Chapter 1 What Is Economics?

Economics studies the allocation of scarce resources among people—examining what goods and services wind up in the hands of which people. Why scarce resources? Absent scarcity, there is no significant allocation issue. All practical, and many impractical, means of allocating scarce resources are studied by economists. Markets are an important means of allocating resources, so economists study markets. Markets include not only stock markets like the New York Stock Exchange and commodities’ markets like the Chicago Mercantile, but also farmers’ markets; auction markets like Christie’s, or Sotheby’s (made famous in movies by people scratching their noses and inadvertently purchasing a Ming vase), or eBay, or more ephemeral markets such as the market for music CDs in your neighborhood. In addition, goods and services (which are scarce resources) are allocated by governments, using taxation as a means of acquiring the items. Governments may be controlled by a political process, and the study of allocation by the politics, which is known as political economy, is a significant branch of economics. Goods are allocated by certain means, like theft, deemed illegal by the government, and such allocation methods nevertheless fall within the domain of economic analysis; the market for marijuana remains vibrant despite interdiction by the governments of most nations. Other allocation methods include gifts and charity, lotteries and gambling, and cooperative societies and clubs, all of which are studied by economists.

Some markets involve a physical marketplace. Traders on the New York Stock Exchange get together in a trading pit. Traders on eBay come together in an electronic marketplace. Other markets, which are more familiar to most of us, involve physical stores that may or may not be next door to each other and customers who search among the stores and purchase when they find an appropriate item at an acceptable price. When we buy bananas, we don’t typically go to a banana market and purchase from one of a dozen or more banana sellers, but instead go to a grocery store. Nevertheless, in buying bananas, the grocery stores compete in a market for our banana patronage, attempting to attract customers to their stores and inducing them to purchase bananas.

Price—exchange of goods and services for money—is an important allocation means, but price is hardly the only factor even in market exchanges. Other terms, such as convenience, credit terms, reliability, and trustworthiness, are also valuable to the participants in a transaction. In some markets such as 36-inch Sony WEGA televisions, one-ounce bags of Cheetos, or Ford Autolite spark plugs, the products offered by distinct sellers are identical; and, for such products, price is usually the primary factor considered by buyers, although delivery and other aspects of the transaction may still matter. For other products, like restaurant meals, different brands of camcorders, or traveling on competing airlines, the products differ to some degree, by quality reliability and convenience of service. Nevertheless, these products are considered to be in the same market because they are reasonable substitutes for each other.

Economic analysis is used in many situations. When British Petroleum (BP) sets the price for its Alaskan crude oil, it employs an estimated demand model, for gasoline consumers and for the refineries to which BP sells. A complex computer model governs the demand for oil by each refinery. Large companies such as Microsoft and its rival Netscape routinely use economic analysis to assess corporate conduct and to determine if their behavior is harmful to competition. Stock market analysts rely on economic models to forecast profits and dividends of companies in order to predict the price of their stocks. Government forecasts of the budget deficit or estimates of the impact of new environmental regulation are predicated on a variety of different economic models. This book presents the building blocks for the models that are commonly used by an army of economists thousands of times per day.