10 Principles of Economics- Jan 5th
What Economics is All About
Scarcity refers to the limited nature of society’s resources.
Economics is the study of how society manages its scarce resources, including
• how people decide how much to work, save,
and spend, and what to buy.
• how firms decide how much to produce,
how many workers to hire.
• how society decides how to divide its resources between national defense, consumer
goods, protecting the environment, and other needs.
Principle 1: People face Trade-offs
All decisions involve trade-offs, ex.
-going to a party the night before your midterm leaves less time for studying.
-having more money to buy stuff requires working longer house, leaving less time for leisure.
Society faces an important tradeoff:
efficiency vs. equity
efficiency: getting the most out of our scarce resources.
equity: distributing prosperity fairly among society’s members.
Tradeoff: Equity can be improved by redistributing income from the well-off to the poor. But
this reduces the incentive to work and produce, and shrinks the size of the economic “pie.”
Principle 2: The Cost of Something is What you Give up to Get it
-making decisions requires comparing the costs and benefits of alternative choices
-opportunity cost: whatever must be given up in order to obtain something
-ex: The opportunity cost of…
…going to college for a year is not just the tuition, books, and fees, but also the foregone wages.
…seeing a movie is not just the price of the ticket, but the value of the time you spend in the
theater. Principle 3: Rational People Think at the Margin
A person is rational if she systematically and purposefully does the best she can to achieve her
objectives, given the opportunities she has.
Many decisions are not “all or nothing,”
but involve marginal changes – incremental adjustments to an existing plan of action.
Rational people often make decisions by comparing marginal benefits and marginal costs.
-Ex: A student considers whether to go to college
for an additional year, comparing the fees & foregone wages to the extra income he could earn
with an extra year of education.
An airline deciding how much to charge passengers who fly standby will compare the extra
(marginal) cost of adding a passenger versus the extra revenue (marginal benefit) of filling that
Principle 4: People Respond to Incentives
incentive: something that induces a person to act, i.e. the prospect of a reward or punishment.
Rational people respond to incentives because they make decisions by comparing costs and
• In response to higher gas prices,
sales of “hybrid” cars (e.g., Toyota Prius) rise.
In response to higher cigarette taxes,
the incidence of smoking falls
Principle 5: Trade Can make Everyone Better Off
Rather than being self-sufficient, people can specialize in producing one good or service
and exchange it for other goods.
Countries also benefit from trade & specialization:
• get a better price abroad for goods they produce.
• buy other goods more cheaply from abroad than could be produced at home. Principle 6: Markets are Usually a Good Way to Organize Economic Activity
A market is a group of buyers and sellers.
(They need not be in a single location.)
“Organize economic activity” means determining
• what goods to produce
• how to produce them
• how much of each to produce
• who gets them
In a market economy, these decisions result from the interactions of many households and