Fundamentals of Economics

Economics has been known as the dismal science ever since Thomas Carlyle coined the phrase to summarize T. R. Malthus’ sad predictions in the 19th century: that the fate of humanity’s economic life would be poverty, hardship and even starvation.  In most of the developed world today, this prediction has not been borne out, but in many third world nations, there are large pockets of poverty, hardship and starvation, and the contrast between these worlds illustrates some of the fundamentals of economics at work and how they are all interrelated.

The most basic principle of economics is the “law of supply and demand”, which is based on the concept of scarcity of goods.  Since there are no “goods”, including the means to pay for those goods, that are unlimited in supply, human beings have to make choices between the options open to them.  Even air and water, the basics of life, can be limited so that water in the desert and air on a mountain command a premium.  Each person makes a decision as to how he wants to allocate his limited resources. In a subsistence society, man allocates his only resources, time and labor, to raising food, building shelter and weaving cloth. If the soil and weather conditions are optimum in a certain locale, it would be easy for each member of the society to raise enough crops for himself and have some left to give to his neighbor in exchange for something the neighbor may have. However, if crops were that easy to grow, everyone would have more than they needed, which would force the value (prices) of these crops down.  Imagine, however, that trees were very rare and so it was difficult to build a strong shelter. The enterprising members of this society could travel to a region where there was wood and spend their time and labor resources obtaining this good.  This is called the “production possibility frontier”, which, in turn will affect the law of supply and demand. The wood to build shelters would become very valuable since there would not be much of it, since it requires so much in resources to produce.  Now each member of this society has to decide on how much of his relatively cheap food he is going to give up in order to obtain the expensive wood.

We have the same choices in modern, industrialized societies. Each member has to choose how he is going to spend his limited resources. Some of the members may have very few resources and have to spend most of them on basic necessities.  Others who have few resources many nevertheless make different choices, to cut back on a basic such as shelter in order to afford a luxury such as cigarettes. Many members of developed societies have more than enough resources to obtain food, clothing and shelter and need to make their economic decisions about whether they want to live in big house or live in a smaller house and afford a nice vacation every year. These choices (cigarettes for a nicer apartment, a vacation instead of a bigger house) are called “opportunity costs”, since each member is giving up one thing (the cost) to obtain something else (opportunity).

In some societies some items may be cheaper than others. Homes in Switzerland are very expensive because building materials and land are scarce and therefore expensive. Relatively speaking, homes in the United States are cheap because the United States has a lot of natural resources and land. This is the principal of “comparative advantage”.  Members of society in Switzerland have to make different choices regarding shelter than members of society in the United States.

As societies develop, these shifts constantly and naturally occur, so that if the price of housing comes down, our smoker may still be able to afford a better apartment, and our homeowner might be able to keep his big house and still go on vacation. Housing prices (cost of shelter) may come down because the supply of housing in the area goes up or interest rates go up and make it less desirable for people to have a mortgage.

At a certain point, however, in each society and for each good, choice becomes more limited. Once the price of cigarettes becomes so expensive that a smoker could no longer afford them and an apartment, he would have to give up cigarettes in order to have a place to live.  No matter how expensive food became, members of both subsistence and advanced societies would have to have food. This is the principal of “elasticity of demand”.  The demand for food is very inelastic because it is essential to life. The demand for other goods, such as cigarettes and vacations is elastic. We will give them up in order to have food and shelter.

Woven into all of these economic principles, however is another principle. There are some consumers who, no matter how high the price of cigarettes becomes, or not matter what they had to give up to take vacations, would still pursue that good. This is the principle of “utility”, which measures the perceived benefit each consumer receives from the goods he chooses. On an individual basis, this sometimes contradicts the laws of supply and demand. Since, under the law of supply and demand, as prices rise for an elastic good such as cigarettes go up, demand should go down and all smokers should no longer buy cigarettes.  An addicted smoker, however, will sacrifice many things in order to afford cigarettes now matter how high the price.  Someone who can’t live without vacations may end up with no home and just “follow the sun”.

These fundamentals of economics, therefore, can be summed up by these interrelations: the law of supply and demand, as determined by the comparative advantage of different societies and the production possibility frontier, dictates prices, which dictate demand, except as affected by the elasticity of a good and its utility to the consumer.


Categories Economics

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