Economic Principles

Principles of microeconomics

The principles of microeconomics focus on small-level decisions and interactions. That means that we will focus on individuals and their outcomes rather than a population of people. Microeconomics also covers individual firms rather than all firms in the economy.

By narrowing the scope in which we analyze the world, we can better understand minute changes and variables that lead us to certain outcomes. All living creatures naturally practice microeconomics without even realizing it!

We'll cover the following foundational economic concepts:

• Scarcity

• Resource Allocation

• Economic Systems

• Production Possibilities curve

• Comparative Advantage and trade

• Cost-benefit analysis

• Marginal analysis and consumer choice

The economic principle of scarcity

The economic principle of scarcity refers to the difference between people's unlimited wants and finite resources to satisfy them. Have you ever wondered why individuals in a society have wildly different means and standards of living? This is a result of what is known as scarcity. So, all individuals experience some form of scarcity and will naturally attempt to maximize their outcomes. Every action comes at a trade-off, whether it's time, money, or a different action we could have done instead.

What are some of the key factors that lead to scarcity? Let's take a look at Figure 1 below:

Fig. 1 - Causes of scarcity

To varying degrees, these factors combined affect our ability to consume everything we wish to.

They are:

• Unequal Distribution of Resources
• Rapid Decreases in Supply
• Rapid Increases in Demand
• Perception of Scarcity

Now that we've established what scarcity is and how we must shape our decisions in response to it, let's discuss how individuals and firms allocate their resources to maximize their outcomes.

Principles of resource allocation in economics

To understand the principles of resource allocation in economics, let's first describe an economic system. Groups of individuals living together naturally form an economic system in which they establish an agreed-upon way of organizing and distributing resources. Economies typically have a mix of private and communal production, which can vary how much of each takes place. Communal production can provide a more equitable distribution of resources, whereas private production is more likely to maximize efficiency.

How resources are allocated between competing uses depends on the type of economic system.

There are three main types of economic systems: command economy, free-market economy, and mixed economy.

• Command Economy - Industries are publicly owned and operations are decided by a central authority.

• Free-market Economy - Individuals have control over operations with little government influence.

• Mixed Economy - A wide spectrum that combines free-market and command economy to varying degrees.

Regardless of the type of economic system, three basic economic questions need to always be answered:

1. Which goods and services should be produced?

2. What methods will be used to produce those goods and services?

3. Who will consume the goods and services that are produced?

Other elements can be included in decision-making, such as natural resource advantages or trade proximities. Using these questions as a framework, economies can design a clear path to establishing successful markets.

Next, we will cover how individuals and firms optimize their choices by analyzing different possible outcomes.

Marginal analysis and consumer choice

At the core of every economic analysis is the structure of viewing decisions and outcomes at the margin. By analyzing the effect of adding or taking away a single unit, economists can better isolate and study individual market interactions.

To optimally use marginal analysis, we choose to make decisions whose benefits outweigh the costs and continue making those decisions up until the marginal benefit is equal to the marginal cost. Firms seeking to maximize their profits will produce a quantity where marginal cost equals marginal revenue.

All consumers face constraints of time and money and seek to receive the largest benefit for the lowest cost. This occurs every time a consumer goes to a store. Naturally, we seek the product that provides the greatest benefit at the lowest cost.

Economists count on this, as to make models, they must assume that market actors will maximize their total utility. It is one of the core assumptions that economists make when modeling behavior. Therefore, for the most part, it is assumed that market actors will always try to maximize their total utility.

Now that we have established how economies allocate their resources in different systems we will analyze how they maximize their production and determine how much to produce.

Economic Principles and the Production Possibilities Curve

One of the most useful economic models for efficient production is the production possibilities curve. This model allows economists to compare the trade-off of producing two different goods and how much can be produced by dividing resources between them.

Consider the graph and adjoining example below:

Candy Island has 100 production hours and is trying to determine how to allocate its hours to its two industries - Chocolate and Twizzlers.

Fig. 2 - Production possibilities curve example

In the graph above we see the production output possibilities of Candy Island. Depending on how they distribute their production hours, they can produce X amount of Twizzlers and Y amount of chocolate.

An effective method to interpret this data is to look at increases in one good and how much you must give up of the other good.

Say Candy Island wanted to increase chocolate production from 300 (point B) to 600 (point C). To increase chocolate production by 300, Twizzler production will decrease from 600 (point B) to 200 (point C).

The opportunity cost of increasing chocolate production by 300 is 400 Twizzlers foregone - a 1.33 unit trade-off. This means that at this exchange, to produce 1 chocolate, Candy Island needs to give up 1.33 Twizzlers.

What other information can economists analyze from the PPC?

What does it mean if production occurs to the left or inside the PPC? This would be an under-utilization of resources, as there would be available resources that were left unallocated. In that same mindset, production can't occur past the curve, as it would require more resources to be available than the economy can currently sustain.

Principle of comparative advantage in economics

When countries are establishing their economies, it is paramount to identify their comparative advantages. Comparative advantage occurs when one economy has a lower opportunity cost of production for a specific good than another. This is demonstrated by comparing two economies' productive capacity and efficiency in producing two different goods.

Check out this example below for how comparative advantages can occur.

The ability to trade changes economic options greatly, and it works hand in hand with comparative advantage. Countries will trade for a good if they have higher opportunity costs for production than another; this trade facilitates efficient use of the comparative advantage.

Therefore, assuming free trade, Candy Island would be better off producing Twizzlers and trading exclusively for Chocolate, as Isla de Candy has a lower opportunity cost for this good. By engaging in trade, both islands will be able to specialize, which will result in both of them receiving a higher quantity of both goods than would be possible without trade.

To make effective economic decisions, it's important to have a complete analysis of the costs and benefits of any action. This will be covered in the subsequent section.

Economic Principles and Cost-Benefit Analysis

For an economic analysis of decision making a particular set of assumptions must hold. One assumption is that economic actors will consider opportunity costs and then determine the total economic cost of an outcome.

This is done through a cost-benefit analysis, where all the possible costs are weighed against the benefits. To do this properly, you must measure the opportunity cost and include that in the cost-benefit analysis. The opportunity cost is the utility or value that would have been provided by the next best option.

This example may seem a bit overwhelming, but we often analyze decisions and try to make the best one by assigning them some value, which economists call 'utility'. Utility can be described as the value, effectiveness, function, joy, or satisfaction we receive from consuming something.

In the example above, we would compare the two best options to spend $5 on and decide on the utility they provide. While the wild opportunity costs in the example may seem overwhelming, we know that many of them are highly unlikely. If we quantify the utility with a likelihood of occurrence, we'll have a balanced utilitarian view. The equivalent of this for firms and producers is how they make decisions to maximize total revenue.

Principles of economics examples

Shall we present some principles of economics examples? Kindly consider the example below for the concept of scarcity.

The above scenario describes the scarcity of bedrooms for the family. How about we build on it to provide an example of resource allocation?

Here, the resources have been allocated in the best way possible for each kid to get an equal share of a room.

All the basic economic concepts laid out in this explanation form a structure of economic thinking and analysis for individuals and firms to maximize their benefits while minimizing costs.