10 Principles of Economics You Should Know [Infographic]

Economics is a critical part of our life. Almost everything we do is in one way or the other connected to it. Whether we go to work in the morning, buy something to eat for lunch, or simply sit at home and watch TV in the evening, there is always a multitude of economic principles at play.

Thus being familiar with the most fundamental of those principles can be extremely helpful, Not only will it help you to understand what is going on in the world around but it will also enable you to take well-informed and better decisions which is vitally important in all part of life. 

With this in mind we have created an infographic that illustrates and explains the 10 most relevant principles of economics you should know. Take a look:

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Diminishing Marginal Utility

The concept of marginal utility is one of the most fundamental principles of economics. It describes the additional satisfaction an individual gets from consuming one more unit of a good or service. This information is critical for predicting and explaining consumption decisions.

Although actual utility cannot be measured in hard numbers, it is possible to reveal consumer preferences, tendencies, and other relevant aspects that are critical for decision making. However to be able to do this, we must first look at the principle in some more detail. 

Thinking at the margin

First of all, to describe decision making processes accurately it is necessary to think at the margin. Particularly we need to focus on the "next step" and analyze its consequences (e.g. what happens if we buy one more bottle of water, etc.). In other words, to understand decision making processes we have to look at the effects of small (marginal) changes from various states.

The idea behind this is actually quite simple. Rational individuals should always consider costs and benefits associated with every action they take. As long as the additional benefits (i.e. marginal benefits) are greater than the additional costs (i.e. marginal costs), the individual will be better off afterwards and thus take the action. For example, if you have to decide whether or not to buy ice cream you probably trade off your desire for ice cream against its price and only buy it if you feel like you are better off if you do so.

Hence, mathematically speaking marginal utility is the first derivative of total satisfaction (i.e. total utility) at a specific point. This aspect will be relevant once we introduce the law of diminishing marginal utility.

Diminishing marginal utility

The law of diminishing marginal utility states that the additional utility of a good (or service) decreases as its supply increases. This suggests that every additional unit that is consumed has a lower marginal utility than the unit before. At a certain point the additional utility can even become negative for some products. In those cases consuming another unit will actually decrease overall satisfaction. This principle is illustrated in the graph below.

Illustration 1: Diminishing Marginal Utility

The most important thing to note from this graph is that the utility curve (UC) is not linear, but becomes flatter as quantity (Q) increases. As a result the changes in total utility (U) resulting from an increase in Q become smaller as total quantity grows. For example, if quantity increases from q1 to q2, the change in total utility (u2 - u1) is quite significant. However if quantity increases from q3 to q4, there is only a very small increase in total utility (u4 - u3) even though the change in quantity is the same. 

To make this more comprehensible we can look a simple example: the utility of a glass of water. On a hot summer day the satisfaction you get from drinking this glass will most likely be high (especially if you have not had anything to drink for a long time). However if you have just consumed two other glasses of water a minute ago you are probably not that thirsty anymore so the additional satisfaction you get from drinking the additional water will not be that high anymore. At some point if you drink too much you might even get sick and have to vomit, thus marginal utility becomes negative.

Limitations and Exceptions

Although the law of diminishing marginal utility is an important and widely applicable concept there are certain exceptions that need to be considered. Thus for the sake of completeness the most relevant of those limitations are listed below.

• As mentioned before, the law of diminishing marginal utility only applies to rational individuals. If individuals do not act rationally their actions become somewhat erratic which makes it impossible to accurately describe and predict their behavior.
• The law does not account for fashion trends or other changes in taste. If a product comes into fashion its utility increases (irrespective of the quantity consumed), whereas its utility decreases once it goes out of fashion.
• There is no (or limited) diminishing marginal utility for goods that are added to a collection (e.g. stamps, coins, etc.). This is due to the fact that collections generally become more valuable the more extensive they are.
• The law is not applicable for situations that require a specific amount of a good or service to achieve a desired outcome. A common example here is the use of antibiotics. While the right dose might cure an illness, not taking enough pills will leave bacteria with an increased resistance and thus aggravate the illness.

In a nutshell

The concept of marginal utility is one of the most fundamental principles of economics. It describes the additional satisfaction an individual gets from consuming one more unit of a good or service. Most products experience diminishing marginal utility, which means the amount of additional utility decreases as their supply increases. For those goods and services every additional unit that is consumed has a lower marginal utility than the unit before. Even though this concept is widely applicable it is important to note that there are several limitations (i.e. assumption of rational individuals, disregard of fashion trends) and exceptions (i.e. collections, required specific amounts) to it.

Money, Money, Money

For many people, money is equal to bills and coins. However, even though this is not wrong, it is only one part of the equation. Generally speaking, money is a set of assets that is commonly used and accepted as payment for goods and services in an economy. This suggests that anything can be considered money, as long as it fulfills certain criteria (i.e. as long as it is generally accepted).

To really understand what money is, we must therefore look at the relevant functions it performs within the economy. To keep things simple, we will focus on the three most important ones here: money as a medium of exchange, a store of value, and a unit of account.

1) Medium of exchange

Money can be used in exchange for goods and services. This reduces transaction costs by a huge margin, because people no longer need to barter. In other words, you can just walk into a store and buy a pair of jeans (or whatever you need) in exchange for your money. This only works as long as the seller is confident, that he will be able to use the currency he receives to buy goods or services of equal value later on.

2) Store of value

Money can serve as a store of value. That means, it can be used to transfer buying power into the future. If you sell your car for instance, you can keep the money for a while and use it to buy a new car later in the future. For that reason money needs to be durable and must not lose its value over time. 
Please note that this may not be perfectly accurate in reality, as money can actually lose some of its value due to inflation. However we consider this effect negligible for now (but we will cover it later).

3) Unit of account

Money is also a measure of economic value. Every good you can buy in a shopping center has a price tag on it. Thanks to that we can easily compare the value of completely different goods. To give an example, you may want to buy some ice cream for 2$ and a shirt for 20$. By comparing the prices you know that the ice cream is worth about 1/10 of a shirt. Using money as a unit of account is very convenient because it allows us to compare virtually everything. 

In a nutshell:

Money is a set of assets that is generally used and accepted as a medium of exchange for goods and services in an economy. Apart from its function as a medium of exchange, money also serves as a store of value and a unit of account. Everything that fulfills these three functions can be considered money.

The Importance of Economic Models

Models are a very important tool when it comes to understanding economic principles. Yet they are often subject to criticism, mostly because many of them are said to be simplistic and far away from reality. Because of that the importance of economic models is often underestimated.

To be fair, the critics may have a point. The models are indeed simplistic and not always close to reality. But that is exactly what makes them great. To keep things short, they have two very important functions.

1) Models simplify reality

There is no point in creating a model that describes every detail of a certain object. For example, there is no need to build a model of a car that is 100% identical to the actual vehicle. In that case we could just look at the car itself.
Instead a good model will omit certain details and build on certain assumptions. This will make it much easier for us to examine it and actually learn something.

2) Models guide our attention to certain topics
The second function is very much connected to the first one. By omitting certain details while keeping others, the model automatically guides our attention in a certain way. Depending on what we are trying to learn, the model can put the focus on different topics. At this point it is important to note that including different details will dramatically change the quality and purpose of every model. 
Now that has implications for our car example. If for instance we are trying to figure out how an engine works, we need to include all the relevant rods, wheels and pins into the model. The bumper design however is not relevant and can be omitted. Naturally these relevant details are entirely different if we are trying to create a new design for our car and so on.

In a nutshell

Models are very powerful tools that help us comprehend economic principles by simplifying reality and guiding our attention to specific features of an object.

Looking at economic models the right way will come in handy as we are learning more about economics. Sometimes even looking at what is not included can help us understand what a topic is all about.

Macroeconomics vs. Microeconomics

The study of economics can roughly be divided into two branches: Macro- and Microeconomics. For the sake of completeness, there are certain other branches as well, but differentiating between those two will be good enough for us (for now).

The two disciplines look at the economy from different perspectives. While macroeconomics can generally be described as the study of the economy as a whole, microeconomics is often referred to as the study of small economic units (such as households, firms, specific markets, etc.). However, it is important to note that the two are still interdependent in many ways.

To see why we should not treat the two discipline completely isolated from each other we need to examine them in a bit more detail.

Macroeconomics
As the name suggests, the field of macroeconomics looks at the economy on a very broad scale. It analyzes the behavior of the entire economy. To do this it often makes use of aggregated variables, such as aggregated demand or aggregate production, and so on. The goal is then to find relationships and interdependences between those variables. 

Some of the topics that are covered in macroeconomics are:

• Monetary and fiscal policy and its effects
• Taxes
• Interest rates
• Economic trends (booms and recessions)
• Economic growth
• Trade and globalization

Microeconomics
Again the name implies that microeconomic studies look at the economy on a small, detailed scale. It analyzes the behavior and decision making of individuals and companies within an economy. By doing so, it builds the foundation for many macroeconomic studies, as it provides the data to calculate the aggregate variables mentioned above.

The topics that are covered in microeconomics include:

• Consumer behavior (decision making, utility maximization)
• Profit maximization of firms
• Supply and demand (for individual markets)
• Externalities
• Labor economics

In a nutshell:

Macroeconomics is the study of the economy as a whole (from a broad perspective) and microeconomics is the study of small units (from a close perspective). Even though they cover different areas of economics, they are still highly interrelated and should not be isolated from each other.

A brief Introduction to Economics

Economics can be defined as the study of the production and distribution of goods and services within a society. However this is a very broad definition that may seem little helpful for understanding what economics is really about, especially for beginners. 

In order to comprehend the given definition we first need to be able to think like an economist, at least to a certain degree. Thus, to start off it seems useful to take a look at some of the most basic economic principles, before diving into the world of fancy definitions and technical terms. 

Since this is supposed to be a brief introduction we will focus on the three most fundamental principles here.

1) Scarcity

There are not enough resources for everyone's wants. Most resources are limited and there is only a certain quantity available for distribution. However people essentially have unlimited wants for those resources and hence try to get as much of them as possible (In other words: more is always better).

2) Trade-offs

Because of the scarcity mentioned above, people are forced to make choices, since they cannot get everything they desire. This may be obvious when it comes to money (i.e. "Should I spend those 2$ on ice cream or on an apple?"), but holds true for all decisions we face in our life. For Example: On a sunny day you could either spend the day at the beach, or have a nice barbecue with your friends. If you chose the barbecue you obviously can't go to the beach at the same time.

3) Opportunity Costs

This term describes the value of what has been given up in order to get something else. Again this does not necessarily have to be a monetary value. In our example above, the opportunity cost of having a barbecue would be not being able to be at the beach at that time. In other words, opportunity costs are the possible benefits you could have received by taking an alternative decision.

In a nutshell

People can't get everything they want because resources are scarce. Thus they have to take decisions and deliberately forgo certain things. Those things are then called opportunity costs.

Keeping these three simple principles in mind, we can now look at the world in a different way and think more like economists. This will make it easier to understand economic behavior as it gets more complex (and even more interesting).