Economics is the study of scarcity. It's how people interact with value.
Economics gives you tools to understand how people produce, distribute, and consume goods and services.
By applying economic theory, you can make well-reasoned business decisions. You can better understand competitive forces.
You can also understand concepts like the “diamond-water paradox,” which economist Adam Smith pondered but was ultimately unable to solve.
In this paradox, Smith struggled to explain why in this life – which cannot exist without water but can easily exist without diamonds – diamonds are far more valuable than water.
There are entire books written about the study of economics. There's no way I can outline the entire field of study in this one article. But here I will outline the core of this field of study.
Microeconomics vs Macroeconomics
At the highest level – and even this is perhaps a slight oversimplification – there are two branches to the study of economics:
- Microeconomics: A firm or individual view of how companies and people make decisions.
- Macroeconomics: How entire economies (countries) interact and trade, how nations' economies are structured, and the decision-making of economies writ large.
Within each of these branches there are multiple sub-segments:
- Understand consumer behavior
- How firms make decisions
- Examine market structures (monopoly, oligopoly, competition)
- Use supply and demand to analyze impact of changes in supply or demand on price and quantity
- How people and firms act to reduce costs and maximize profits
- Understand the behavior or individuals or firms when facing uncertainty.
- Economics and global interactions
- Business cycles at a country level: unemployment, inflation, aggregate supply and aggregate demand
- How domestic output is measured
- Monetary markets
- Monetary policy
- Fiscal policy.
First Principles: Economic Concepts, Definitions, and Examples
When studying either microeconomics or macroeconomics, a few concepts remain the same, which for the sake of this article I will call First Principles.
At a high level here are the economic concepts that apply to economics (and the study of this field) and that you must be aware of.
- The Law of Demand: The law of demand states that the quantity purchased varies inversely with price. In other words, the higher the price, the lower the quantity demanded.
- The Law of Supply: The law of supply states that as the price of an item goes up, suppliers will attempt to maximize their profits by increasing the quantity offered for sale.
- Scarcity: A good is scarce if it is impossible to consume more of the good without having to give something else up. Back to the diamond-water paradox: diamonds are scarce, and therefore expensive.
- Opportunity Cost: When a decision is made about how to allocate a scarce good, an opportunity cost is incurred. The opportunity cost of an allocation is the next best allocation that is no longer possible (because the scarce good has been used up). The standard terminology is that the opportunity cost of a good is the “value of the next best foregone alternative.” When estimating the opportunity cost, you should consider all costs and benefits that vary as a consequence of a decision, and only those costs and benefits that vary with the decision. Typical examples of costs are overhead, depreciation, research and development.
- The Cost-Benefit Principle: this principle simply says that an action should be taken if the additional benefits are greater than the additional costs.
- Marginal Cost: Is the additional cost to produce one additional unit of a good. Typically, as output increases, marginal cost increases.
- Producer Surplus for a Single Unit of Output: The difference between the price a firm receives from producing and selling a unit of output and the marginal cost of producing that particular unit.
I want to use a simple set of examples to demonstrate these core economic principles in practice.
Imagine you own a store that helps people buy engagement rings. You have a website and a physical retail space, equipment to make and fix jewelry, and a small team of dedicated employees.
The law of demand states that as the price of your rings goes up, people will buy fewer of them.
The law of supply states that as the price of rings goes up, you will try to increase the number you can sell.
Where this supply and demand meet, an equilibrium is obtained.
Scarcity states that as the material of the rings is harder to come by (for example gold, diamonds, and so on) the prices of these inputs will increase.
Opportunity cost states that when using gold to make a ring, you are not using this gold to make some other product - like earrings or a watch. You are making an explicit decision to use the raw material to make one final product: a ring. Because you can’t use that same gold to also make another item, this represents an opportunity cost.
The cost-benefit principle states that you should take an action if the added benefits are greater than the added costs. For example, let’s say that you want to sell one more ring but doing so requires you to keep your store open for another 30 minutes. What should you do? If the economic benefits of remaining open outweigh the costs of keeping the store open, that action should be taken.
Marginal cost is how much it costs to produce another unit of a good. Imagine that getting the property and equipment to make a ring is really expensive: you need space, a furnace, and trained technicians. These costs are all fixed: you need to buy these to start your operation.
But once you start making a single ring, how much does it take you to make a second? Or a third? This cost is your marginal cost.
In general, some businesses have high variable costs and others have very low variable costs.
Imagine an airline.
Every time an airline flies a plane they are paying for the use of the airplane, fuel, a flight crew, landing taxes, parking fees, and so on. Their variable costs are seemingly very large.
It is hard to start an airline because the fixed costs and the variable costs are high. Before flying your first flight you will need shell out a large sum of money.
Compare that with Google: it took a lot of money to set up data centers and hire really smart people to build Google Search. But each incremental search query costs Google very little (fractions of pennies). In short, Google’s core search business has low variable costs that are driven even lower by distribution and scale.
Software is a field that usually has a low to moderately low variable cost structure. That is because once the software is built and deployed, it can be run at scale relatively cheaply. Here are some additional examples you can think through:
- QR Code Generator: takes a lot of work to build but can essentially run without heavy lifting once it’s live. When you have a product that doesn’t take too much specialized inputs to build - and has low costs to run, what do you think happens? The answer: you have lots of entrance into the space competing for users.
- Shopify: an e-commerce platform for online stores and retail point-of-sale systems. Again: many years of work to start and build but each additional merchant that uses the platform costs very little. Many merchants on Shopify run off network websites for monetization. Why? Because websites are the ultimate articulation of a low fixed cost, very low variable cost business. Each user (or piece of traffic) doesn’t cost the owner more money. The same cost structure applies to Business-2-Business marketplaces as well. This contracts decisively with the manufacturer of airplanes or rings or cars which have underlying costs each and every single time they are consumed.
- Many software companies are trying to create their own software delivery platforms in-house, which can take a lot of time, and usually it is hard to forecast the many different fixed and variable costs that are associated with this development. Even further, once this software is built, it takes a lot of engineers to manage the platforms, perform QA/QC work, and continuously perform upgrades. Given this cost structure, what do many firms do? They turn to 3rd parties to perform this work because their internal people are a scarce resource.
- A final example is software development: much like the tools you learn on freeCodeCamp, software development is all about the “start”. This represents the fixed costs to get going: a computer, an IDE, and access to programming languages. But once you build an app or website, your incremental costs remain low.
At its core, economics is the branch of knowledge concerned with the production, consumption, and transfer of wealth. If you want to understand why people, firms, and countries behave the way they do – and how they interact with and manage scarce resources – economics is an incredibly useful guide.
By understanding supply, demand, scarcity, opportunity costs, the cost-benefit principle, marginal cost, and produce surplus you are well on your way to scratching the surface of this important field.