Ten Principles of Economics

1. People Face Tradeoffs

Because resources are in scarce supply, we simply cannot make everything we
want. When we devote resources towards one particular task, those resources
cannot also be devoted to another task (at least not at the same time). Therefore,
making a decision to do something carries with it the implication that you cannot
also do something else.

. The Cost of Something Is What You Give Up to Get It
!ow much does it really cost you to see a concert" This may sound like a strange
#uestion, but economists will argue that the true cost of something is revealed by
what people give up to get it. $or e%ample, suppose you want to see The &ave
'atthews Band.

Q !ow much does the ticket really cost"
! (ou might say, )* got the ticket for +,-.) !owever, economists want more
information. !ow long did you wait in line in order to buy the ticket" &id you
miss time at work when you were in line" What is the value of your time"
.uppose you missed / hours of work while waiting in line and you currently hold
a 0ob that pays +12hour.

"pportunit# Cost of a
Concert Tic$et
Ticket Price $30
Value of your time $48
(6 hrs. @ $8/hr)
Total $78

3n economist would argue that you gave up +,- for the ticket, plus time that is
worth +41. *n other words, the true cost of the ticket to you is +51. This may seem
like a lot of money for a concert ticket, but the fact that you paid +,- for the ticket
and gave up +41 in wages reveals that the ticket was worth at least +51 to you 6
otherwise you would have decided not to buy the ticket.

,. %ational People Thin$ at the &argin
The word marginal appears often in economics. $or economists, marginal is
synonymous with )incremental,) or )additional.) *n general, when viewing
economic decisions, it is the comparison of marginal benefit to marginal cost that
is important.
Q .hould you pay for a +4- per month on7campus parking permit"
! *t depends on the e%pected marginal benefit and e%pected marginal cost of
buying the parking permit. The marginal benefit of having an on7campus parking
space is that you will have a shorter walk to and from class every day. The
marginal cost is +4- per month.
!ow much you benefit from parking on campus depends on where you park when
you park off campus. *f you normally have to park a great distance away (say a
half7mile on average), it8s likely that the marginal benefit will e%ceed +4- per
month. *f you normally can park for free right across the street from campus, the
marginal benefit is likely to be less than +4- per month.
The key to making any optimal decision is to follow the rule of rational choice.
Whenever e%pected marginal benefit e%ceeds the e%pected marginal cost, you8ll
buy the parking space. Whenever e%pected marginal benefit is less than the
e%pected marginal cost, you won8t buy the parking space.
Q .uppose you buy a parking pass. .hould you buy a second parking pass"
! 3gain, this depends on the e%pected marginal cost and the e%pected marginal
benefit of the second parking pass. *n this case, the marginal cost is still
+4-2month. !owever, if you drive yourself to school each day, having a second
parking permit provides no further benefit. 3s a result, almost nobody would buy
a second parking permit for him or herself.
4. People %espond to Incentives
'arginal costs and benefits are not fi%ed forever. They change over time as
economic and other conditions in the marketplace change. Because of these
changes, you might make different decisions over time.

9emember the decision about whether or not to pay for an on7campus parking
space" :ets suppose that you originally decided to buy the space for +4-2month.
$urther suppose that, si% months later, a free parking garage opens across the
street from campus. The parking garage has reduced the average distance you8d
have to walk whenever you park off campus. *n other words, the parking garage
has reduced the marginal benefit of paying for an on7campus parking space. *f the
marginal benefit is reduced to less than +4-2month, you8ll stop paying for that on7
campus parking space.

;. Trade Can &a$e Ever#one 'etter "ff
Trade allows all players in the market to speciali<e in what they do best and
promotes more efficient production of goods and services. 3t the same time,
speciali<ation means that people will have to trade, because they8re no longer
producing everything they need on their own. 3s an e%ample, think of everything
you8ve purchased in the last year.

Q Would you have been able to produce all of these items by yourself in the last
year"
! =robably not.

This illustrates that trade allows all of us to consume more goods and services
than we could individually produce. This notion holds true whether we look at
trade within the >nited .tates or trade between the >nited .tates and other
countries.

/. &ar$ets !re Usuall# a Good Wa# to "rgani(e Economic !ctivit#
Who, in the >... economy, decides what (and how much) gets produced" $ree
markets. *f you never gave this idea much thought, you should consider it now.
?ur economy is organi<ed around the idea that markets, which are not controlled
by anybody, are the best way to organi<e the interaction of buyers and sellers. 3s
an e%ample, think of all the times you8ve been to the grocery store in the last year.

Q !ow often do you call the grocery store ahead of time to ensure that they8ll
have what you8re coming to get"
! @ever.

Q !ow often does the grocery store have what you8re shopping for"
! 3lmost always.

?n the surface, the first #uestion sounds completely ridiculous. !owever, the fact
that the grocery store has what you want, when you want it merely illustrates the
point that free markets are the best way to organi<e economic activity. Arocery
stores in the former >..9 were often unable to supply the products their
customers came in to buy. The reason for this was that economic activity in the
former >..9 was organi<ed by a Bentral =lanning Bommittee, not by free
markets, and the Bentral =lanning Bommittee was often wrong in deciding what
should be produced.

5. Governments Can Sometimes Improve &ar$et "utcomes
While free markets are viewed by economists as the best way to organi<e
economic activity, they are by no means perfect. There are times when the
outcome of free market interactions of buyers and sellers leads to undesirable
results. 3s a result, economists look for ways to improve undesirable market
outcomes. ?ne e%ample of a market failure is pollution. =ollution is an e%ample
of a market interaction between a buyer and seller that imposes a cost on a third
party. Cconomists refer to these third party costs (or sometimes third7party
benefits) as e%ternalities. 3nother e%ample of a market failure is a public good.
(ou8ll learn that public goods, like the interstate highway system in the >nited
.tates will not be efficiently provided by free markets. 3s a result, government
intervention may improve the situation. ?ther e%amples of market failures include
common resources, monopoly, and income ine#uality.

1. ! Countr#)s Standard of *iving +epends on Its !,ilit# to Produce Goods and
Services
!ow much we can consume, whether it be TD sets or food or health care, depends
on our ability to produce the products we want to consume. Bountries that are
more productive will have higher per7capita consumption and conse#uently a
higher standard of living. 3 ma0or #uestion that must be addressed by economists
isE *f living standards are linked to our productivity levels, then how do we
continue to improve our productivity over time" Whether this involves education,
capital accumulation, or improving technology, our answer to the #uestion will go
a long way towards determining what type of life we will be able to live in the
future.

F. Prices %ise When the Government Prints Too &uch &one#
*n our economy, the si<e of the money supply (e.g. the number of dollars
circulating in the economy) is controlled by the $ederal 9eserve .ystem.
*nflation, or the rate of increase in prices, is related to the rate of growth of the
money supply. When the $ed increases the money supply rapidly (as in the
1F5-s), inflation heats up. When the $ed increases the money supply slowly (as in
the 1FF-s), inflation slows down. When the money supply is increased very
rapidly (as in Aermany in the 1F-s, or more recently in 3rgentina or Bolivia)
inflation can go simply out of control.

1-. Societ# Faces a Short-%un Tradeoff ,et.een Inflation and Unemplo#ment
The idea that there is a tradeoff between inflation and unemployment, in the short7
run, is illustrated in the figure below. >nemployment is the red series, and
inflation is the blue series. @otice how they tend to move inversely. The
implication of this relationship is that reducing one may cause the other to rise.

Source Economic Report of the President, February, 1999
/e# Terms
scarcit#
the limited nature of society8s resources
economics
the study of how society manages its scarce resources
efficienc#
the property of society getting the most it can from its scarce resources
e0uit#
the property of distributing economic prosperity fairly among the members of society
opportunit# cost
whatever must be given up to obtain some item
marginal changes
small incremental ad0ustments to a plan of action
mar$et econom#
an economy that allocates resources through the decentrali<ed decisions of many firms
and households as they interact in markets for goods and services
mar$et failure
a situation in which a market left on its own fails to allocate resources efficiently
e1ternalit#
the impact of one person8s actions on the well7being of a bystander
mar$et po.er
the ability of a single economic actor (or small group of actors) to have a substantial
influence on market prices
productivit#
the #uantity of goods and services produced from each hour of a worker8s time
inflation
an increase in the overall level of prices in the economy
Phillips curve
the short7run tradeoff between inflation and unemployment
The federal government controls the amount of U2S2 dollars in circulation2
True
$alse
32 People .ho are retired do not face tradeoffs2
True
$alse
42 Usuall#5 the cost of something is more than simpl# the amount of mone# #ou pa# for it2
True
$alse
62 Since the U2S2 econom# is so much ,igger and more productive than &o(am,i0ue5 there
is no .a# the U2S2 could gain from trading .ith &o(am,i0ue2
True
$alse
72 "ne of the pro,lems .ith economic polic# is that economists o,serve a short-run
tradeoff ,et.een inflation and unemplo#ment5 so policies that tend to reduce one ma#
increase the other2
True
$alse
82 The concept of e0uit# implies that .e should tr# to get the most .e can from our limited
resources2
True
$alse
92 Economists refer to an overall increase in the level of prices as :inflation:2
True
$alse
;2 "pportunit# cost5 .hich is defined as :.hatever must ,e given up to o,tain some item:
.ill include indirect or non monetar# costs as .ell as mone# pa#ments2
True
$alse
<2 Whenever a mar$et transaction affects some,od# not involved in the transaction5
economists sa# there is an e1ternalit#2
True
$alse
=>2 +ifferences in the standard of living are related to differences in output per person2
True
$alse
In a free mar$et econom#5 scarce resources are allocated ,#
the government
a central planning committee
the individual actions of millions of households and firms
corporations
32 Suppose #ou .ait in line for = hour to ,u# a theater tic$et2 The tic$et is a ?97 seat5 and
#ou give up ?37 in .ages ,# .aiting in line to ,u# the tic$et2 What is the opportunit# cost
of #our theater tic$et@
+;
+;-
+5;
+1--
42 E0uit# means that
all people in the economy have e#ual incomes
the benefits generated by utili<ing our resources are fairly distributed among all people in the
economy
society8s output per worker is ma%imi<ed
the goods and services produced by the economy are allocated to people based on their need
to have them
62 If an actor in the econom# .ants to ma1imi(e their .ell-,eing5 the# should ta$e action
.henever
the marginal benefit of taking action e%ceeds the marginal cost
the marginal cost of taking action e%ceeds the marginal benefit
the marginal benefit of taking action e#uals the marginal cost
none of the above
72 Which of the follo.ing is an e1ample of a marginal change@
a firm increases its output by 1 unit and its profit rise by +;-
a consumer sells their car and buys a motorcycle
a worker changes 0obs and increase her salary by +4-,---
all are e%amples of marginal changes
82 The United States can gain from trade
only with developed countries
only with developing countries
only with countries that produce goods the >. does not produce
with all countries
92 !dam Smith descri,ed the .or$ings of mar$et economies in The Wealth of Nations2
What did he call this mar$et mechanism@
the guiding force
the invisible hand
the missing link
governmental policy
;2 The term mar$et failure refers to
a situation where firms are forced out of business
a situation where workers are forced out of work
a situation where resources are not allocated efficiently
a situation where incomes are not allocated e#uitably
<2 !n actor in the econom# has mar$et po.er .henever
that actor8s actions can influence the market price
that actor8s actions cannot influence the market price
the actor is small relative to the si<e of the market as a whole
B and B are both true
=>2 Internationall#5 variations in living standards can ,e largel# attri,uted to
differences in populations
differences in government spending
differences in economic systems
differences in productivity