Summary - When a consumer decides to purchase one brand of jeans over another brand, they are practicing economics. When a car manufacturer makes decisions about which makes and models of cars to mass-produce, they are practicing economics. When the Federal Reserve decides to raise or lower interest rates, they are doing so based on what they are being told by economic indicators. Economics is a social science that boils down to how resources are allocated.
The two main categories of economics are microeconomics and macroeconomics. As an investor, it’s important to understand both categories and how they relate to each other. Microeconomics has to do with the health of an individual company or sector. Macroeconomics has to do with the health of the broader economy as a whole.
The core principles of basic economics are supply and demand, elasticity, and opportunity cost. All of these factor into the decisions that consumers and producers make.
Households, businesses, and countries all practice economics when they make decisions on how to allocate resources. However, understanding economic theory is essential to developing strategies to help ensure the decisions they make will lead to the best outcome.
In this article, we’re going to provide an overview of basic economics. We’ll review the two types of economics, and some of the core principles of economics including supply and demand, elasticity, and opportunity cost. We’ll also take a look at outside factors that can affect supply and demand.
What is basic economics?
Basic economics is the study of how societies allocate a limited amount of resources which can have alternative uses. Economics is broadly divided into two categories: microeconomics and macroeconomics. Microeconomics looks at individual markets within a larger economy. Macroeconomics looks at an entire economy. Each category can be broken down into subcategories, but for understanding basic economics it’s sufficient to know the two main categories.
An economy seeks to efficiently make use of its existing resources so that they can be of the greatest benefit to the most people. For goods and services that have a material value, an economy uses prices a guide for consumers and producers. Prices will rise when the value of something exceeds our ability to obtain it. For example, if a particular crop is affected by weather, its price will go up. It's not that the particular crop became more expensive to harvest, but it became more scarce. To ensure that as many people can enjoy the crop as possible, the price will rise. Conversely, if a farmer enjoys an abundant crop, consumers will generally pay less for it. The crop did not become less expensive to harvest, it just became more abundant. This illustrates one of the most fundamental principles of economics, the principle of supply and demand.
Supply and demand is at the core of basic economic theory
Prices change in response to supply and demand. When the demand for a good or service exceeds its supply, prices go up. Conversely, when supply exceeds demand, prices go down. A related concept to supply and demand is that of elasticity. Elasticity refers to the amount a price can change before it starts to hurt sales. Let's look at a couple of examples.
If you’ve ever tried to reserve a hotel room in a city where a major convention is taking place, you see both of these theories in action. There is a finite supply of rooms and a potentially infinite number of people in need of them. Hotels raise the price for everyone to force the sharing of the resources. Put another way, by raising the prices, they make it difficult for anyone person to take a disproportionate share of the resources. However, hotels have to pay close attention to what other hotels of similar caliber are charging. If one hotel charges too much, they risk having customers choose other hotels which would then cause them to have to lower their prices to stimulate demand.
Another example of supply and demand that consumers see regularly occurs when they are shopping. Some items, such as groceries, are generally abundant and the prices are generally stable. Other items may see a significant range of prices between one seller and the next. Many brands go to great lengths to establish a value for their goods or services that goes beyond price. Otherwise, it can be a race to the bottom in which case the less expensive item will almost always win.
Economics creates winners and losers
This idea of winners and losers is also a core tenet of basic economics. Both are related to pricing. On the producer side, we see this when competition enters a market. Many small businesses struggle when a large, chain store enters their market. Since these large companies often can offer goods and services at a lower cost, the small business is forced to adapt to a new pricing model or risk going out of business. For consumers, winning and losing often comes down to what we can afford. In our earlier hotel example, if the hotels raise prices high enough many consumers will have to stay further away from the convention to find affordable lodging. Or, they may have to decide to make other arrangements, including skipping the convention altogether.
Technology has added another layer of complexity to the issue of market efficiency. Many businesses of all sizes have been able to reduce their labor costs due to technological advances. This can bring prices down, but also takes away jobs that can affect the economy in other ways. This introduces another important concept of basic economics: opportunity cost.
Opportunity cost means understanding the value of your choices
An opportunity cost is simply the cost of doing one thing at the expense of another. If we choose to take a nap, we are choosing not to do other things with that time. In that case, we are prioritizing the benefits of that nap as being more beneficial than the cost of not doing something else with that time. Opportunity cost is about value, not price. And value comes down to what is important to you. To illustrate this let’s look at a car purchase.
Let’s assume you have a budget of $36,000 to buy a car. You like two cars. One costs $35,000 and the other costs $25,000. Both are within your budget so the price is not the issue. The issue comes down to a more complicated question of how else could you use the $11,000 you saved on the lower cost vehicle? Would saving that money allow you to pay down additional debt? Would it help offset commuting costs and allow you to stay in an area with a lower cost of living? These are opportunities that you would lose if you choose to buy a more expensive car. However, if the $35,000 car has a higher safety rating and you have been in a recent car accident, you may decide that the security is worth more than anything else.
What outside factors can affect supply and demand?
In a free-market economy, one of the key factors that affect supply and demand is competition. When consumers are offered choices, they let businesses know where to allocate their resources based on how and where they spend their money. For example, when Henry Ford first started manufacturing automobiles, there was no competition. He mass-produced the same style of automobile in the same color, year after year. When General Motors started manufacturing automobiles in different styles and colors, consumers started to buy their cars instead of Ford’s. Now that they had options, consumers expressed their preference. Soon General Motors replaced Ford as the country’s leading automaker. Competition for goods and service leads to more pricing equality and the need for companies to differentiate their products.
When it comes to natural resources, supply and demand can be upset by geopolitical events, by natural disasters, or even by a statement or policy initiative from our government or that of another country. When supply is threatened, producers will raise prices and those costs get passed along. If a gas station needs to pay more for the gasoline that it receives, it will pass that cost along to the consumer. While the consumer may feel they are being taken advantage of it's important to remember that the goal of that gas station is to make a profit. The cost of gasoline is only one cost that they bear. They also have to pay employees. They have to pay for the facilities that they are using. All of these costs affect their margin. When they have to pay more for the gasoline that they will sell, not raising the price would affect their margins.
Understanding the profit margin
There are all kinds of prices. The prices of consumer goods are the most obvious for consumers. But for a business, there is a price for labor in wages or salaries. Borrowed money also has a price in the form of interest. All of these prices work together when a company sets the pricing for their goods and services.
For example, stores pay producers a wholesale cost for the goods in their store. They, in turn, sell those goods to their consumers at a higher price. The difference between the price they bought the goods for and the price they sell them for is their profit margin. The higher the margin, the more profit the store receives. For popular items that have limited supply, the store will typically charge a high price if they know consumers will pay it. These high margin items are extremely valuable to a business. In some cases, certain brand names that have high value to consumers allow a retailer to charge a higher price.
However, some items will have limited value to consumers. These are typically low margin products. In some cases, like as in grocery stores, these items will often be called "loss leaders" because the store makes very little profit on them but they bring people into the store where they are likely to spend money on other, higher-priced – and higher-margin items.
Understanding what goes into a company’s profit margin is important not only for consumers but for investors who are trying to understand the ability of a business to generate a profit. Businesses that have high labor costs will generally have higher prices than another business with lower labor costs. This is because the higher cost is going into ensuring that the business owner has enough revenue to not only pay for their goods but also to pay their labor costs.
A brief look at macroeconomics
All of the examples we’ve been using to this point are dealing with microeconomics. The principles of supply and demand, elasticity, opportunity cost, and profit/loss apply to the broader economy as well. The health of the U.S. economy or even the global economy is commonly referenced by Gross Domestic Product (GDP). GDP is the market value of a country's goods and services, not money or paper assets. This is an important distinction. The wealth of a nation is created by the real goods and services that money can buy. For example, during World War II many products such as cars and home appliances stopped being made. This would seem almost comical today, but back then the production capacity and machinery of our nation's manufacturers were needed to produce the military equipment. Not surprisingly, the period after the war saw one of the great expansions of our nation's GDP in history as all these items that had not been produced were not being mass-produced to feed a pent up demand.
Since 2018, international trade is a key macroeconomic principle that is among the key factors affecting the stock market and the national and global money supply.
The bottom line on basic economics
Understanding basic economics is simple, but it requires paying attention to a variety of variables which can change yearly, monthly, or even daily. However, when you pay attention to the basics of supply and demand, buyers and sellers, profit and loss, and opportunity cost, you can better understand how nations and businesses make decisions. In turn, when you understand what is going on in the economy around you, you have the knowledge and the power to make fundamentally sound economic decisions.
Beyond helping you make wise financial decisions, understanding economics gives you a better idea of how the world works, particularly concerning financial markets. As an investor, understanding basic economics is essential to performing fundamental analysis of a company and its financial health. From a broader perspective, a sound economic analysis can help you look at a nation’s fiscal policy and its effect on the health of the national or global economy. This can give you an idea of how to allocate the assets in your portfolio.