Understanding Economics
Economics is a broad field, and an introductory business course can only provide a foundation. Later courses in microeconomics and macroeconomics examine these topics in much greater depth. For business students, however, the basic concepts in this chapter are important because every organization operates within an economic environment.
What Is Economics?
Economics studies how resources are employed in a society to produce goods and services used by members of that society. At the heart of economics is a basic problem: people and societies have wants that exceed the resources available to satisfy them.
This condition is called scarcity. A useful way to remember it is:
Unlimited wants + limited resources = scarcity.
Because resources are limited, individuals, businesses, and governments must make choices about how those resources will be used. Resource development focuses on increasing the resources available to meet wants—for example, by developing new energy sources or improving farming techniques.
Macroeconomics and Microeconomics
Economics is commonly divided into two major branches:
- Macroeconomics focuses on an economy as a whole. Examples include national GDP, unemployment, inflation, taxation, government spending, and fiscal policy.
- Microeconomics focuses on the behavior of individuals and organizations in particular markets. Examples include the supply of gasoline, the price of a product, and how consumers respond when that price changes.
A simple memory aid is: macro = the big picture; micro = individual markets and decisions.
Scarcity Creates Choices and Opportunity Costs
Scarcity means choices must be made. When one alternative is selected, another alternative is usually given up. The opportunity cost is the value of the choice that was not selected.
For example, if you can either work for several hours or use that time for recreation, choosing recreation means giving up the income you could have earned. Businesses face similar choices when deciding how to use money, employees, equipment, and other limited resources.
Adam Smith and Capitalism
Adam Smith is closely associated with the development of economic thought and the explanation of capitalism. In capitalism, the means of production and sales are primarily owned by individuals rather than government and are operated to earn a profit.
The Chapter 2 material emphasizes four basic rights associated with capitalism:
- The right to own private property.
- The right to own a business and retain or reinvest its profits.
- Freedom of competition.
- Freedom of choice.
The notes also identify state capitalism, in which government rather than individuals owns and operates some businesses.
Free Markets
In a free market, market forces help determine what is produced, how much is produced, and the prices at which goods and services are exchanged. Producers consider expected prices when deciding how much to produce, while consumers make choices based partly on price and available alternatives.
A farmer, for example, may decide what crop to produce based on expected market prices. Consumers may switch to substitute products if the price of a preferred product becomes too high.
Understanding Supply
Supply is the amount of a product businesses are willing to sell at varying prices. In the basic supply relationship, producers are generally willing to supply more when the market price is higher.
A grain producer may store grain while waiting for a more attractive price. As the price rises, the producer may become willing to release more of that grain for sale. This illustrates the general relationship between price and quantity supplied.
Understanding Demand
Demand is the amount of a product consumers are willing to buy at varying prices. The basic demand relationship moves in the opposite direction from supply: as prices rise, consumers generally become willing to purchase less.
Gasoline provides an easy example. If gasoline becomes substantially more expensive, consumers may reduce driving, combine trips, or choose more fuel-efficient vehicles. If gasoline becomes much less expensive, consumers may be less concerned about fuel consumption.
Equilibrium: Where Supply and Demand Meet
The equilibrium price, sometimes called the market price, occurs where the quantity producers are willing to supply and the quantity consumers are willing to demand meet.
This intersection is important because it represents a price at which the plans of buyers and sellers are in balance. Changes in supply or demand can move the equilibrium and therefore change the market price.
Degrees of Competition
Markets differ in the number of competitors and in how similar their products are. The Chapter 2 notes identify four degrees of competition:
- Perfect competition — many businesses sell essentially the same product. Agricultural commodities are an example.
- Monopolistic competition — businesses sell similar but differentiated products. Soft drinks are an example.
- Oligopoly — very few businesses sell similar products, consumer choices are limited, and barriers can make it difficult for new competitors to enter. Air travel is given as an example.
- Monopoly — a single entity provides the product or service. Utility providers are a common example of regulated or natural monopolies.
Comparing Economic Systems
Economic systems differ in how much decision-making is left to individuals and markets and how much is performed by government.
- Free-market economy — the market determines what goods and services are produced, who receives them, and how the economy grows.
- Command economy — government determines what goods and services are produced, who receives them, and how the economy grows.
- Mixed economy — some resource allocation is determined by markets and some by government.
Most modern economies contain a mixture of market activity and government involvement rather than fitting perfectly into a single category.
Socialism and Communism
Socialism is presented in the chapter as an economic system involving greater government ownership or control of some important businesses and greater redistribution of wealth. Smaller businesses may still be operated by entrepreneurs, while government may play a larger role in areas such as utilities and social services.
The study notes identify possible benefits associated with socialist systems, such as greater social equality and extensive public benefits, and possible disadvantages such as fewer incentives for entrepreneurs to accept risk and the possibility of highly educated workers leaving for other countries.
Communism is an economic and political system in which government makes most economic decisions and owns most factors of production.
Measuring an Economy: Gross Domestic Product
Gross domestic product (GDP) is the total value of final goods and services produced within a country during a given year. GDP is one of the major measures used to describe the size and performance of an economy.
Unemployment
The unemployment rate measures the percentage of the civilian labor force that is unemployed and has actively tried to find work within the recent period specified by the measure.
The Chapter 2 notes identify four types of unemployment:
- Frictional
- Structural
- Cyclical
- Seasonal
These categories help economists distinguish among different reasons people may be without work.
Inflation, Disinflation, Deflation, and Stagflation
- Inflation — an increase in the general price of goods and services over time.
- Disinflation — price increases continue, but the rate of inflation is slowing.
- Deflation — prices for goods and services decline.
- Stagflation — the economy is slowing while prices continue to increase.
Two important price measures are the Consumer Price Index (CPI), which measures price changes at the consumer level, and the Producer Price Index (PPI), which measures price changes at the producer level.
Business Cycles
Business cycles are periodic rises and falls in economic activity over time. The study notes identify four long-term phases:
- Economic boom — a period of strong economic activity.
- Recession — a period of economic decline; the study notes describe it as two or more consecutive quarters of decline in GDP.
- Depression — a severe recession.
- Recovery — the economy stabilizes and begins to grow again, potentially leading toward another economic boom.
Putting It Together
Economics helps explain how people, businesses, and governments make choices when resources are limited. Businesses must understand the markets in which they compete, how prices influence supply and demand, what type of economic system surrounds them, and how broader economic conditions affect customers and operations.
For an introductory business student, these ideas provide a foundation for later topics such as global business, management, marketing, finance, production, and entrepreneurship.
Common Mistakes to Avoid
- Confusing macroeconomics with microeconomics.
- Thinking scarcity means a resource does not exist at all. Scarcity means wants exceed available resources.
- Forgetting that opportunity cost is the value of the alternative given up.
- Reversing the basic supply and demand relationships: higher prices generally encourage more supply but less demand.
- Confusing a monopoly with an oligopoly.
- Assuming modern economies are purely free-market or purely command economies.
- Confusing disinflation with deflation. Disinflation means inflation is slowing; deflation means prices are declining.