Introduction to the principles of economics

economicsCredit: The idea of an article about Economics and the theory behind it may scare or bore many people. When thinking about the economy one typically visualizes huge tables of numbers, percent values and spooky concepts like inflation and taxes. While these are all part of the area of study of Economics, one could argue that these are an outcome of it rather than a core constituent.

From a slightly higher point of view Economics can be seen as the social science that analyzes the behavior of “agents” (which can be single individuals, small groups, large corporations or even entire nations) and the way in which they interact with each other in an environment characterized by limited valuable resources. The term "valuable" here doesn't necessarily refer to monetary value, but more loosely to anything that may constitute a desirable resource.

In this sense the study of Economics is focused on analyzing the behavior of the agents. Its main goal is to try to understand the reasons that drive their actions and hopefully derive generic principles to help predict the outcome of current and future situations, events and policies.

The best seller and highly recommended book “Principles of Economics” by G. Mankiw outlines ten economic principles that may help to better understand human behavior in the economic's context and lay the foundation of Economics theories. I present here the first four principles, that focus on the way in which people make decisions.

  1. People face trade-offs: It means that in order to get something we have to give up something else. This is true for every choice we make. Even the simple decision to stay at home and read a book implies that we give up some time during which we might have done something else.
  2. The cost of something is what you give up to get it: When evaluating a choice people tend to sum all the direct costs involved with this choice and use this value to decide. A proper decision must take into account also “opportunity costs”, that is the value of things that we give up to pursue the choice. Take the case of a freelance worker that wants to attend a friend's wedding. The direct cost of the choice is represented by the cost of the trip, the present and probably a new dress. The opportunity cost on the other hand is represented by the money that he will not earn during the lost day of work. Always take into account opportunity costs to make decisions.
  3. Rational people think at the margin: Marginal changes are small incremental changes to one's actions and plans. Choices are often driven by their marginal benefits and marginal costs. For example faced with the possibility of eating a pancake your answer may differ according to how many you have already eaten: the marginal value of a single pancake is different if you have just had five of them than if you have had none.
  4. People respond to incentives: This is pretty self-explanatory. Incentives are “prizes” to stimulate a given action or reaction, and people tend to respond to them.

These simple principles are obviously not exhaustive but offer a good foundation to better understand why economic agents behave in a certain way. This understanding can be enhanced by adding a last important remark: value is relative. There is no such thing as the “True” value of a thing. Value depends always on the needs and desires of the agents involved. The value of a bottle of water varies a lot if you are a bar's owner or a thirsty man.