Basics of Economic Theory
As with all sciences, the study of economics has many basic theories and assumptions. While at times these theories and assumptions are either disputed or relaxed in order to improve its ability to analyze certain events, all are commonly used in the field of economics today.
Supply and Demand
The basic law of supply and demand is arguably the most important aspect of economic theory. Although the slopes are shifted depending on situation, supply and demand curves generally follow a specific rule of thumb. Graphically, demand is usually denoted as a downward-sloping line which signifies the amount demanded of a certain good or service at any given price.
Supply is usually denoted as an upward-sloping line which signifies the quantity supplied at any given price. The point of intersection of the two is usually the equilibrium point, where the price and quantity of a certain good or service are accepted by both consumers and producers.
Absolute and Comparative Advantage
The idea of absolute advantage, a term coined by Adam Smith, stated that two countries (later on adapted to companies or individuals) may gain from trade if each produces what it is best at. By trading, the two countries will gain, because their “production possibilities frontier” will be at a higher level than if each country had stuck to autarky.
After Adam Smith’s profound discovery, David Ricardo, another political economist, built on the idea of absolute advantage by producing the idea of comparative advantage. Ricardo noticed that even though some countries may be more efficient at producing all goods and services, countries may still gain by specialization.
His argument was that countries only needed to specialize in what they were “relatively” efficient at producing, and therefore even if a country holds absolute advantage over all aspects of production, it is still possible to gain through specialization and trade by comparative advantage.
Utility Maximization
The study of economics typically assumes that individuals, corporations, and nations are all utility maximizers. By assuming so, the study of economics is able to hold the variable of human inefficiencies as a constant, and therefore study how humans behave given certain constraints. Furthermore, by assuming “utility maximization” instead of “profit maximization”, economics is able to account for the non-monetary ways in which people derive their happiness.
Perfect Competition
In addition to utility maximization, the field of economics usually assumes perfect competition. The idea of perfect competition states that market transactions have little or no transaction costs, companies entering the marketplace face little or no barriers to entry, and a large number of consumers and producers exist in the marketplace.