Chapter 1: First Principles

Introduction: What you Will Learn in This Chapter

• A set of principles for understanding the economics of how individuals make choices

• A set of principles for understanding how economies work through the interaction of individual
choices

• A set of principles for understanding economy-wide interactions

A. Principles That Underlie Individual Choice: The Core of Economics

Individual choice is the decision by an individual of what to do, which necessarily involves a decision of
what not to do.

Basic principles behind the individual choices:

1. Resources are scarce.

2. The real cost of something is what you must give up to get it.

3. “How much?” is a decision at the margin.

4. People usually take advantage of opportunities to make themselves better off.

Principle# 1: Choices Are Necessary Because Resources Are Scarce

A resource is anything that can be used to produce something else.

• Examples: land, labour, capital, entrepreneurship (Four Factors of Production)

Resources are scarce – the quantity available isn’t large enough to satisfy all productive uses.

• Examples: petroleum, lumber, intelligence

Principle# 2: The True Cost of Something Is Its Opportunity Cost

The real cost of something is its opportunity cost: what you must give up in order to get it (the highest-
valued alternative foregone).

Opportunity cost is crucial to understanding individual choice

 Example: The cost of attending an economics class is what you must give up to be in the
classroom during the lecture. Sleep? Watching TV? Rock climbing? Work?

All costs are ultimately opportunity costs.

In fact, everybody thinks about opportunity cost.

The bumper stickers that say “I would rather be … (fishing, golfing, swimming, etc…)” are referring to
opportunity cost.

It is all about what you have to forgo to obtain your choice.

Principle# 3: “How Much?” Is a Decision at the Margin

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

• Decisions about whether to do a bit more or a bit less of an activity are marginal decisions.

• Marginal Analysis

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.

The study of such decisions is known as marginal analysis.

• Examples: Hiring one more worker, studying one more hour, eating one more cookie, buying
one more CD, etc.

Principle# 4: People Usually Respond to Incentives, Exploiting Opportunities to Make Themselves

Better Off

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

• Examples:
1. Price of gasoline rises à people buy more fuel-efficient cars;
2. There are more well-paid jobs available for college graduates with economics degrees à
more students major in economics.

People respond to these incentives.

B. Interaction: How Economies Work

Interaction of choices—my choices affect your choices, and vice versa—is a feature of most economic
situations.

Principles that underlie the interaction of individual choices:

1. There are gains from trade.

2. Markets move toward equilibrium.
3. Resources should be used efficiently to achieve society’s goals.
4. Markets usually lead to efficiency.
5. When markets don’t achieve efficiency, government intervention can improve society’s welfare.
Principle# 5: There Are Gains From Trade

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

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.

Principle# 6: Markets Move Toward Equilibrium

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

Any time there is a change, the economy will move to a new equilibrium.

 Example: What happens when a new checkout line opens at a busy supermarket?

Principle #7: Resources Should Be Used Efficiently to Achieve Society’s Goals

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

Should economic policy makers always strive to achieve economic efficiency?

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.

Efficiency vs. Equity

• Example: Handicapped-designated parking spaces in a busy parking lot

• A conflict between:

 equity, making life “fairer” for handicapped people, and

 efficiency, making sure that all opportunities to make people better off have been fully
exploited by never letting parking spaces go unused.

• How far should policy makers go in promoting equity over efficiency?

Principle #8: Markets Usually Lead to Efficiency

The incentives built into a market economy already ensure that resources are usually put to good use.

Opportunities to make people better off are not wasted.

• Exceptions: Market failure (the individual pursuit of self-interest found in markets makes society
worse off )à the market outcome is inefficient
Principle #9: When Markets Don’t Achieve Efficiency, Government Intervention Can Improve Society’s
Welfare

Why do markets fail?

• Individual actions have side effects not taken into account by the market (externalities).

• One party prevents mutually beneficial trades from occurring in the attempt to capture a
greater share of resources for itself.

• Some goods cannot be efficiently managed by markets. Example: air traffic control

C. Economy-Wide Interactions
Principle# 10: One person’s spending is another person’s income.

During recessions, a drop in business spending leads to:

• Less income, less spending…and further drops in business spending, layoffs, and rising
unemployment.

Principle# 11: Overall spending sometimes gets out of line with the economy’s productive capacity.

Overall spending (amount of goods and services that consumers and businesses want to buy) sometimes
doesn’t match the amount the economy is capable of producing.

When the overall spending falls short of what is needed to keep workers employed, the economy
experiences recession.

When overall spending outstrips the supply, the economy experiences inflation.

When the economy experiences shortfalls or excesses in spending, government policies can be used to
address the imbalances.

Principle# 12: Government policies can change overall spending.

Economic growth: the increase in living standards over time.

Economy’s potential: the total amount of goods and services it can produce.

Emergence of new technologies and increases in resources available for production boost the
economy’s potential, hence living standards.

Increases in living standards are usually unequally distributed among a country’s residents, creating
winners and losers.

For example, new sources of energy benefit the economy and the environment—they are winners. But
at the same time, the reduced demand for coal has hurt mining communities, creating losers.