Lesson Overview: Economics is the basis of business and thus the basis of personal finance. This section is designed to give you a primer on economics so that you can begin to participate in economic decision making, learning how and why people make a decision and weighing the costs and benefits of a decision. Special thanks to Timmy Leong and Benjamin Anderson-Krim of Newton South FBLA (MA) for their help with this section.
Section 1.1 – The Fundamental Problem
Economics is based upon a simple principle, that there are unlimited wants, but limited resources in the world. Humans cannot produce everything that we want in the quantity that we want it. This creates something called scarcity. When our wants and needs outweigh our resources, we have scarcity. Economics is the study of how people satisfy their wants and needs in a society with scarcity.
Section 1.2 – Decision Making
Because we can’t have all that we want and need, we need to make decisions about what we do, purchase, and use. Everything has both a cost and a benefit. A cost is what one gives for something, while a benefit is what one receives for something. A cost can be something tangible, like money, or something intangible, like time. For example, going out for pizza for dinner costs $10 and 45 minutes.
What you could have done in those 45 minutes is called opportunity cost. An opportunity cost is the next best option that was lost when the decision was made. In the pizza scenario, the opportunity cost is the money you could have saved by eating at home, or spending some of that 45 minutes doing work, spending time with family etc.
When making a decision, one must weigh the cost, benefit, and opportunity cost. They also must consider the trade-offs. A trade-off is an alternative to a decision. For example, the trade-off in our dinner scenario would be eating at home or going out to eat.
It’s easy to confuse opportunity costs and trade-offs, but they’re two distinctly different things. An easy way to remember the difference is to note that trade-offs cause opportunity costs. An opportunity cost is the cost of your decision between trade-offs.
Let’s see an example of this through the decision making case study.
When making a decision, people often don’t just consider the benefits and costs of a decision. Instead, we tend to respond to incentives. Incentives can be positive, such as having a higher salary or more respect from your boss, or negative, such as a threat of punishment, but they motivate us to complete a task.
Do you get an allowance at home? If you do, say your parents were to take it away. Would you be less willing to do your chores? If you don’t get an allowance, would getting one make chores more appealing? This is a prime example of how we respond to incentives.
Section 1.3 – Voluntary Exchange
Voluntary exchange is the idea that two people exchange goods/services or a stand in (money) because the item they are exchanging for is worth more to them than the item they are giving up.
An example of a voluntary exchange would be: You give up $5 for a hamburger because the enjoyment you will get from the hamburger is worth more to you than your five dollars, while the hamburger maker values the money you gave them more than the hamburger. In this transaction, both the buyer and seller benefit.
This is the basis of a market economy, and the entire economy is made up of thousands of markets that are each just millions of these simple exchanges combined together.
Section 1.4 – Economic Statements
Economists make two types of statements: positive and normative. Positive statements refer to how the economy is doing from an objective view. Normative statements, on the other hand, refer to how the speaker believes the economy should be doing. Think of positive statements as fact, and normative statements as opinion.
These statements can, and do, affect decision making. Positive statements are objective, meaning that they have no bias, but they also lack to tell the whole story. Normative statements on the other hand, can be biased, but tell a greater story. Both of these statements should be considered when making a decision.
For example, “Jimmy got a C on his last math test” is a positive statement. This forces the reader to determine if this is a good or bad grade. “Jimmy is showing great improvement” in math class is a normative statement. This allows the reader to determine where Jimmy once was. By using both statements, the reader now knows that Jimmy was previously far below the C range, but still has significant room for improvement in math class, thus giving a full picture. That said, there can be biased and contradicting normative statements. Another normative statement in regards to Jimmy could be “Jimmy struggles in math class.” All normative statements and their source must be considered before making a decision.
Economic Statements Case Study: This case will allow you to analyze economic statements and make a decision upon them using a real-world example.
Section 1.5 – Supply and Demand
Earlier we learned that people have unlimited wants, but the world has limited sources. In essence, there is unlimited demand and limited supply. In economics, demand is used to describe one’s desire and willingness to pay a price for a certain good or service, while supply is the total amount of a specific good or service that is available to consumers.
There is something called elasticity which describes how flexible one’s desire to obtain a good is. If demand for a good is elastic it means that as the price changes, so does demand. With an inelastic product, price does not change demand. A bottle of soda is an elastic good, while gas for your car or home is an inelastic good. Usually the more dependent one is on a good, the more inelastic that good is.
Supply and demand also play a key role in determining prices themselves. How great demand or supply is affects how much a good or service is sold for. The graphic below shows how price usually changes as a result of varying demand and supply.
Conclusion: When making a decision, it is important to weigh all of the factors. While the incentive may be alluring, there could be a hidden cost or trade-off that should be examined. By using economic decision making in your daily life, you’ll make smarter financial decisions in the short and long-term.
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