2 What is Economics?

What is Economics?

Economics is the study of how humans make decisions in the face of scarcity. These can be individual decisions, family decisions, business decisions, or societal decisions. If you look around carefully, you will see that scarcity is a fact of life.

Scarcity means that human wants for goods, services, and resources exceed what is available. Resources, such as labor, tools, land, and raw materials are necessary to produce the goods and services we want, but they exist in limited supply. Of course, the ultimate scarce resource is time — everyone, rich or poor, has just 24 hours in the day to try to acquire the goods they want. At any point in time, there is a finite amount of resources available.

At the core of the Economics science lies the problem of “scarcity.” We always want more than we can get, so we face scarcity , the inability to satisfy all our wants. Everyone faces scarcity, because no one can satisfy all of his or her wants. ⁽²⁾

Faced with scarcity, we must make choices — we must choose among the available alternatives. The choices we make depend on the incentives we face. We have thus arrived at the definition of economics as provided in the learning unit.

To summarize, Economics is the social science that studies the choices that individuals, businesses, governments, and entire societies make when they cope with scarcity ; the incentives that influence those choices; and the arrangements that coordinate them. ⁽¹⁾

Economics Defined

Economics involves the study of how people choose to use the limited resources of land, capital, labor, and entrepreneurship—known as factors of production (that might have alternative uses) — to produce all the goods and services and distribute them to the people for consumption. In addition, Economics involves the study of activities that involve exchange between people, which can be for goods and services, labor, or loanable funds. Money is only an exchange tool. Thus, money is not a factor of production in economics.

Microeconomics is the study of the choices that individuals and businesses make and the way these choices interact and are influenced by governments. Microeconomics answers the following questions:

What determines how households and individuals spend their budgets? What combination of goods and services will best fit their needs and wants, given the budget they have to spend? How do people decide whether to work, and if so, whether to work full time or part time? How do people decide how much to save for the future, or whether they should borrow to spend beyond their current means?

What determines the products, and how many of each, a firm will produce and sell? What determines what prices a firm will charge? What determines how a firm will produce its products? What determines how many workers it will hire? How will a firm finance its business? When will a firm decide to expand, downsize, or even close? We will learn about the theory of consumer behavior and the theory of the firm. ⁽²⁾

Macroeconomics is the study of the aggregate (total) effects on the national economy and the global economy of the choices that individuals, businesses, and governments make. Macroeconomics looks at the economy as a whole. It focuses on broad issues such as growth of production, the number of unemployed people, the inflationary increase in prices, government deficits, and levels of exports and imports. ⁽¹⁾

Macroeconomics answers the following questions:

What determines the level of economic activity in a society? In other words, what determines how many goods and services a nation actually produces? What determines how many jobs are available in an economy? What determines a nation’s standard of living? What causes the economy to speed up or slow down? What causes firms to hire more workers or to lay workers off? Finally, what causes the economy to grow over the long term? ⁽¹⁾

Microeconomics and macroeconomics are not separate subjects, but rather complementary perspectives on the overall subject of the economy. To understand why both microeconomic and macroeconomic perspectives are useful, consider the problem of studying a biological ecosystem like a lake. One person who sets out to study the lake might focus on specific topics: certain kinds of algae or plant life; the characteristics of particular fish or snails; or the trees surrounding the lake. Another person might take an overall view and instead consider the entire ecosystem of the lake from top to bottom: what eats what, how the system stays in a rough balance, and what environmental stresses affect this balance. Both approaches are useful, and both examine the same lake, but the viewpoints are different.

In a similar way, both microeconomics and macroeconomics study the same economy, but each has a different viewpoint. Moreover,macroeconomics has microeconomic foundations, which we will begin to discover in Module 2 when we study the supply and demand model, which is the cornerstone of both microeconomics and macroeconomics.

An economy’s macroeconomic health can be defined by a number of goals: growth in the standard of living, low unemployment, and low inflation, to name the most important. How can macroeconomic policy be used to pursue these goals? Monetary policy , which involves policies that affect bank lending, interest rates, and financial capital markets, is conducted by a nation’s central bank. For the United States, this is the Federal Reserve.

Fiscal policy , which involves government spending and taxes, is determined by a nation’s legislative body. For the United States, this is the Congress and the executive branch, which originates the federal budget. These are the main tools the government has to work with.⁽²⁾

In the last two modules, we will focus on macroeconomic policies by utilizing the broader Aggregate Demand-Aggregate Supply model, which is first introduced in Module 2.