Ten Principles of Economics
In this chapter, look for the answers to these questions:
• What kinds of questions does economics address?
• What are the principles of how people make decisions?
• What are the principles of how people interact?
• What are the principles of how the economy as a whole works?
What Economics Is All About
• Scarcity: the limited nature of society’s resources
• Economics: the study of how society manages its scarce resources, e.g.
• how people decide what to buy, how much to work, save, and spend
• how firms decide how much to produce, how many workers to hire
• how society decides how to divide its resources between national defence, consumer goods, protecting
the environment, and other needs
Points to elaborate on. Some examples:
“How do people decide how much to work?” Time is scarce resource – there’s just not enough time to do everything
we’d like to do. How do we decide how much of our time to spend working? There’s a tradeoff: the more time we
spend working, the higher our income, and therefore the more stuff we can buy. But, the more time we spend
working, the less time we have for leisure – hanging out with friends, going hiking, watching movies, etc. (You
might want to ask your students how THEY decide how much time to spend working. Some will say it depends on
how many classes they are taking, or the time requirements of the available jobs. But probably at least a few will say
the wage – the higher the wage, the more worthwhile to work.)
“How do firms decide what kind of labor to hire?” Firms can hire unskilled or skilled workers. The skilled workers
are more productive, but cost more than the unskilled workers.
“How do firms decide how much to produce?” Ask your students, and see if any of them say “it depends on the
price of the product they sell.” (Probably some will say “it depends on whether there’s a lot of demand for the
product”. To which you might respond “and if there’s a lot of demand for the product, what does that mean for the
price that firms can get for the product?”)
The Principles of how People Make Decisions
Principle #1: People Face Tradeoffs
All decisions involve tradeoffs. Examples:
• Going to a party the night before your midterm leaves less time for studying.
• Having more money to buy stuff requires working longer hours, which leaves less time for leisure.
• Protecting the environment requires resources that could otherwise be used to produce consumer goods.
Society faces an important tradeoff:
efficiency vs. equality
Efficiency : when society gets the most from its scarce resources
Equity : when prosperity is distributed uniformly among society’s members
Tradeoff: To achieve greater equality, could redistribute income from wealthy to poor.
But this reduces 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.
• The opportunity cost of any item is whatever must be given up to obtain it.
• It is the relevant cost for decision making.
Examples: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 cinema.
• systematically and purposefully do the best they can to achieve their objectives.
• make decisions by evaluating costs and benefits of marginal changes – incremental adjustments to an
• When a student considers whether to go to college for an additional year, he compares the fees & foregone
wages to the extra income he could earn with the extra year of education.
• When a manager considers whether to increase output, she compares the cost of the needed labour and
materials to the extra revenue.
Principle #4: People Respond to Incentive
• Incentive: something that induces a person to act, i.e. the prospect of a reward or punishment.
• Rational people respond to incentives.
• When gas prices rise, consumers buy more hybrid cars and fewer gas guzzling SUVs.
• When cigarette taxes increase, teen smoking falls.
The Principles of How People Interact
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
• 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
If each person had to grow his own food, make his own clothes, cut his own hair, we would have a world full of