- Date : 05/04/2020
- Read: 4 mins
An understanding of these concepts will equip you with vital tools for your own decision making
Economics, at its simplest, is a study of how and why choices are made. An understanding of economics provides you with vital tools for your own decision making. Here are five key concepts that form the basis of all economics.
Look around and you will realise that there is a gap between the resources available and the wants that need to be satisfied. This gap between limited or scarce resources and theoretically unlimited wants is called scarcity. This forces people to allocate resources in a manner that all basic needs are satisfied and as much of the wants are fulfilled as possible.
For example, when you enter a metro train on your way to office/ school, the number of seats available is limited. But the number of passengers who enter the metro are much higher. This raises the question of how to allocate these seats. One way is to let each passenger find a seat based on his abilities. The other is to reserve some seats for some passengers – like reserving some seats for senior citizens. Another solution could be to limit the demand by only allowing a limited number of people enter the metro.
Scarcity leads to competition. The Samuel Johnson Dictionary defined it as “the act of endeavouring to gain what another endeavours to gain at the same time”. You would be familiar with this already – through childhood games, sporting events, trying to get a seat in the metro, finding a job are all competitions. All modern economies are built on the concept of competition, and the fact that different entities end up with different scare resources. One way of ensuring favourable outcomes for society as a whole in such a scenario is the market system.
3. Demand & supply
Given the scarcity of resources, no human being can be self-sufficient. So, they produce something and “supply” it to their fellow humans. In return, they take something from them to fulfil their own “demands”. This, of course, is trade. In simple terms, supply is how much of something is available in the market and demand is how much of it the people want. One way these are related is through price.
Generally speaking, if the demand for something increases faster than the supply – the price will go up. This is because the supplier realizes that more money can be made from whatever he/she is supplying. Price acts as a mechanism for filtering out demand. Imagine going out to shop for mangoes, if the price were as high as ₹1000 per kg – you would most likely not demand those, and the demand will get limited to people who can afford such a price. On the other hand, if the price is lowered – more and more people would want to buy the mangoes resulting in a higher demand.
Inflation refers to the ongoing change in the general level of prices in an economy. For an economy which is in a growing phase – like India’s economy – it is important to have a positive inflation. That is, over time the average price level of things must rise. Why is this so? Simple – this is the only scenario where investments will turn profits and you will want to make investments as the value of the money you hold goes down with time.
The problem with hyperinflation, i.e. inflation higher than 50% is that people cannot afford to buy anything and their basic needs may also go unfulfilled – think of Zimbabwe or Venezuela in recent years. On the other hand, negative inflation as experienced by Japan for an extended period halted the growth of the economy as there is no incentive to invest. Further, if you know that the price of things will fall further in the future – you will postpone all non-essential purchases resulting in a deadlock.
5. Trade deficit
Trade takes place not just between individuals within a nation – but also across borders. At its most basic, the two are no different – just a matching of demand and supply happening at a suitable price. But when a country spends more money on imports than it earns from its exports, it runs a trade deficit – also known as a current account deficit. The opposite happens when the exports outstrip the imports earning the country a trade surplus.
This is a natural outcome of trade and the underlying scarcity of resources. At no point in time can all countries have a trade surplus or vice-versa. Therefore, running a trade deficit is not bad in itself and should be evaluated in the light of other economic indicators of a nation. Read this beginner’s guide to capital markets.