Chapter 1 Ten Principles of Economics.

Introduction. What is Economics? The simplest answer to that question would be the one given by the famous British economist Alfred Marshall (1842 -1924): Economics is the study of mankind in the everyday business of life.

Economics deals with how people make decisions; all sorts of people (consumers, investors, the government...) and all sorts of decisions (what business to start up, how many workers to hire, how to provide Social Security benefits, how to fight inflation...) You will be surprised to discover in how many different areas of life economics is applied (engineering, public administration, law, telecommunications, political science...)

Economics tries to answer very basic questions: What? How? When? Who? What goods and services should we consume or produce? In what amounts? Where should we spend our money? health care education housing vacations

How do we produce these goods and services? What resources do we use? Energy: electricity, gas, solar or nuclear power? Food: produced by large corporations or by family farms? Workers (labor): how many workers do we hire? Machines (capital): what type of machines should we use? Wealth (the richer consume more) Need (the most needed consume more) Effort (the ones that work harder consume more) Political factors (every citizen consumes the same)

Who consumes the goods and services produced? What method of distribution?

Ultimately all questions addressed using the economic methodology derive from the problem of having to make choices under conditions of scarcity. Everything available in a finite supply is scarce simply because when we decide to use it for one purpose we necessarily give up a series of alternative uses (i.e.: time, money, effort.)

How People Make Decisions

Although the field of economics does not have a central dogma that all economists believe in or are expected to preach there are certain principles that are considered to be always true. You will see these principles come up during the semester:

Principle #1: People Face Tradeoffs

Economists are fond of saying there is no such thing as a free lunch. This means that

making decisions requires trading off one goal for another. For example:
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When deciding how to use your time you have to choose how many hours to sleep vs. how many hours to study. You can not do both things at the same time. When deciding where to spend your money on a weekend you can not have an expensive dinner and go shopping the next day. You dont have enough money for both things. How much money is spent in defense requires allocating less money for education. Reducing industrial pollution increases the production costs of firms.

Nonetheless, recognizing that tradeoffs exist does not indicate what decisions should be

made. In fact economics will only point to the costs and benefits of each choice. It will not decide. Principle #2: The Cost of Something Is What You Give Up to Get It

Because of the existence of tradeoffs, making decisions requires individuals to consider the

benefits and costs of some action. Sometimes these costs are not obvious.
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What are the costs of going to college? Some are explicit, some are hidden: Tuition is a fairly obvious cost. Room and board are also explicit costs but we cannot count all of the cost because the person would have to pay for food and shelter even if she was not in school. We would want to count the value of the students time since she could be working for pay instead of attending classes and studying. This is an opportunity cost.

An opportunity cost is whatever must be given up to obtain some item. You can also think Opportunity Cost. Sleeping.

of it as the value of the best alternative that you have to forgo when you make a decision. Decision. Coming to class.

Sleeping. Staying home on a Friday night.

Coming to class and getting an education. Maybe missing the love of your life.

Principle #3: Rational People Think at the Margin

Besides all or nothing decisions (e.g.: sleeping vs. skipping class) we all make decisions

involving incremental choices: should I remain in school an extra semester? Should I overload this semester? Should I study an additional hour for tomorrows exam?

In economics we call these decisions marginal changes. A marginal change is a small Rational people compare the marginal benefit of a choice they are contemplating with its Marginal Benefit Quench thirst Finding everything funny Getting a buzz / Puking Marginal Cost. Less money for music CDs. Less money for movie tickets. Less money for food.

incremental adjustment to a plan of action. Look up how the OED defines marginal.

associated marginal cost and then make the appropriate decision. Decision. Drinking first beer. Drinking second beer. Drinking third beer.

We will revisit this concept later on when we talk about producers theory.

Principle #4: People Respond to Incentives

Because people make decisions by comparing costs and benefits, their decisions may When the price of a good rises, consumers will buy less of it because its cost has risen. When the price of a good rises, producers will allocate more resources to the production of When the government approves a tax or a subsidy it is affecting the decision process. When a fine is imposed it directly changes the cost-benefit balance.

change in response to changes in costs and benefits.

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the good because the benefit from producing the good has risen.

Nonetheless, government-generated positive or negative incentives can have unintended consequences, if not exactly the opposite as initially desired. Example: seat belt laws.

How People Interact Principle #5: Trade Can Make Everyone Better Off

Trade is not a zero-sum game where one party gains at the expense of the other party. This is a commonly heard fallacy regarding international trade. It is not a new lie, though.

If trade were not to be mutually beneficial eventually nobody would trade, except at gunpoint. The major benefit from trade is that it allows people to specialize in whatever they do best. We will see more about this later on. Many countries that once had centrally planned economies have abandoned this system and are trying to develop market economies. The market system works best. A market economy is an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services. The market-set prices reflect both the value of a product to consumers and the cost of the resources used to produce it. These prices are (most often) freely set by market participants.

Principle #6: Markets Are Usually a Good Way to Organize Economic Activity

You probably heard of the Scottish economist Adam Smith and the concept of the invisible hand that he coined in his 1776 work The Wealth of Nations. This idea suggests that although individuals are motivated by self-interest, a sort of invisible hand guides this self- interest into promoting societys economic well-being

Centrally planned economies have failed because they did not allow free markets to work. Government interference in a market (e.g.: taxes) may prevent prices from adjusting optimally, therefore the decisions that households and firms make can be inefficient.

Principle #7: Governments Can Sometimes Improve Market Outcomes

Not all government interventions in markets have negative consequences. In fact, there are two good reasons for the government to intervene: to promote efficiency and increase equity.

Government policy can be most useful when there is market failure (i.e.: a situation in which a market left on its own fails to allocate resources efficiently.) Examples of market failures are externalities (i.e.: when one persons actions impact positively or negatively the well-being of a bystander) and excessive market power (i.e.: the ability of a single economic actor (or small group of actors) to have a substantial influence on market prices.)

Government intervention may correct those externalities and curtail market power.

Additionally, a market economy rewards people for their ability to produce things that other people are willing to pay for, regardless of each individuals need for rewards (i.e.: if you fall sick and do not produce anything your income will disappear and you may starve to death.)

Therefore, there will be an unequal distribution of economic prosperity that may be socially and politically unacceptable.

How the Economy as a Whole Works Principle #8: A Countrys Standard of Living Depends on Its Ability to Produce Goods and Services

Differences in living standards among countries are quite large but they can always be traced back to the same issue: productivity (i.e.: the quantity of goods and services produced from each hour of a workers time.) The speed at which living standards improve is also a matter of how fast productivity rises so there is an obvious interest in the study of what determines economic productivity in a country.

Principle #9: Prices Rise When the Government Prints Too Much Money

When the cost of living increases in a country we say there is inflation (i.e.: an increase in the overall level of prices in the economy.) But, what causes inflation? The most accepted theory about the origins of inflation is the excessive money creation by the government. Roughly, when too much money is print the value of money falls and prices rise to reflect this fact. Many historical episodes back this theory: Germany after World War I (in the early 1920s), the United States in the 1970s, Latin America in the 1980s, Russia in the 1990s

Principle #10: Society Faces a Short-Run Tradeoff between Inflation and Unemployment Although inflation is bad in terms of eroding the purchasing power of wages it can have an associated positive effect on unemployment (for reasons that will be explained later on.)

This conclusion is based on the work of the British economist A. W. Phillips. In fact this particular tradeoff between inflation and unemployment is named the Phillips curve after him. This is a controversial topic among economists because it is not fully understood nor confirmed but it helps to understand business cycles (i.e.: fluctuations in economic activity, such as employment and production, during different periods of time.)