The five fundamental principles of economics, basic terms we need to know in order to move on. -, Learning Economics... Solved!


The five fundamental principles of economics, basic terms we need to know in order to move on.

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This post was updated in August 2018 to include new information and examples.

There are five fundamental principles of economics that every introductory economics begins with at the start of the semester: rationality, costs, benefits, incentives, and marginal analysis.

Below is a list of these five concepts with a brief intuitive discussion and examples.

1. People make rational choices:

If you drove to work/school today, I bet you would disagree with this one (because of all of the irrational drivers out there).  However, it is an assumption that economists make to let the models work. Remember that to economists, rationality means that people act in their own best interest with the information that they have available to them. It doesn't mean they make the best long term decisions, it just means they make the best decisions according to their own desire for happiness (with the information that they have).

 In general, most people are rational. For example people eat food, go to work, play nice with others, etc. If people behaved irrationally, then there would be no chance in the world to predict their behavior.  By assuming that people are rational, and make decisions based on what is best for them, we can break down the decision making process.  This allows us to study the factors that influence decision making.

2. Costs and opportunity costs: 
The most common use of the word cost is a monetary cost. Generally we are concerned with the trade offs that are associated with decisions we make. We have to pay for food, movies, or classes.  But there are other types of costs; in economics we call these opportunity costs.  For more info on opportunity costs, look here. To summarize, opportunity costs are the value of the highest foregone activity. An example would be giving up the opportunity to work while you are attending classes. In this case, you have to pay for classes (a monetary cost) AND give up other activities (an opportunity cost).

3. Benefits:

The reason we incur costs is because we also derive benefits from them.  Benefits can take many forms, but the most common are monetary or happiness related.  In economics we try to measure happiness using the word “utility”, which is basically a numerical measure of how satisfied someone is consuming or using a good or service. We are interested in benefits because they are typically the thing that individuals and firms are trying to maximize with their behavior (utility and profit respectively).

4. Incentives: 

Incentives are the rewards and punishments we experience every day. This is sometimes called the carrot and the stick. The carrot is a benefit trying to make someone do something (positive reinforcement) while the stick is a cost trying to scare someone into doing something (negative reinforcement).

We like to get rewards, so we will generally make a decision so that we will get rewarded.  At the same time we don’t like punishment so we will avoid decisions that will result in us getting punished.  Economists are interested in how people respond differently to rewards and punishments for similar scenarios. 

For example, is it more effective to reward people for driving safe by lowering their car insurance premium every year when they don’t get in an accident, or is it better to punish them by jacking up their rates when they do get in an accident?  Economists would use surveys and data to see which is more effective at getting people to drive safe.  Another example about incentives can be seen here.

5.  Marginal Analysis:

Almost everything analyzed in economics is done so on the margin.  This means that economists are interested in the NEXT decision being made.  Focusing on the margin means only considering the NEXT piece of pizza eaten, or the NEXT video game being made.  If you are familiar with calculus then this concept makes sense.  If not, think about drinking beer with your friends.  Whenever you order your NEXT beer you consider how much you want that NEXT beer, and how much money that NEXT beer will cost you.  While decisions made in the past will affect your happiness from that NEXT beer, and the amount of money you have, the decision to buy that NEXT beer is made then.

Remember:  In economics, we assume people are rational, this allows us to try to predict their behavior through the use of models.  Opportunity costs rule the day in economics, the price of something is its opportunity cost because you are giving up that money to get it.  Everything is analyzed on the margin, I might as well introduce this to you now, you will get tired of hearing marginal cost=marginal benefit.

For more examples and to help you develop your intuition on this five fundamental ideas you can check out the video below: