Hazlitt's Economics in One Lesson:
A young hoodlum, say, heaves a brick through the window of a baker’s shop. The shopkeeper runs out furious, but the boy is gone. A crowd gathers, and begins to stare with quiet satisfaction at the gaping hole in the window and the shattered glass over the bread and pies. After a while the crowd feels the need for philosophic reflection. And several of its members are almost certain to remind each other or the baker that, after all, the misfortune has its bright side. It will make business for some glazier. As they begin to think of this they elaborate upon it. How much does a new plate glass window cost? Two hundred and fifty dollars? That will be quite a sum. After all, if windows were never broken, what would happen to the glass business? Then, of course, the thing is endless. The glazier will have $250 more to spend with other merchants, and these in turn will have $250 more to spend with still other merchants, and so ad infinitum. The smashed window will go on providing money and employment in ever-widening circles. The logical conclusion from all this would be, if the crowd drew it, that the little hoodlum who threw the brick, far from being a public menace, was a public benefactor.
Now let us take another look. The crowd is at least right in its first conclusion. This little act of vandalism will in the first instance mean more business for some glazier. The glazier will be no more unhappy to learn of the incident than an undertaker to learn of a death. But the shopkeeper will be out $250 that he was planning to spend for a new suit. Because he has had to replace a window, he will have to go without the suit (or some equivalent need or luxury). Instead of having a window and $250 he now has merely a window. Or, as he was planning to buy the suit that very afternoon, instead of having both a window and a suit he must be content with the window and no suit. If we think of him as a part of the community, the community has lost a new suit that might otherwise have come into being, and is just that much poorer.
The glazier’s gain of business, in short, is merely the tailor’s loss of business. No new “employment” has been added. The people in the crowd were thinking only of two parties to the transaction, the baker and the glazier. They had forgotten the potential third party involved, the tailor. They forgot him precisely because he will not now enter the scene. They will see the new window in the next day or two. They will never see the extra suit, precisely because it will never be made. They see only what is immediately visible to the eye.
Post Hoc fallacy
The post hoc ergo propter hoc fallacy is the most common fallacy and the easiest to fall victim to. In this fallacy, people assume that because Event A precedes Event B, Event A is necessarily the cause of Event B. However, this is easily disproven. If you go to the beach and it rains, you cannot assume that it rains because you go the beach.
Correlation does not prove causation. Often studies will attempt to prove any number of things by showing that when people did something, something else happened to them. However, this proves nothing. For instance, you cannot assume that because 90% of people who took the SAT applied to college that taking the SAT caused people to attend college. More likely, it is the other way around.
Fallacy of composition
The fallacy of composition shows that just because something is true for an individual unit, it does not mean that it is true for the aggregate. For example, if you leave a sporting event a few minutes early because there will be traffic at the end, you cannot assume that everyone should leave a few minutes early. This will simply cause traffic a few minutes earlier. More often this fallacy involves applying microeconomic principles on the macroeconomic scale.