Ten Principles of Economics

The scarcity of nearly all resources requires that we manage their use – we simply cannot produce all of the goods and services that people would wish to have…

…each member of society cannot have everything they might want or achieve the highest standard of living to which they might aspire…

Economics is the study of how individuals and societies make

decisions about how to utilize their scarce resources…

Resources are generally placed into one of three categories (or “Factors of

Production”)…“Land” refers to the materials required to produce goods and services

“Labor” refers to the manpower required to

produce goods and services

“Capital” refers to the equipment, machinery and facilities required to produce goods and services

How people make decisions…

Principle #1: Trade-offs (There is no such thing as a free lunch!)To get one thing we want, we often have to give up something else we want

Making decisions often require that we

trade-off one goal against

another

Some classic economic trade-offs:• “Guns or Butter” – National defense or Consumer

goods?• Clean environment or Lower prices and Higher

income?• “Equality or Efficiency” – Government redistribution of

wealth (welfare, unemployment, Medicare, etc.) helps promote equality in society but reduces incentives for maximizing production (loss of profit through taxation)

Principle #2: Cost-Benefit Analysis (Oh, what could have been!)

Every decision had both costs and benefits!

The costs (or benefits) of a decision aren’t always obvious:• Time• Loss of resources

that could be used for other goals

• Loss of currently available alternative opportunities and activities

• Reputation• Future opportunities

or consequences

The goals and resources that you give up to get something are called the Opportunity Cost

of that decision.

Principle #3: Rationality (Living on the edge!)

This child faces a decision about whether to add one more block to her tower. She must consider:• The extra block will make her tower

taller and more impressive (benefit)• The extra block will make the tower

fall (cost)She is considering a “marginal change” in her plan of action by weighing the marginal costs and marginal benefits of adding a block.

Most of our decisions are not black or white, they are in the gray area - at the margin, or edge – does the marginal benefit outweigh the marginal cost of one added unit of resource (material, time, effort)?

A Case in Point…Pricing for Stand-by

FlightsA 200 seat

airplane costs $100,000

dollars to fly

The average cost per

passenger is therefore $500

Never sell tickets for less than

$500

But what if there are empty seats on the flight?

Each empty seat costs the airline $500.

If the seat is sold for $300, only the marginal (extra

cost) of that passenger is lost

since the seat would be empty

anyway ($500 lost)

The only marginal cost is the peanuts and

soda the passenger gets

($3).

So, it is better to sell the seat for less than $500 than to let it go empty (the

marginal benefit - $300 – is greater than the marginal cost – ($3 for soda and a bag

of peanuts)

Principle #4: Incentives (What’s in it for me?)

People will work hard for rewards and go out of their way to avoid punishment. This basic psychological idea is the foundation of all economic behavior – the rest is detail.

Some examples:

• High prices punish consumers (so they buy less), but reward producers (they will make more)

• Low interest rates punish savers (they get less for saving) but reward borrowers (they have to pay less for their loans)

• Tax deductions for mortgage interest reward homeowners (they pay less tax) and encourage people to buy houses

• Higher gas taxes would reward (and so encourage) carpooling, hybrid cars and use of public transportation

A Case in Point…The National Seatbelt Law

Before seatbelts…

Drive slowly and carefully?

Takes longer

Arrive safely, survive

accidents

Drive slowly and carefully!

After seatbelts…

Drive slowly and carefully?

Takes longer

Arrive safely, survive accidents

Drive much faster!

The requirement of seat belts changed the incentives for

drivers

and changed their behavior – more accidents, more

pedestrian deaths, fewer passenger deaths

Drivers were rewarded for slow speeds with more safety – fewer accidents

How people interact…

Principle #5: Trade (Everyone wins when trade is fair and free)

Allows nations to specialize in what they do best and have resources to produce.

Allows nations to enjoy a greater variety of goods and services

Competition can keep prices lower

Can lead to more efficient, cost-effective use of resources

Some trade terms…

Balance of Trade: the balance between a nation’s exports

(goods sold to trading partners – money in!) and imports (goods bought from trading partners –

money out!)Exports

Imports

ExportsMoney in

Exports

Money in

ImportsMoney

outImports

Money out

Trade Deficit: imports (money out!) outweigh exports (money in!)

Trade Surplus: exports (money in!) outweigh imports (money out!)

We spend more on foreign goods than we make selling

our goods

We make more from selling our goods than we lose buying

foreign goods

Principle #6: Markets (The Invisible Hand that drives the economy)

A market economy is one in which buyers (consumers) and sellers (producers) interact – all trying independently to minimize their costs and maximize their benefits…

The “Invisible Hand” was coined by

Adam Smith to describe

the behavior of people in a

market

The result of their interactions is the regulation of prices and the available quantity of goods and services – without a centralized decision-maker.

The “Invisible Hand” uses

price to guide the self-

interested behavior of

people interacting in

a market

A Case in Point…The Demise of the Sony Walkman

Behold the Walkman – take your music with you!! - $259.00

Enter the iPod – smaller, more capacity, no

tapes!! - $299.00

As the iPod became popular, demand for the Walkman decreases, by fall 2002, the Walkman

sells for $78!

Apple Launches iTunes in 2003, demand for iPods grows. Walkman can be bought for under $30 !!

In the market for personal audio devices, consumer

demand and producer innovation (iPod Touch,

iPhone, iPad – all with audio) have determined both the quantity, type and price of

players available.

Principle #7: Government (A helping hand for the Invisible Hand)

Government protects

property rights through rules

and regulationsWithout these protections,

there would be less incentive to

produce

The Economic

Pie

Government action in the economy serves one of two specific goals:

Make more and bigger pies:• Increase efficiency of

production and use of resources – encourage production and investment

• Prevent harmful externality (negative impact of a person’s actions on the well being of others) – ex. Pollution

• Prevent market power (the ability of one person to control market prices) – ex. monopolies

Divide the pie more evenly:• Use income taxes and

public programs to achieve a more equal distribution of economic well-being

• Balance economic inequalities created by social prejudices and discrimination

Promote equality

Promote efficiency

How the Economy works as a Whole…Principle #8: Productivity (Got to keep producing

stuff)

Productivity is the amount of goods and services produced

by a unit of labor.

Productivity = Standard of

Living Average IncomeSome Key Factors: Education

of labor force, quality tools and technology

Principle #9: Inflation (The cost of having too much money!)Inflation is a general rise in the prices of goods and services. It can come from three sources (all

related to quantity of money):

Demand Pull: Too much money chasing after too few goods (very high demand for a good raises prices)

Cost Push: Something happens to raise the cost of

producing a good or service (raising the

price of the good)

Government allows too much money in circulation: Lowers

the value of the money, raising prices

of goods

Principle #10: Inflation and Unemployment (More Trade-off)

Here’s how the trade-off works:• Increasing money stimulates spending

and demand• Higher spending and demand raises

prices (increasing inflation)• Higher spending and demand also

encourages businesses to hire workers (decreasing unemployment)

• Decreasing money does the opposite

These are short-run effects that can be manipulated by government policy to respond to the business cycle (fluctuations in employment and production).

• People make trade-offs in all economic decisions (No free lunches!)

• The cost of something is exactly what you give up to get it (Opportunity cost!)

• Rational people make decisions at the margins (The cost/benefit of just one more!)

• People respond and act according to incentives (What’s in it for me!)

• Trade can make everybody better off (Variety is the spice of life!)

• Markets are a good way to regulate price and quantity of goods (The helpful Invisible Hand!)

• Governments can sometimes improve market outcomes (Helping the helpful Invisible Hand!)

• Productivity determines Standard of Living (Must keep producing goods!)

• Inflation is almost always about too much money (The cost of too much money!)

• In the short-run we trade-off between inflation and unemployment (Wiggle room!)

So, lets review…

Terminology

• Scarcity• Economics• Trade-off• Efficiency• Equality• Opportunity Cost• Cost/Benefit Analysis• Rationality• Margin• Marginal Change• Marginal Cost• Marginal Benefit• Incentive• Market Economy• Invisible Hand• Property Rights• Market Failure• Externality• Market Power• Productivity• Inflation• Demand Push• Cost Pull• Trade Surplus• Trade Deficit• Trade Balance• Business Cycle

• Limits on the availability of nearly all resources• The study of how we make decisions about how to use our

scarce resources• Giving up one item/goal in order to achieve another item/goal• Society getting the most that it can out of its resources• Distributing economic prosperity uniformly among members of

society• Whatever is given up in order to obtain some item/goal• Weighing the relative importance of the costs and benefits of a

decision• Systematically doing the best possible to achieve goals given

available opportunity• The edge (adding or subtracting one more unit of something)• Small, incremental changes in a plan to achieve a goal• The cost of adding one more unit of something• The benefit of adding one more unit of something• A reward, positive outcome that encourages an

action(disincentive is the opposite)• An economy that uses resources according to the interaction of

many people• Self-interest that guides and regulates a market through the

price of goods• The right to own and exercise control over one’s scarce

resources• When a market, left on its own, fails to use resources efficiently• The effect of one person’s actions on the well-being of others• The ability of a single person to substantially impact market

prices• Quantity of goods and services produced by one unit of labor• General increase in prices• Inflation caused by too much money chasing too few goods (too

high demand)• Inflation caused by rising prices of production (land, labor,

capital)• When the value of exports exceeds the value of imports• When the value of imports exceeds the value of exports• When the value exports and imports is equal• Normal fluctuations in production and employment