Principles of Economics
These are my notes on principles of economics.
Economists Study the choices that people make. To understand these choices, they focus on the costs and benefits involved. Economics is the study of people’s choices. The first principle of economics is that people try to optimize. They try to choose the best available option. The second principle of economics is that economic systems tend to be in equilibrium. This is a situation in which nobody would benefit by changing their own behavior. The third principle of economics is empiricism. This is analysis that uses data. Economists use data to test theories and to determine what is causing things to happen in the world.
Economics involves far more than money because it is the study of all human behavior. Choice is the unifying feature of all the things that economists study. Economists think of almost all human behavior as the outcome of choices.
An economic agent is an individual or a group that makes choices. The second important concept to understand is that economics studies the allocation of scarce resources. Scarce resources are things that people want, where the quantity that people want exceeds the quantity that is available. Scarcity exists because people have unlimited wants in a world of limited resources.
Economics is the study of how agents choose to allocate scarce resources and how those choices affect society. Economists study the original choice and its multiple consequences for other people in the world.
Positive economics describes what people actually do. Normative economics recommends what people and society ought to do.
Descriptions of what people actually do are objective statements about the world. These statements can be confirmed or tested with data.
Normative economics advises individuals and society on their choices. It is almost always dependent on subjective statements, which means that normative analysis depends at least in part on opinions.
Economics is also divided into two other ways. Macroeconomics and microeconomics. Microeconomics is the study of how individuals, households, firms, and governments make choices. This leads to the study of how those choices affect prices, the allocation of resources, and the well-being of other agents.
Macroeconomics is the study of the economy as a whole. They like to study economy-wide situations like growth of gdp or unemployment.
Economists emphasize three key concepts. They are optimization, equilibrium, and empiricism. Optimization is about picking the best feasible option. Economists believe that people’s goal of optimization explains most choices that people make. Equilibrium holds that economic systems tend to be in equilibrium. This is a situation in which no agent would benefit personally by changing their behavior. The economic system is in equilibrium when each agent cannot do any better by picking another course of action. In other words, equilibrium is a situation in which everyone is optimizing at the same time. Empiricism is evidence-based analysis. It is analysis that uses data.
All optimization problems involve trade-offs. Trade-offs arise when some benefits must be given up in order to gain others. Economists use budget constraints to describe trade-offs. A budget constraint is the set of things that a person can choose to do without breaking his budget. Budget constraints are useful economic tools, because they quantify trade-offs. When economists talk about the choices that people make, the economist always takes into account the budget constraint. It’s important to identify the feasible options and the trade-offs and a budget constraint gives us that information.
We face trade-offs whenever we allocate our time. When we do one thing, something else gets squeezed out. This is an opportunity cost. Evaluating trade-offs can be difficult because so many options are under consideration. Economists tend to focus on the best alternative activity. This best alternate activity is another definition of the opportunity cost. This is what an optimizer is giving up when he allocates his time to something.
Cost-benefit analysis is a calculation that identifies the best option by summing benefits and subtracting costs, with both benefits and costs denominated in a common unit of measurement. Cost-benefit analysis is used to identify the alternative that has the greatest net-benefit. To an economist, cost-benefit analysis and optimization are the same thing. When you pick the option with the greatest benefits, you are optimizing. So, cost-benefit analysis is useful for normative economic analysis.
In most economic situations, you aren’t the only one trying to optimize. Other people’s behavior will influence what you decide to do. Economists think of the world as a large number of economic agents who are interacting and influencing one another’s efforts at optimization. In equilibrium, both the sellers and the buyers are optimizing. Nobody would benefit by changing their behavior.
People’s private benefits are sometimes out of sync with the public interest. This is the free-rider problem. Equilibrium analysis helps us predict the behavior of interacting economic agents and understand why free riding occurs.
Economists test their ideas with data. We refer to such evidence-based analysis as empirical analysis or empiricism. Economists use data to determine whether our theories about human behavior match up with actual human behavior. Economists are also interested in understanding what is causing things to happen in the world.