INTRODUCTORY ECONOMICS (ECON 101)

Unit 1
BASIC ECONOMIC CONCEPTS

Topic 2: TEN PRINCIPLES OF ECONOMICS

INTRODUCTION

The word economy comes from the Greek word for “one who manages a household.” At first,
this origin might seem peculiar. But, in fact, households and economies have much in
common. A household faces many decisions. Like a household, a society faces many
decisions. Household and economy have much in common

Households Society
 Faces decisions  Faces decisions like what jobs will be
 It decides which member of the done and who will do them
household do which task and what  It must allocate the output of goods and
members get in return services that they produce e.g. who
 In short, the household must allocate its should eat rice, potatoes
scarce resources among its various  Management of society’s resources are
members taking into account each important because resources are scarce
member’s abilities, efforts and desires

Although the study of economics has many facets, the field is unified by several central ideas.
In this Unit, we look at Ten Principles of Economics. These principles are discussed more in
detailes throughout the course.

HOW PEOPLE MAKE DECISIONS

Principle #1: People Face Tradeoffs

The first lesson about making decisions is summarized in the adage: “There is no such thing
as a free lunch.” To get one thing that we like, we usually have to give up another thing that we
like. Making decisions requires trading off one goal against another.

Or consider parents deciding how to spend their family income. They can buy food, clothing, or
a family vacation. Or they can save some of the family income for retirement or the children’s
college education. When they choose to spend an extra dollar on one of these goods, they
have one less dollar to spend on some other good.

When people are grouped into societies, they face different kinds of tradeoffs. The classic
tradeoff is between “guns and butter.” The more we spend on national defense to protect our
shores from foreign aggressors (guns), the less we can spend on consumer goods to raise our
standard of living at home (butter).

Another tradeoff society faces is between efficiency and equity. Efficiency means that society
is getting the most it can from its scarce resources. Equity means that the benefits of those

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resources are distributed fairly among society’s members. In other words, efficiency refers to
the size of the economic pie, and equity refers to how the pie is divided. Often, when
government policies are being designed, these two goals conflict.

Principle #2: The Cost of Something is What You Give Up to Get It

Because people face tradeoffs, making decisions requires comparing the costs and benefits of
alternative courses of action. In many cases, however, the cost of some action is not as
obvious as it might first appear. Consider, for example, the decision whether to go to college.
The benefit is intellectual enrichment and a lifetime of better job opportunities. But what is the
cost?

The opportunity cost of an item is what you give up to get that item. It is the value of the best
alternative foregone when an item or activity is chosen. When making any decision, such as
whether to attend college, decisionmakers should be aware of the opportunity costs that
accompany each possible action.

Principle #3: Rational People Think at The Margin

Economists use the term marginal changes to describe small incremental adjustments to an
existing plan of action. Keep in mind that “margin” means “edge,” so marginal changes are
adjustments around the edges of what you are doing.

To make this decision, you need to know the additional benefits that an extra year in school
would offer (higher wages throughout life and the sheer joy of learning) and the additional
costs that you would incur (tuition and the forgone wages while you’re in school). By
comparing these marginal benefits and marginal costs, you can evaluate whether the extra
year is worthwhile.

As these examples show, individuals and firms can make better decisions by thinking at the
margin. A rational decisionmaker takes an action if and only if the marginal benefit of the action
exceeds the marginal cost.

Principle #4: People Respond to Incentives

Because people make decisions by comparing costs and benefits, their behavior may change
when the costs or benefits change. That is, people respond to incentives. When the price of an
apple rises, for instance, people decide to eat more pears and fewer apples, because the cost
of buying an apple is higher. At the same time, apple orchards decide to hire more workers
and harvest more apples, because the benefit of selling an apple is also higher.

Public policymakers should never forget about incentives, for many policies change the costs
or benefits that people face and, therefore, alter behavior. A tax on gasoline, for instance,
encourages people to drive smaller, more fuel-efficient cars. It also encourages people to take
public transportation rather than drive and to live closer to where they work. If the tax were
large enough, people would start driving electric cars.

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Exercise: For example, consider public policy regarding auto safety. Today all cars have seat
belts, but that was not true 40 years ago. In the late 1960s, Ralph Nader’s book Unsafe at Any
Speed generated much public concern over auto safety. Congress responded with laws
requiring car companies to make various safety features, including seat belts, standard
equipment on all new cars. How does a seat belt law affect auto safety? The direct effect is
obvious.

HOW PEOPLE INTERACT

Principle #5: Trade Can Make Everyone Better Off

Trade between two countries can make each country better off. Consider how trade affects
your family. When a member of your family looks for a job, he or she competes against
members of other families who are looking for jobs. Families also compete against one another
when they go shopping, because each family wants to buy the best goods at the lowest prices.
So, in a sense, each family in the economy is competing with all other families. Despite this
competition, your family would not be better off isolating itself from all other families. If it did,
your family would need to grow its own food, make its own clothes, and build its own home.
Clearly, your family gains much from its ability to trade with others. Trade allows each person
to specialize in the activities he or she does best, whether it is farming, sewing, or home
building. By trading with others, people can buy a greater variety of goods and services at
lower cost. Countries as well as families benefit from the ability to trade with one another.
Trade allows countries to specialize in what they do best and to enjoy a greater variety of
goods and services.

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

A market economy an economy that allocates resourcesthrough the decentralized decisions of

Central planners failed because they tried to run the economy with one hand tied behind their
backs—the invisible hand of the marketplace. At first glance, the success of market economies
is puzzling. After all, in a market economy, no one is looking out for the economic well-being of
society as a whole. Free markets contain many buyers and sellers of numerous goods and
services, and all of them are interested primarily in their own well-being. Yet, despite
decentralized decisionmaking and self-interested decisionmakers, market economies have
proven remarkably successful in organizing economic activity in a way that promotes overall
economic well-being.

Principle #7: Governments can Sometimes Improve Market Outcomes

There are two broad reasons for a government to intervene in the economy: to promote
efficiency and to promote equity. That is, most policies aim either to enlarge the economic pie
or to change how the pie is divided. The invisible hand usually leads markets to allocate
resources efficiently. Nonetheless, for various reasons, the invisible hand sometimes does not
work. Economists use the term market failure to refer to a situation in which the market on its

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own fails to allocate resources efficiently. One possible cause of market failure is an
externality. An externality is the impact of one person’s actions on the well-being of a
bystander. The classic example of an external cost is pollution.

Another possible cause of market failure is market power. Market power refers to the ability of
a single person (or small group of people) to unduly influence market prices.

HOW THE ECONOMY AS A WHOLE WORKS

Principle #8: A Country’s Standard of Living Depends on its Ability to Produce Goods
and Services

Almost all variation in living standards is attributable to differences in countries’ productivity—

Principle #9: Prices Rise When the Government Prints too much Money

Inflation an increase in the overall level of prices in the economy. Because high inflation
imposes various costs on society, keeping inflation at a low level is a goal of economic
policymakers around the world.

What causes inflation? In almost all cases of large or persistent inflation, the culprit turns out to
be the same—growth in the quantity of money. When a government creates large quantities of
the nation’s money, the value of the money falls.

Principle #10: Society Faces a Short-Run Tradeoff between Inflation and Unemployment

If inflation is so easy to explain, why do policymakers sometimes have trouble ridding the
economy of it? One reason is that reducing inflation is often thought to cause a temporary rise
in unemployment. The curve that illustrates this tradeoff between inflation and unemployment
is called the Phillips curve, after the economist who first examined this relationship. Phillips
curve: a curve that shows the short-run tradeoff between inflation and unemployment