Chapter 1: Ten Principles of Economics
Scarcity: the limited nature of society’s resources
Economics: the study of how society manages it scarce resources
“How do people decide how much to work” = time is a scarce resource, not enough time to do
everything we want. There is a tradeoff; the more time we spend working, the higher our
income but less time for leisure and vice versa.
“How do firms decide what kind of labor”= unskilled or skilled workers. Skilled are more
productive but unskilled are cheaper.
“How do firms decide how to produce”= it depends on the price and the demand, the more
demand the cheaper the product.
Principles of How People Make Decisions
1) Principle #1: People Face Tradeoffs
-to get one thing we like, we usually have to give up another thing we like. Making decisions
requires trading off one goal against another.
-Society faces an important trade off: Efficiency vs. Equality
Efficiency: when society gets the most from its scarce resources
Equity: when prosperity is distributed uniformly among society’s members
-In essence, efficiency refers to the size of the economic pie and equity refers to how the pie is
Tradeoff: To achieve great equality, we could redistribute income from wealthy to poor
(through progressive tax system, as well as social programs like food stamps and unemployment
insurance that try to provide a safety net for people at the low end of the income distribution) =
equity. This reduces incentives to work and produce which shrinks the size of the economic pie =
2) Principle #2: The Cost of Something is What You Give up to Get It
-Because people face trade off, making decisions require comparing the costs and benefits of
alternative courses of actions. Cost of action is not as obvious as it might first appear.
Example: Cost of going to university is not only books and tuition; it’s also time and potential
wages you could have earned throughout the year.
Opportunity Cost: of an item is what you give up to get that item. Example, seeing a movie is
not just the price of the ticket but the value of the time you spend in the theatre.
-“The best things in life are free”= even things without an explicit monetary costs are not truly
free because they have an opportunity cost (love/scenery =foregone wages)
3) Principle #3: Rational People Think at the Margin
Rational People: systematically and purposefully do the best they can to achieve their
objectives. They make decisions by evaluating costs and benefits of marginal changes-
incremental adjustments to an existing plan.
-Rational people often make decisions by comparing marginal benefits and marginal costs.
-The Diamond-Water Paradox: water is essential for life but virtually free; diamonds are
inessential but expensive. This is based on marginal benefit where it depends on how many
units a personal already has therefore diamonds are rare = marginal benefit.
-The near zero marginal cost of an airline taking an extra passenger when the flight isn’t full4) Principle #4: People Respond to Incentives
Incentive: something the induces a person to act (reward/punishment)
-Rational people respond to incentives because they make decisions by comparing costs and
-Text Example: There use to be no seatbelts in cars which made people drive slowly and
carefully. Government enforced seatbelt laws which actually increased accidents. Less drivers
injured/died but more pedestrians got hurt.
Example: You are selling car, you already spent 1000 on repairs and then transmission breaks
down. It is 600 to fix it.
-Option 1: Book value is 6500 if transmission works, 5700 if it doesn’t. Benefit of fixing
-Option 2: Book value is 6000 if transmission works, 5500 if it doesn’t. Benefit of fixing
transmission is 500. Paying 600 is not worthwhile.
Summary: People face tradeoffs among alternative goals, the cost of any action is measured in
terms of forgone opportunities, rational people make decisions by comparing marginal costs
and marginal benefits, and that people change their behavior in response to the incentives they
How People Interact
5) 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 because it aids in getting a better price
abroad for goods they produce and you are able to buy other goods more cheaply from abroad
than produced at home.
6) Principle #6: Markets are Usually a Good Way to Organize Economic Activity
Market: a group of buyers and sellers (need not be in a single location)
-“Organize economic activity” means determining: what is