Chapter 1: First Principles

Introduction

Many principles involve *individual choice.* Decisions involve making a choice from among a limited number of alternatives (scarcity, constraints). But, it's not only that simple. *We also make decisions in an environment that is shaped by the decisions of others.* Each person in a market economy depends on many others; our choices interact. *Economics at a basic level is about individual choice, to understand market economies, we need to look at economic interaction; how my choices affect your choices, and vice versa.*

Define: opportunity cost

The real cost of an item is its opportunity cost; it's what you must give up in order to get something.

Define: equity

equity means that everyone gets his or her fair share. Since people can disagree about what's "fair," equity isn't as well defined a concept as efficiency.

Objective:

1) A set of principles for understanding the economics of how individuals make choices 2) A set of principles for understanding how economies work through the interaction of individual choices 3) A set of principles for understanding economy-wide interactions

Chapter 1 Summary:

1) all economic activities involve individual choice 2) people must make choices because resources are scarce 3) the real cost of something is its opportunity cost -- what you must give up to get it. All costs are opportunity costs. Monetary costs are sometimes a good indicator of opportunity costs, but not always. 4) Many choices involve not whether to do something, but how much of it to do. "How much" choices call for making a tradeoff at the margin. The study of marginal decisions is known as marginal analysis. 5) Because people usually exploit opportunities to make themselves better off, incentives can change people's behavior. 6) Most economic situations involve the interaction of choices, sometimes with unintended results. In a market economy, interactions occurs via trade between individuals. 7) Individuals trade because there are gains from trade, which arise from specialization. Markets usually move toward equilibrium b/c people exploit gains from trade. 8) To achieve society's goals, the use of resources should be efficient. But equity, as well as efficiency, may be desirable in an economy. There is often a tradeoff between equity and efficiency. 9) Except for certain well-defined exceptions, markets are normally efficient. When markets fail to achieve efficiency, government intervention can improve society's welfare. 10) In a market economy, one person's spending is another person's income. As a result, changes in spending behavior have repercussions that spread through the economy. 11) Overall spending sometimes gets out of line with the economy's capacity to produce goods and services. When spending is too low, the result is a recession. When spending is too high, it causes inflation. 12) Modern governments use macroeconomic policy tools to affect the overall level of spending in an effort to steer the economy between recession and inflation.

Individual Choice Principles:

1. *Choices are necessary because resources are scarce.* You cannot always get what you want. There are constraints on income, health, time, etc. So, you must make choices on how you want to spend your money, what you do with your 24 hours in a single day, etc. Many people are so limited by the number of hours in a day, they're willing to trade money for time (convenience store charge higher prices than regular supermarkets). *People must make choices because resources are scarce.* Examples of scarce resources: minerals, lumber, petroleum, labor, skill, intelligence, water. *As individuals must make choices, so must society as a whole.* 2) *The true cost of something is its opportunity cost.* The opportunity cost of an item -- what you must give up in order to get that item -- is its true cost. This cost involves more than a straight monetary value. *Every choice you make means forgoing the next best alternative.* Example: You must decide between taking Computer Science course of a Music Theory course. Both at $750. The opportunity cost of taking Music Theory class is the skill you would've gained from the computer science class, and the $750 which you could've spent on anything else besides a class. Example: Going to college. The opportunity cost does include tuition and housing costs (monetary expenses), but also the income students would make if they worked instead of schooled, or the experiences they could have if they travelled instead of schooled. 3) *"How much" is a decision at the margin.* While some important choices include an "either-or" choice (ex. go to college for 4 years of work full time), many important decisions impact "how much" you do something. You'll do an action anyway, but "how much" of it you do may need to be considered. How much time will you spend studying on your econ final compared to your comp sci final, etc. This decision involves a trade off. Decisions of this type are called marginal decisions. *"How much" decisions require making trade-offs at the margin: comparing the costs and benefits of doing a little bit more of an activity versus doing a little bit less."* 4) *People usually respond to incentives, exploiting opportunities to make themselves better off.* When people are offered opportunities to make themselves better off, they normally take them. They respond to incentives, and exploit these beneficial opportunities until they're exhausted. This is the basis of all predictions by economists; rational behavior. *Economists tend to be skeptical of any attempt to change people's behavior that doesn't change their incentives." If someone won't benefit more by changing their behavior, why change it?

Economy Wide Interactions Principles:

10) *One person's spending is another person's income.* Small economic changes have a chain reaction. Lower spending on certain goods may result in lower income throughout an economy; so as spending falls, income falls. Ex: a cut in business investment spending, like the one that happened in 2008, leads to reduced family incomes, and families respond by reducing consumer spending, which leads to another round of income cuts, etc. 11) *Overall spending sometimes gets out of line with the economy's productive capacity.* Macro economics emerged when a collapse of consumer and business spending, a crisis in the banking industry, and other factors, led to a plunge in overall spending, leading to the Great Depression. The lesson? Overall spending (the amount of goods and services that consumers and businesses want to buy), sometimes don't match up with the amount of goods and services the economy is capable of producing. *If overall spending is too high, the economy experiences inflation, a rise in prices throughout the economy. This rise in prices occurs because when the amount that people want to buy outweighs the supply, produces raise their prices and still find willing customers. 12) *Government policies can change spending.* Dramatically. The government itself does a lot of spending (military equipment, education, etc), and can choose to do more or less. It can vary how much it collects from public taxes, which impacts how much income consumers and businesses have left to spend. It can control the quantity of money in circulation. *Gov spending, taxes, and control of money are the tools of macro economic policy.*

12 Basic Principles:

4 Principles Involving Individual Choice: 1. Choices are necessary because resources are scarce 2. The true cost of something is its opportunity cost 3. "How much" is a decision at the margin 4. People usually respond to incentives, exploiting opportunities to make themselves better off 5 Principles Involving Individual Choice Interaction: 5. There are gains from trade 6. Markets move toward equilibrium 7. Resources should be used efficiently to achieve society's goals 8. Markets usually lead to efficiency 9. When markets don't achieve efficiency, government intervention can improve society's welfare 3 Principles Involving Economy-Wide Interaction: 10. One person's spending is another person's income 11. Overall spending sometimes gets our of line with the economy's productive capacity 12. Government policies can change spending

Interaction of Individuals Principles: How Economies Work

5) *There are gains from trade.* There is a much better standard of living for everyone when there is trade involved; people provide the good or service for which they have highest comparative advantage (lowest opportunity cost). We have an economy because there aren't too many self sufficient individuals, so there are gains from trade, where people can get more of what they want than they could have gotten by being self sufficient. Trade arises from specialization, and the advantages of it are discussed in Adam Smith's book, The Wealth of Nations. We realize that *the economy as a whole can produce more when each person specializes in a task and trades with others.* This is why people typically choose only one career. 6) *Markets move toward equilibrium.* People will make the choices that will benefit them the most until they're exhausted; in a situation in which individuals cannot make themselves better off by doing something different is called equilibrium. *An economic situation is in equilibrium when no individual would be better off doing something different. Because people respond to incentives, markets move toward equilibrium.* The fact that markets naturally move towards equilibrium is why we can depend on them to work in predictable ways.'' 7) *Resources should be used efficiently to achieve society's goals.* An economy's resources are used efficiently when they are use din a way that has fully exploited all opportunities to make everyone better off; aka efficiently. *When an economy is efficient, it is producing the maximum gains from trade possible, given the resources available.* However, should economic policy makers always strive to achieve efficiency? Not quite, because the efficient outcome at not exactly align with society's goals. There is typically a trade off between equity and efficiency: *policies that promote equity often come at a cost of decreased efficiency in the economy, or vice versa.* Consider the parking lot example, and handicap spaces.... 8) *Markets usually lead to efficiency.* The incentives built into a market economy ensure that resources are usually put to good use and that opportunities to make people better off are not wasted. However, there are exceptions to this principle. In cases of market failure, the individual pursuit of self interest found in markets make society worse off; the market outcome may be inefficient. 9) *When markets don't achieve efficiency, government intervention can improve society's welfare.* Here are why markets may fail: a. Individual actions have side effects that are not properly taken into account by the market. An example is an action that causes pollution. b. One party prevents mutually beneficial trades from occurring in an attempt to capture a greater share of resources for itself. An example is a drug company that prices a drug higher than the cost of producing it, making it unaffordable for some people who need it. c. Some goods, by their very nature, are unsuited for efficient management by markets. For example, air traffic control. Government policies are appropriate for each situation. This may show up in adding subsidies, tolls, taxes, etc.

Define: incentive

An incentive is anything that offers rewards to people who change their behavior.

Define: marginal decisions

Decisions about whether to do a bit more or a bit less of an activity are marginal decisions. The study of such decisions is known as marginal analysis.

Scarcity and Rescources

Resources are scarce; there's not enough of the resources available to satisfy all the various ways a society wants to use them.

Define: equilibrium

an economic situation is in equilibrium when no individual would be better off doing something different.

Define: efficient

an economy is efficient if it takes all opportunities to make some people better off without making other people worse off

Define: Resource

anything that can be used to produce something else

Define: trade

in a market economy, individuals engage in trade: they provide goods and services to others and receive goods and services in return

Define: interaction

interaction of choices -- my choices affect your choices, and vice versa -- is a feature of most economic situations. The results of this interaction are often quite different from what the individuals intend.

Define: Individual Choice

the decision by an individual of what to do, which necessarily involves a decision of what not to do

Define: gains from trade and specialization

there are gains from trade: people can get more of what they want through trade than they could if they tried to be self sufficient. This increase in output is due to specialization: each person specializes in the task that he or she is good at performing (has less opportunity cost).

Define: trade off

you make a trade off when you compare the costs with the benefits of doing something.