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Introduction to Economics: Basic Concepts & Principles

Introduction to Economics: Basic Concepts and Principles

As a novice, economics seems to be a dry social science that is laced with diagrams and statistics; a complex branch that deals with rational choices by an individual as well as nations — a branch of study which does not befit isolated study but delving into the depths of other subject areas (such as psychology and world politics).

What is Economics?

Economics Definition: Economics is essentially a study of the usage of resources under specific constraints, all bound with an audacious hope that the subject under scrutiny is a rational entity which seeks to improve its overall well-being.

Two branches within the subject have evolved thus: microeconomics (individual choices) which deals with entities and the interaction between those entities, while macroeconomics (aggregate outcomes) deals with the entire economy as a whole.

A typical college student (or an overburdened husband?) appreciates the lessons of economics in day-to-day life. Semester books and carton of cigarettes (choices) are to be purchased with a limited amount of pocket money (constraints).

The aim of studying economics is to understand the decision process behind allocating the currently available resources, the needs always unlimited but resources being limited.

Adam Smith wrote ‘An inquiry into the Nature and Causes of the Wealth of Nations‘ which as the name suggests, was an attempt at understanding the reasons behind the economic growth (or lack thereof) of a nation.

An interesting backdrop to consider here — the fundamental assumption that we need to make for the whole economic system (as we know it today) to work is that human beings are motivated by pure self-interest and will take decisions that they think will make them ‘better off’ now or sometime in the future.

The economic and political systems of a country are closely inter-linked and jointly determine the well-being of its citizens.

Economics Basics – Demand & Supply

Demand and Supply

It is perhaps one of the most fundamental tenets and provides a fundamental framework in which to assess the actions of an economy.

Definition of Demand: Demand is the quantity of a good (or service) the buyers are willing to purchase at a particular price.

Definition of Supply: Supply is the quantity of a good the sellers are willing to deliver at a particular price. Meanwhile price is a result of the constant tug-of-war between the demand and supply.

And all other random things kept constant for a good (brand, quality etc.); higher the price— lower will be the demand from the consumer (to save up for other purchases).

Higher the price, higher will be the supply from the manufacturers (make hay while the sun shines!).

The former is called the law of demand, and latter is called the law of supply.

Time also plays a huge role in a free-market economy, more so in the case of entities in a competition to serve the consumers. Stock-outs are no good for a supplier as it affects the brand and the consumer can move elsewhere.

If there is an excess of demand, the producers have to gauge the nature of demand first (seasonal, increasing trend) to react in a swift fashion, to corner the market and retain the existing customers.

The stable state of equilibrium in an economic system makes the economy efficient, the suppliers are moving their goods and the consumers are getting what they are demanding.

The only point worth noting: the point of equilibrium is ever-elusive and fluctuates like a wild boar in each minute quantum of time.

Economics Basics – The free market hypothesis

In a perfect free market, for any good or service— the total quantity supplied by the sellers and the total quantity demanded by the buyers will reach a state of economic equilibrium over time.

Things closely follow the free market paradigm if two basic assumptions hold true: perfect competition and absence of “unnecessary” government quotas and regulations.

Perfect competition assumes that no seller is large enough to sway the natural movement of the market owing to its large market share and cash reserves, which too often becomes the case for corporations in a capitalistic system with the wherewithal to wipe out smaller players.

In these cases, regulations to prevent monopolies and unfair practices become all the important to ensure that the market remains efficient.

On the other hand, too many government regulations and quotas (pre-liberalization India was on the verge of bankruptcy) hinder the natural process towards equilibrium and result in easily avoidable inefficiencies in the system.

How much government regulation is the right amount is a question which we are yet to answer with full confidence, but we know for sure that both extremes can be really bad!

Economics Basics – Cost, efficiency and scarcity

  • Going by the geeky definition, opportunity cost is the value of the next-highest-valued substitute use of that resource. For instance you may forego going to the physics class for a session of LAN gaming, but the risk of not understanding subsequent lectures and flunking the semester is the opportunity cost you should be aware of. Every entity has a different point-of-view regarding this opportunity cost as the needs and resources of entities keep shifting with time.
  • Economic efficiency is the measure of output obtained with a given set of inputs, i.e. least amount of wastage. Technological ability usually decides the upper limit for the maximum efficiency which can be achieved.
  • The basic definition of scarcity is slightly philosophical— humans have unlimited desires but the means of production being finite and limited (labor, land and capital), various trade-offs are to be made to allocate the resources in the most efficient way possible.
  • The production-possibility frontier (PPF) is a bridge which ties the three concepts. If we assume that the economy produces just a couple of goods (guns and butter are the default choices for economists, scary lot!), then the economy can produce a greater quantity of guns only if it reduces the quantity of butter produced. Each point on the PPF curve shows the maximum possible output of an economy (i.e. the potential that the economy holds).
  • Elasticity is defined as the change in quantity of the goods associated with a change in the prices. It usually depends on the nature of product (luxury v/s necessity), the number of substitutes available in the market, share of wallet etc.
    • If quantity of the good changes drastically with a change in its prices, it is said to be elastic (PS3 selling at a 40% discount will see a sharp rise in the total number of units sold).
    • If quantity of the good does not change much with a change in its prices, it is said to be inelastic (onions need to be purchased even after the prices double as it is a basic necessity and there are no actual substitutes).
  • Utility is the satisfaction that one achieves from consuming a good/service, and is an abstract concept based on the individual in question. Marginal utility is the extra satisfaction one gets from each additional unit of consumption.

    Taking a holistic example in lieu of an easier and obvious one — research proves that the money one earns contributes hugely towards average life happiness in the initial stages of getting those riches, but its role tapers off sharply as the income grows.

    The economists refer to this is as the law of diminishing marginal utility. The third chocolate doesn’t seem as tasty as the first one, eh?


The ‘specialist world’

The fundamental concept which is responsible for economic growth as we know it is specialization of labor. If an entity is really efficient in producing a commodity (output to input ratio is high), it has an advantage over another entity which is not that efficient in producing the commodity under consideration.

If I am good at making shoes and you are good at making jam, it makes sense to do what we are good at and trade afterwards.

Moreover, the economies of scale prove to be an icing on the cake — the production cost per unit decreases as we produce more and more of the same units (the initial one-time setup cost can be a major part of the total expense). And the best part is that both parties are better off after doing the transaction (and so is Mother Earth, for less wastage).

Just to appreciate the grandeur of this simple idea, just imagine your standard of living in a world where you have to produce everything for yourself. You would likely revert to a medieval lifestyle, growing your own food and defending our own property. Say goodbye to the iPhones, cushy jobs, roads (even the shitty ones), branded clothes and the air-conditioned comforts.

Studying economics can be both rewarding and intimidating at first, but knowledge of basic economics is essential not only for the B-School junta but for anyone who interacts with markets. In an era where having money is one of the prime determinants of the ability to make more of it, you better watch out and get your basics right.

Learn more about the most important topics in Economics

Introduction to Microeconomics
Introduction to Macroeconomics
Game Theory in Economics
Price Elasticity of Demand

Back to the top: MBA Syllabus
And if you are interested, here’s a quick guide to Masters in Applied Economics.

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