What is economics?
[Figure 1: diagram of economy]
Economics is the study of the efficient, strategic use of limited resources. For consumers, this means deciding strategically how much to spend and what to spend it on, how much to save, and how much to work. (Etymologically, the word “economics” comes from the Greek “oikonomika,” meaning the management of the household—so the “consumer theory” sense of the word is the oldest.) For producers, it means deciding how much to produce, how to produce it, and at what price to sell it.
Economists typically model producers and consumers as rational agents, each solving an optimization problem that can be represented mathematically.
A consumer is a person (or sometimes a group or organization) who buys and uses goods and services.
Consumer’s objective: maximize “utility” within choice set, constrained by budget.
Result of consumer optimization:
1) A “demand function” for goods, describing the quantity of each good this consumer would buy, as a function of prices.
2) “Labor supply”—how many hours would this consumer want to work, as a function of wages.
Details: Consumers have preferences over bundles of goods and services that they can consume. Economists model the consumer’s preferences mathematically in terms of a “utility function,” that maps more-preferred outcomes to higher utilities. Consumer choice is modeled as a constrained maximization problem, in which a consumer finds the vector of goods that maximizes their utility subject to a budget constraint. Traditionally, economists assume that consumer choice is “rational,” ie that for any consumer, there exists a function U() such that the consumer always chooses the set of goods (from within the choice set) that maximizes the function U(). In this course, we will discuss the postulates that must be satisfied by such a function. In general terms, though, “rational” behavior requires both certain conditions on the preferences themselves, to avoid circular/self-contradicting/otherwise paradoxical preferences; as well as strategic behavior which is consistent with these preferences.
If I have time, I may eventually cover behavioral economics. Real consumer preferences are known to be only imperfectly rational, and behavioral econ tries to use this knowledge to generate a more psychologically-realistic consumer theory. However, developing functions that behave like humans is quite difficult (and would probably be a triumph in the field of artificial intelligence), and many economists continue to use the classical assumptions of rationality: even if we know the theory is an imperfect approximation of consumer choice, it still describes a sound strategy—and in fact, sophisticated consumers may choose to act in accordance with theory.
A firm (also called a business) is an organization that produces or trades goods. Firms acquire money (revenue) by selling the goods they produce, but they also incur costs by buying inputs (labor, capital, land, materials, etc). Firms are owned by one or more consumers, who may be sole proprietors, partners, shareholders in a corporation, etc. The firm strategically maximizes its profits, which benefits its owners by relaxing their budget constraints (ie giving them more money).
Economists often speak of “producers,” and the branch of microeconomics that describes firms is called “producer theory.” Technically a producer is any person, organization, or entity that produces goods, but most producers are firms. Even if a good is produced by a single individual, that individual must still maximize their profits from production, so we often use “producer” and “firm” interchangeably to refer to someone who produces goods and sells them with the intent of maximizing profit.
Firm’s objective: Maximize profit.
Result of firm optimization: “Supply function” of goods, describing the quantity of goods produced as a function of market price.
Goods (or services, labor, bonds, or any other traded thing) are traded in a market. Historically this could refer to an actual place, but now when we speak of the “market for X,” we refer to the sum total of everyone who is buying or selling X.