Overview of Economics: A Firm Base

A Firm Base

Let's look at a few basic concepts that underlie the entire discipline of economics.

First, economics assumes that people make rational choices in the face of scarcity. It assumes that people can and will rationally decide what they want and what they are willing to do without. In some cases, this may seem odd. Are economists saying that people deliberately choose jobs with low pay? Are they saying that people choose poorly made products over high quality ones?

Well, in a way, yes, they are saying that. While individuals may face a limited range of choices or make bad choices, they do make choices. Economics aims to explain and predict people's choices and the ways in which various conditions affect their choices. Of necessity, economists must assume that people are making rational rather than irrational economic decisions.

Second, economics assumes that people have preferences that underlie their economic decisions. This concept resembles the idea of rational choice, but it focuses more on people's likes and dislikes and the trade-offs they are willing to make among these likes and dislikes. The assumption is that people know what they prefer and make choices that reflect these preferences.

Third, people's choices and preferences—their decisions—take the form of transactions in the marketplace. In these transactions they buy and sell labor, products, and services in exchange for money. Furthermore, these transactions collectively amount to economic activity. For example, someone who decides to work at a certain job in a certain place for a certain salary has engaged in a transaction. When we sum up all of the transactions that people in an economy have made regarding where they will work and for how much, the result is employment activity. That activity can be quantified, described, and studied.

Fourth, economic activity occurs in markets. A market is a place where goods and services and the factors of production—raw materials, labor, and plant and equipment—are bought and sold. Although most of us think of a market as a physical place, economists define markets more broadly. The market for financial securities, for example, is located not only on Wall Street but also in cyberspace where online brokerage services enable people to buy and sell securities. Economics delves deeply into markets—how they function and how people function within them.

Finally, some mechanism is required for a market to function properly. The mechanism used in most markets is the price mechanism, and prices are expressed in money. (Bet you were wondering when we would get around talking about money.) In all modern economies, money is recognized as the medium of exchange. A medium of exchange is something people within an economy have agreed to use as a standard of value. Certain Native American tribes reportedly used wampum, the purple parts of clamshells, as money. Other forms of money have included gold, furs, and huge round stones—all of which make about as much sense as using pieces of paper displaying pictures of deceased leaders. Essentially, money is anything that people agree to use as a medium of exchange on a large scale.

These concepts—people making rational choices and expressing preferences in marketplace transactions valued in money—are indeed basic. They form the basis of all that follows in economics. Keep these concepts in mind as we examine matters like the law of supply and demand in Supply, Demand, and the Invisible Hand.