Back to Basics - Economics simplified

The art (or science, as some would like to call it) of balancing our infinite needs with resources that are finite in nature is called Economics.

Concisely, it deals with means and ways to optimally distribute the available resources to benefit all. In simple words, economics deals with the production, distribution & consumption of goods & services as well as the commercial activities of a society or nation as a whole. While economics seems to be a mystery for a vast number of laymen, with a maze of confusing jargon, it isn’t. Instead, all of us, in some form or the other, are affected by it in our daily lives. It remains the domain of a chosen few. If concepts are properly understood, it can actually be fun.

Economics simply means analyzing the behaviour of individuals and firms, as well as social and political institutions, to see how well they convert humanity’s limited resources into goods & services that best satisfy human wants and desires. In doing so, economists try to understand the intricate relationship between maximizing human happiness and the phenomenon known as diminishing returns, which describes the unfortunate but true aspect that each additional amount of a resource that is put into a production process, brings forth successively smaller amounts of output.

Scarcity –the root of all problems

Scarcity lies at the heart of all problems and economics involves a study of the choices that we make by considering our constraints. When needs are fulfilled, they are replaced by wants. Our desires are unlimited while there aren’t enough resources to give everyone what they want.

Is money, the root of all evils? 

In ordinary conversation, we use the term money to describe income or wealth. Money (or money supply) refers to anything that is generally accepted as payment for goods or services i.e. money is a medium of exchange.

Tradeoff

You must have come across the phrase, ‘there is no such thing as a free lunch’. To get one thing that we want, we usually have to give up another thing that we like. Making decisions require trading off one goal against the other.

Opportunity costs

The opportunity cost of a decision is what you had to give up buying the thing you wanted. Suppose, you wish to buy a new cell phone but you also want to buy a laptop, however, you may not have money to purchase both. Similarly, if you choose to attend a program that will gain you a higher qualification, then the dream vacation that you had planned is the cost of this decision; something has to be sacrificed, one has to pay for everything, not necessarily in monetary terms. 

You can’t have everything you want as life has plenty of constraints - time, resource, and technology and it is these limitations that force us to choose from among our many happy options. For example, oil can be used to manufacture pharmaceuticals that can save many lives. However, it can also be used to make diesel, which is used to drive ambulances that save lives. Both pharmaceuticals and diesel are good uses of oil so, society has to come up with some way of deciding how much oil needs to be supplied for each of these two good uses, knowing all the while that each litre of oil, if it goes to one, cannot be used by the other.

Economics is mainly classified into two categories  

• Macroeconomics is the branch of economics that studies the behaviour and performance of an economy as a whole. It focusses on the aggregate changes in the economy such as employment, growth rate, gross domestic product, and inflation.

• Microeconomics is the branch of economics that studies the behaviour of individuals, households, and firms in decision making and allocation of resources. It generally applies to markets of goods & services and deals with individual and economic issues.

Many of the factors that play a role in economics have a direct implication on the financial markets, such as:

• First and foremost, it’s important to understand how prices are set in a market economy. Supply and demand also determine the prices in addition to the competition.
• Additionally, factors like inflation need to be understood and their impact factored in.
• Interest rates determine how much people/firms borrow and how they utilise the borrowings to spur further economic activities.
• Foreign exchange rates which essentially compare the value of one currency with respect to another also cause fluctuations in the markets.
• The health of a nation is gauged by concepts like the gross domestic product (GDP), which refers to the value of all goods & services produced in the country.
• Finally, government rules, tax regulations, and fiscal & monetary policies determine which way the markets will trend.

Laws of supply & demand

The economic theory that explains the interaction between the sellers and the buyers of a resource is the law of supply and demand, which explains the effect such a relationship between the availability of a particular product and the desire or demand for this product, will have on its price.

Supply and demand illustrate the working of a market as well as the interaction between the suppliers and the consumers. Supply and demand curves determine the price and quantity of goods and services. Any changes in supply and demand will have an effect on the equilibrium price and the quantity of the good sold. It will also affect the incentives for producers and consumers.

Supply is the amount of the good that is being sold in the market by producers. At higher prices, it is more profitable for firms to increase supply. So, the supply curve slopes upward.

Demand is the quantity of a good that consumers wish to buy at different prices. At higher prices, less will be demanded. As prices fall, more will be demanded.

The most significant feature of supply and demand is their role in determining the price of a good/service.

If we start off with the price of P2, there will be a demand for Q2, but the supply of only Q1. In other words, there will be a shortage and a possible group of people trying to buy a limited quantity. In this case, there is an incentive for firms to raise the price. As the price increase, firms would have a reason to supply more. The higher price will also limit demand and the demand will decrease. The price will rise until supply equals demand at price (P1) and the quantity of Q3. With a shortage, firms put up the prices and supply more (indicated by movement along the S curve).