1.2 What Is Economics?

There are many possible definitions of economics. One of the shortest of these is “Economics is the science of choice.” While this definition highlights the fact that all of us are involved in making choices because of scarcity, it is incomplete. A better definition is “Economics is the study of how individuals and societies choose to use scarce resources to produce goods and services to help meet the wants and needs of individuals and society.” There are several italicized key words in this definition. Understanding what these words mean to economists is a good way for you to begin your study of economics, since you need to know how economists think in order to truly understand economics.

Choose

Each day, all of us are faced with choices. For example, you choose whether to use your time to attend class or to do something else, like study, work, or exercise. At lunch, you might choose between spending your money on a hamburger or a pizza. On a Saturday, you might choose between studying for next week’s midterm and going to a beach or ski resort. Societies also choose, through a political process, how to use the resources available to the government. For example, society might choose between spending tax revenue on national defense or on education.

Scarce

Choices are necessary because of scarcity. A resource is scarce if the amount available is less than the amount that people would want to use if the price were zero. If there were a shortage of the resource at a zero price, the resource would have a positive price in the market. This gives us a test for the existence of economic scarcity. If you have to pay for a resource or a product in a market, it is scarce. The resources that are of interest to economists are called economic resources and include labor, capital, natural resources, and human capital. These resources are used directly to produce goods and services. Hence, while money is used to buy economic resources, it is not itself an economic resource because it is not used directly to produce things.

If the amount of a resource available is greater than the amount people would use if the price were zero, then there is a surplus, and the resource is free rather than scarce. For example, suppose there are 100,000 acres of agricultural land available on a frontier recently settled by 1,000 farmers but that each farmer cannot successfully use more than 50 acres, even if the price of land is zero. Under these circumstances, there is more land available than farmers want to use at a zero price, so the land is free in the economic sense. However, if settlement continues and more than 2,000 farmers come, the land will become scarce, and farmers will have to pay a positive price in the market to obtain land. While economic resources may occasionally be free in specific circumstances, they are usually scarce.

It is important to remember that economic scarcity is a relative concept that is determined by comparing the amount of something available with the amount that people would use if it were at a zero price. The fact that something is limited in supply does not make it scarce. Everything on and around the earth is limited in supply, but not everything is scarce. For example, there is a limited amount of air in the earth’s atmosphere, but air is usually not scarce. The air you breathe in your bedroom, the library, or a classroom is free in the economic sense because the amount of air available is greater than the amount that people want to breathe. Suppose, however, that you were locked in a small, sealed container. The air (oxygen) in the container would be quickly reduced as you breathed it, and a shortage would develop. The air would now be scarce, and you would be willing to pay to get more of it. It is interesting to note that while air is not scarce in polluted cities like Beijing and Tokyo, clean air is scarce, and people are willing to pay street vendors for a few breaths of clean oxygen.

Choices must be made when a resource is scarce because there is not enough of the resource available to meet all desired uses. For example, the amount of time a person has is limited to 24 hours each day. Between 8 a.m. and noon, you have four hours of time (“labor time”) that you must allocate among several possible activities. Because your labor-time resource is limited to four hours during that period, and there are likely more than four hours of activities that you would do “if you had time” (attend class, study, work, play basketball, play video games, eat, sleep, etc.), your labor resource is scarce, and you must decide how to allocate that scarce resource among all of the activities you would like to do. In this example, suppose that you decide to attend classes between 8 a.m. and noon rather than work a part-time job for $10 per hour. In making that choice, you weighed the value to you of attending classes against the value to you of working. In deciding to attend class, you had to give up the opportunity to work. The cost to you of attending classes instead of working is called by economists your opportunity cost of attending classes. The opportunity cost of using a resource in one way is the value of the best alternative use of the resource. In our example, the opportunity cost to you of using your labor time to attend class between 8 a.m. and noon is $40, the amount of income you gave up by not working. Opportunity cost doesn’t have to be measured in monetary terms. What if the best alternative use of your resource had been playing basketball between 8 a.m. and noon? If you made a rational choice to attend classes, the value to you of playing basketball, measured in enjoyment and better health, must have been less than the value to you of attending classes, measured in educational attainment and higher lifetime income because of increased human capital.

Goods and Services

All of the things that you consume to maintain or improve your life can be classified as goods or services. A good is a tangible thing (you can touch it), such as a smartphone, a hamburger, or a hoverboard. Since these goods are scarce, you are willing to pay for them in the market. A few goods, like air, are free. A service is intangible (you can’t touch it), such as a haircut, a rock concert, or a medical checkup. In addition to goods and services, there are also “bads” that you are sometimes forced to consume, such as air pollution. If you understand that air pollution makes you worse off because of its effects on your health and life expectancy, you should be willing to pay to consume less of it. Economists are primarily interested in studying scarce (also called economic) goods and services, but they are also called upon to identify the best ways for society to deal with bads, like pollution.

Wants and Needs

Goods and services are produced in order to help meet the wants and needs of those who consume them. Economists would rather not use the word needs because there is wide disagreement in society about what people need. If economists are asked to define needs, they will most likely use a survival definition: a person needs something only if that person would die without it. By this definition, economic needs include sufficient food, water, shelter, and clothing. Everything else is simply a want. Goods and services are produced to help meet wants and needs because not enough goods and services can be produced with society’s scarce resources to satisfy everyone’s wants. While specific individual wants can be met in a given period of time, general wants seem unlimited and cannot be satisfied in a world of finite, scarce resources. Society’s resources are sufficient to produce enough ice cream to satisfy your ice cream want for today, but no matter how many wants you manage to satisfy today, you can probably imagine being better off if you could obtain more of something else you want.

Microeconomics and Macroeconomics

The Scottish moral philosopher Adam Smith is generally recognized as the father of economics. In The Wealth of Nations (1776), Smith analyzed the market system and described how prices are set for individual products and resources, including labor, land, and capital. He also identified the signaling role of prices that causes self-interested buyers, sellers, and resource owners to make decisions that create general economic benefit for society and lead to the efficient use of society’s scarce resources. Smith’s idea that self-interested decisions are coordinated by the market system to the benefit of society is called the invisible hand theory. Smith used the “invisible hand” as a metaphor for the coordinating role of the market price mechanism: the self-interested individual is “led by an invisible hand to promote an end [the public interest] which was no part of his intention. . . . By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”1 Efficiency refers to the most effective use of society’s resources in helping meet people’s wants and needs, and it is at the heart of economists’ evaluation of markets and economic policy. Smith’s analysis was primarily in the realm of microeconomics. Microeconomics is the branch of economics concerned with economic decision-making by individual firms, households, and resource owners. The behavior of individual markets and of the buyers and sellers in those markets is the primary focus of microeconomics, and Adam Smith’s analysis of how the market system works, called the theory of markets, is at the core of microeconomics.

Although Adam Smith was mainly interested in market behavior, or microeconomics, his analysis also has implications for macroeconomics. Macroeconomics, the other major branch of economics and the subject of this textbook, is concerned with the overall performance of the economy and its major sectors. Topics such as the determination of national output and income, inflation, unemployment, and economic growth are part of the subject matter of macroeconomics. Adam Smith was interested in why some nations were rich (high per capita income) and others were poor (low per capita income). In fact, the complete title of Smith’s 1776 book is An Inquiry into the Nature and Causes of the Wealth of Nations. Smith’s conclusion that rich nations have highly productive labor and poor nations have less productive labor is as true today as it was when Smith published his book.

Macroeconomics as a separate branch of economics did not exist until 1936, when John Maynard Keynes published his book General Theory of Employment, Interest, and Money. The 1930s were marked by the Great Depression, a period of seriously reduced economic activity in almost all countries, with the United States and Great Britain hit particularly hard. The output of goods and services in the U.S. fell by one-third, and more than one-fourth of labor, one-third of agricultural land, and one-half of capital were unemployed. International trade also fell by more than one-third. The purpose of Keynes’ book was to explain the causes of the Great Depression and of general business cycles characterized by alternating periods of high inflation and high unemployment. Initially called Keynesian Theory, modern macroeconomics examines a wide range of issues, such as the causes of national and international financial crises, how central banks manage money supply and interest rates to help stabilize economies, the effects of government taxation and spending on overall output and employment, and the impact of government policies on economic growth. In addition, modern macroeconomics helps bridge the gap between macroeconomics and microeconomics by using microeconomic theory—particularly the theory of household decision-making—to develop better foundations for macroeconomic models of consumption, saving, and investment.

While this is a macroeconomics textbook, it includes the basic microeconomic tools of supply and demand and the concepts of efficiency and exchange, which underlie all economic analysis. Before you can properly learn macroeconomic principles, you need to master those tools and concepts. The following two chapters, “Allocative Efficiency and the Benefits of Exchange” and “Markets, Supply, and Demand,” are designed to help you achieve that mastery.