TEN PRINCIPLES OF ECONOMICS ] ord economy comes from the Greek word for|“one wha manages a house- At first, this origin might seem peculiar. But, in fact, houscholds and economies have much in common. A household faces many decisions. It must dicide which members of the household do which tasks and what each member gets in retum, Who cooks din- nex? Who does the laundry? Who gets the extra dessert ot dinner? Who gets to choose what TV show to watch? In short, the housshold must alhwale its scarce resources among its various members, taking into pccount cach member's abilt nem ellos, and desires Like « household, » society faces many decision. A society must deciche what bbe done and who will do them. It need} some pople to grow food, other people to make clothing, and still others to depign computer software. Once society has allocated people (as well as land, bui ous jabs. itm tput of good ings, anct machines) to var 4 mevices that they p nd who will eat potatoes jecide who will drive a Porsche and who will taki the bus also allocate the o re It must decide who will « In THIS CHAPTER you witt Lawn that vcomownice tt about the allocation af scarce ernourses Eewmnine some of the tradeoff that people face Learn the meaning of opportunity cost See howw to ise marginal remsoning when maxing decisions Discuss how incentives affect people's behavior Consider why trade ‘among people or mations cam be good for everyone Discuss why markets are 1 goud, bul not perfect way to allocate resources Learn what determines some trend in the overall economy,economies ‘hes fe ty manage Hs are CU ry of oclety’s FeROUEER 1S {MOHAN Lec nng ocr faahold cannot give every member everything he or he give every individual the highest standard of living t Just as a ‘society can ‘or she might) Keonon| societies, tes combined a study how it te sudy of how society manages its Karce 1es0Urces ng re allocated not by a single central planner but through Mone of rllons of households and firms Economists thy ove make declan: how much they werk what they buy much they sve, and how they invest thelr savings. Economists also stu fy he 4 people inte of buyers an {ssl and that affect th Jct with one another, For instance, they examine how the my sellers of « good together determine the price at which the goo: anti thats gold, Finally, economists analyze forces and trend Tonomy asa whole, including the growth in average ineome, th fraetion of tHe population that cannot find work, and the rate at which prices ar rising. ral central Sox These py you an ove There is no cronomy offLos Angeles, of the United Stats, of of the whole world, an econ omy is just Although the study of economica has many facets, the field is unified by sev leas. Inthe rest ofthis chapter, We look at Ten Principles of Econon nciples recur throughout this book and are introduced here to giv — lew of what economics Is all about. HOW PEOPLE MAKE DECISIONS ystery to what an “economy” js, Whether we are talking about th. §t0up of people interacting with one sin ther as they go about the Wes, Becaute the behavior of an economy rth the behavior of the indivi als who ciples afin PRINCIP The first leg no such thi to give up goal agains tivo fields, have used ‘income for] © up the economy, we start our study of economics wi vidual decisionmaking 4 ma | E a People Face Tradeoffs bout making decisions is summarized in the adage: "There Pee fe ure” To get one thing that we lke, we trully hay ote '8 hat we lke, Making decstons requires trading ff or 4 student who must decide how to all rte, aio Spend allo her time shudying econontarahany ime s aychology; or forever hourshe studies oe cubjecr ane idying the other. And for Jc; ents leciding haw.to spend thelr family income. Hothing, or a family vacation, Or ee of ‘can as Ftirement or the children’s college education, When they: oad ;OHAPTEN A TEN PRINGIMLER OF ECONOMICR re} spend an extra dollar on one af thone pods, they Have one less collar 1 spend . ‘on some other good. 8 When people are grouped into societies, they {ce different kinds of trade he offs. The classic tradeoff is between "guns and buen." The more we apend on ational defense to protect our thores from foreigh aggrersors (guns), the le st we can spend on personal goods to raise our atanfiare of living at home (but he ter), Also important in modern woelety Is the tradepff between clean environ: re ment and a high level of income, Lava that requfe firme to reduce pollution Ww raise the cost of producing goods and wervices. Becqune of the hyler conta, these QW firms end up earning smaller profits, paying loper wages, charging higher de prices, or some combination of these three, Thus, wi}ile pollution regulations give od Us the benefit of a cleaner environment and the Impfoved Ivealth that comes with ids it, they have the cost of reducing the Incomes of thd firma’ owners, workers, and he customers, are ‘Another tradeoff society faces Is beliveen effidiency and equity. Efficiency means that society is getting the most it can fron ite scarce fexources, Equity — the property of society geting the means that the benefits of those resources are distributed fairly among society's — most it can from its scarce resources members. In other words, efficiency refers to the a}ze of the economle ple, and ‘equity ‘equity refers to how the pie is divided, Often, when government policies are faut a being designed, these two goals conflict, ' He eee Oe eee Consider, for instance, policies aimed at achieving « more equal distribution //"h iy Rly ang Mere of economic wellbeing. Some of these policies, sifch as the welfare system ar tH ‘unemployment insurance, try to help those membefs of society who are most in need, Others, stich as the individual income tax, ask the financlally successful to contribute more than others to support the governihent, Although these policies have the benefit of achieving greater equity, they hqve a cost in terms of reduced: efficiney. When the government redstributes incapne from the rch to the poe, the it reduces the reward for working hard; as a resul, people work less and prox on: duce fewer por! ond vie Invather words, when the government tries to nei cut the econ. nop antsy eae gw slices, the pif gots smaller, ue Recognizing sit p> pie tace taoffs ds nt by Itself tell us what deck ie sions they will or should make, A student should npt abandon the study of p thology just because doing so would increase the tne available for the study of ‘econamics. Society should nat stop protecting the e”pvironment just because envi= ronmental regulations reduce our material standaif of living. The poor should not be ignored just because helping them distorts ork incentives. Nonetheless, acknowledging life's tradeoffs is important becauje people are likely to make -s. eis good decisions only if they understand the option that they have available. = PRINCIPLE #2: The Cost of Something Is able What You Give Up to Get It can the Because people face tradeoffs, making decisions jequites comparing the costs vuld find benefits of alternative courses of action. In mahy cases, however, the cost of pee aire action is Rot as obvious as it might first appar her ‘Consider, for example, the decision whether iq go to college. The benefit is intellectual enrichment and a lifetime of better job gpportunities, But what is the si cost? To answer this question, you might be temptbd to add up the money you ily oat Te alton, books, room, and board. Yet thisfotal does not truly represent “f shat you give up to spend a year in college iePARTI INTRODUCTION portunity cost n up to aban ginal changes al adjustments toa ei | The first proplem with this answer is that it Includes some thin not really costs qf going to college. Even if you quit school, you watt. { place to sleep oot food to eat, Room and board are costs of going to colin to theggatent tha they are more expensive at college than elsewhere. Inde,’ cost oP room anf! board at your school might be less than the rent and ion expenses that yont would pay living on your own. In this case, the savings on room and board are a benefit of going to college The second problem with this calculation of costs is that it ignores the largest cost of going to qollege—your time. When you spend a year listening to lectures, reading textbools, and writing papers, you cannot spend that time working at a job, For most students, the wages given up to attend school are the largest sin- gle cost of their education, The opportunity cost of an item is what you give up to get that item. When making any dec}sion, such as'whether to attend college, decisionmakers should be aware of the opportunity costs that accompany each possible action. In fact, they usually are College-age athletes who can earn millions if they drop out of school and play|professional sports are well aware that their opportunity cost of sollege is very High. It is not surprising that they often decide that the benefit is not worth the cpst Ny PRINCIPLE #3: Rational People Think at the Margin Many decisions|in life involve making small incremental adjustments to an exist- ing plan of actipn. Economists call these marginal changes. In many situations, people will make the best decisions by thinking at the margin. Suppose, {dr instance, that a friend asks your advice about how many years to stay in schol. If you were to compare for him the lifestyle of a person with a Ph.D. to thatlof a grade school dropout, he might complain that this compar- ison is not helpful for his decision. Your friend is more likely to have some edu- cation already land to be deciding whether to spend an extra year or two in school. To make this decision, he needs to know the additional benefits that an extra year in sthoo! would offer and the ~sid'ts nal sets that he would incur. Pes 8 hw gies -asts, he can evaluate whether the extra year is worthwhile, As another example of how thinking at the margin helps decisionmaking, con- sider an airling deciding how much to charge passengers who fly standby. Sup- pose that flying a 200-seat plane across the country costs the airline $100,000. In this case, the afverage cost of each seat is $100,000/200, which is $500. One might be tempted to ¢onclude that the airline should never sell a ticket for less than $500. Yet the airline can raise its profits by thinking at the margin. Suppose that a plane is aboui|to take off with ten empty seats, A standby passenger is waiting at the gate willing to pay $300 for a seat. Should the airline sell it to him? Of course it shoufd. If the plane has empty seats, the cost of adding one more pas- senger is minyscule. Although the average cost of flying a passenger is $500, the ‘marginal cost {s merely the cost of the bag-of peanuts and can of soda that the extra passenger will consume. As long as the standby passenger pays more than the marginal gost, selling him a ticket is profitable. As these ¢xamples 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: ~ pea f“PRINCIPLE #4: People Respond to Inc Because people make decisions by comparing costs may change when the costs or benefits change. Tha tives. When the price of an apple rises, for instanc« pears and fewer apples, because the cost of buyin same time, apple orchards decide to hire more work| because the benefit of selling an apple is also high The central role of incentives in determining bel pntives and benefits, their behavior is, people respond to incen- , people decide to eat more j an apple is higher. At the rs and harvest more apples, avior is important for those designing public policy. Public policies often alter tHe costs or benefits of private - actions. When policymakers fail to consider how behavior might change as a result, their policies can have effects that they did As an example of such unintended effects, consi belts and auto safety. In the 1950s few cars had seat| the zeason for the change is public policy. In the late Unsafe at Any Speed generated much public concer} responded with legislation requiring car companie: tures, including seat belts, standard equipment on How does a seat belt law affect auto safety? Thi seat belts in all cars, more people wear seat belts, ant a major auto accident rises. In this sense, seat belts of seat belts on safety is what motivated Congress Yet, to understand fully the effects of this law, ple change their behavior in response to the incenti relevant behavior is the speed and care with whic] mobiles. Driving slowly and carefully is costly bee: and energy. When deciding how safely to drive, marginal benefit from safer driving to the marginal and carefully when the ~nefit of increased safety is ple drive more slowly a1.» carefully when roads clear. . Now consider how a seat belt law alters the rational driver. Seat belts make accidents less cost reduce the probability of injury or death. Thus, a efits to slow and careful driving. People respond t an improvement in road conditions—by faster and| jot intend. ler public policy toward seat belts. Today all cars do, and 1960s, Ralph Nader’s book over auto safety. Congress to make various safety fea- I] new cars. direct effect is obvious. With the probability of surviving ave lives. This direct impact 10 require seat belts. ne must recognize that peo- es they face. In this case, the h drivers operate their auto- use it uses the driver's time fational people compare the kost. They drive more slowly lhigh. This explains why peo- re icy than when roads are ‘ost-benefit calculation of a ly for a driver because they pat belt law reduces the ben- seat belts as they would to less careful driving. The end result of a seat belt law, therefore, is a larger number of accidents. How does the law affect the number of death| wear their seat belts are more likely to survive any more likely to find themselves in an accident. The 1 over, the reduction in safe driving has a clear adver; from driving? Drivers who given accident, but they are et effect is ambiguous. More- ¢ impact on pedestrians (and on drivers who do not wear their seat belts). hey are put in jeopardy by the 5 law because they are more likely to find themsel in an accident but are not protected by a seat belt. Thus, a seat belt law tends to increase thé number of pedestrian deaths. ‘At first, this discussion of incentives and seat belts might seem like idle spec- ulation. Yet, in an article published in 1975, econ| mist Sam Peltzman showed er deaths per accident and that the auto-safety laws have, in fact, had many f these effects. According to Pr 5 evidence, these laws produce both fe} meee ent! The net result is little change in thi number of driver deaths and an increase in the number of pedestrian deaths. cr IH aE aN lle\ DUCTION Se ; ou can watch being nagged grass!” Peltzman’s Analysis of auto safety is just ore example of the ple that people respond to incentives. Many of the incentives thay econ, study are more Straightforward than those of the auto-safety laws, Poy urn , no one is surprised that a tax on apples causes people to buy fever appion t as the seat belt example shows, policies sometimes have effects that are nat git ous in advance) In analyzing any’ policy, one must consider not only the divey effects but also) the indirect effects that work through incentives, If the policy changes incentyes, i will cause people to alter their behavior Heer QUICK QUIZ List and briefly explain the four principles of individual I decisionmaking, HOW PEOPLE INTERACT The first four principles discussed how individuals make decisions. As we go ‘about our lives, many of our decisions affect not only ourselves but other peo- Ple as well. the next three principles concern how people interact with one another. PRINCIPLE #5: Trade Can Make Everyone Better Off You have probably heard on the news that the Japanese are our competitors in the world ecgnomy. In some ways, this is true, for American and Japanese firm. do produce njany of the same goods. Ford and Toyota compete for the same cus tomers in the market for automobiles: Compaq-and Toshiba compete for th. same customers in the market for personal computers. Yet it is Fasy to be misled when thinking about competition among coun tries. Trade between the United States and lapan i where one sifle wins and the other side lone: between two) countries can make each country better off. To see why. consider how trade affects your family. When a member of you family looks for a job, he or she competes against members of other families wh, jobs. Families.also compete against one another when they’ g Shopping, bgcause each family wants to buy the best goods at the lowest price So, in a sense, each family in the economy is competing with all other familie Despite his competition, your family would not be better off isolating itse from all othpr families. If it did, your family would need to grow its own foox clothes, and build its own home. Clearly, your family gains muc from its ability to trade with others. Trade allows.each person to specialize | fhe activitiep he or she does best, whether itis farming, sewing, or home buil ing, By trading with others, people can ‘buy a greater variety of goods and se er cost “ not Tike a sports contest apposite is true: Trad: S as well as families benefit from the ability to trade With o; Ge allows countries to specialize in what they do best and to enj ety of goods and services. The Japanese, as well as the French syci ts le, ct y 1e y id the even greater harm caused by poli the Egyptians and the Brazilians, are as much ourfpartners in the world econ- amy as they are our competitors. PRINCIPLE #6: Markets Are Usually a Good Way to Organize Economic Activity The collapse of communism in the Soviet Union anf Eastern Europe may be the most important change in the world during the past half century. Communist countries worked on the premise that central planhers in the government were in the best position to guide economic activity. These planners decided what goods and services were produced, how much was produced, and who produced arid consumed these goods and services. The theory behind central planning was that only the government could organize economie activity in a way that pro. moted economic well-being for the country as 2 whole. Today, most countries that once had centrally planned economies have aban- doned this system and are trying to develop maket economies. In a market econamy, the decisions of a central planner are replaced by the decisions of mil- lions of firms and households. Firms decide whojn to hire and what to make. Households decide which firms to work for and what to buy with their incomes. These firms and households interact in the marketplace, where prices and self- interest guide their decisions. At first glance, the success of market ecoriomjes is puzzling. It might seem as if decentralized decisionmaking by millions of gelf-interested households and firms would result in chaos. Yet this is not the fase. Market economies have proven remarkably successful ity organizing economic activity in a way that pro- motes general economic well-being. In his 1776 book The Wealth of Nations, economist Adam Smith made the most. famous observation in all of economics: HouseHolds and firms interacting in markets act as if they are guided by an “invisible hand” that leads them to desir able market outcomes. One of our goals in this bpok is to understand how this invisible hand works its magic. As you study econdmics, you will learn that prices are the instrument with which the invisible hand directs economic activity. Prices, reflect both the value of a good to society and th cost to society of making the cod. Because households and firms look at prices when deciding what to buy and sell, they unknowingly take into account, the social benefits and costs of their actions. As a result, prices guide these individual decisionmakers to reach out- comes that, in many cases, maximize the welfare|of society as a whole. There is an important corollary to the skill fof the invisible hand in guid- ing economic activity: When the government prevents prices from adjusting naturally to supply and demand, it impedes the |nvisible hand's ability to coor~ “Gnate the millions ‘of households and firms that make up the economy. This corollary explains why taxes adversely affect thp allocation of resources: Taxes distort prices and thus the decisions of househ@lds and firms. It also explains es that dirbctly control prices, such as rent control. And it explains the failure of communism. In communist countries, prices were not determined in the marketplace but were dictated by central plan- ners. These planners lacked the information tht gets reflected in prices when prices are free to respond to market forces. Centfal planners failed because they tried to run the economy with one hand tied behind their backs—the invisible hand of the marketplace * CHAPTER 4 TEN PRINCIPLES oF EBONOMICS market economy ‘an economy that allocates resourc through the decentralized decision of many firms and households as they interact in markets for goods and servicesVX , PRINCIPLE #7: Governments Can Sometimes Improve Market Outcomes A\drough markets are usually a good way to organize economic activity, this rule das some important exceptions, There are Qo broad reasons for a government to untervene an the economy to promote efficiency and to promote ‘equity. That is most policies alin 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. ‘Eoonomnists use the term market failure to refer to a situation in which the mar- ket on its own tails to allocate resources efficiently, : of market failure is an externality. An externality is the caf one pat son the well-being of a bystander, Pollution is the ¢ example. If a chemical factory does not bear the entire cost of the smoke \ikely emit too much. In this case, the government can raise eco- nomic well-being through environmental regulation. other 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 influ- ence market priges. For example, suppose that everyone in town needs water but 3s only ong well. The owner of the well has market power—in this case a —over the sale of water. The well owner is not subject to the rigorous petition with which the invisible hand normally keeps self-interest in check. ca that, in this ease, regulating the price that the monopolist charges n potentially enhance economic efficiency. The invisible hand is even less able to ensure that economic prosperity is istributed fairly. A market economy rewards people according to their ability 9 produce things that other people are willing to pay for. The world’s best bas- 1] player gars more than the world’s best chess player simply because peo- -e willing to pay more to see basketball than chess. The invisible hand does sore that everyone-has.sufficient food, decent clothing, and adequate health care. A goal of many public policies, such as the income tax and the wel fare system, is to achieve a more equitable distribution of economic well-being. Jo say that the government cait improve on market outcomes at times does not mean that it always will. Public policy is made not by angels but by a political process that is far from perfect. Sometimes policies are designed simply to reward the politically powerful. Sometimes they are made by well-intentioned jeaders who are not fully informed. One goal of the study of economics is te help you judge when a government policy is justifiable to promote efficiency 01 equity and when it is not. not QUICK QUIZ List and briefly explain the three principles concerning economic interactions. HOW THE ECONOMY. AS-A- WHOLE WORKS We started by discussing how individuals make decisions and then Jooked how people interact with one another. All these decisions and interactioymetres errerehanaerr CHAPTER 1 TEN PRINCIPLES OF ECON together make up “the economy.” The last three prigciples concern the workings of the economy as a whole PRINCIPLE #8: A Country's Standard of Living Depends on Its Ability to Produce Goods and Services The differences in living standards around the world are staggering. In 1993, the average American had an income of about $25,000 In the same year, the aver- age Mexican earned $7,000, and the average Nigerian earned $1,500. Not sur- prisingly, this large variation in average income is reflected in various measures of the quality of life. Citizens of high-income countfies have more TV sets, more cars, better nutrition, better health care, and longer/life expectancy than Gtizens of low-income countries. ] Changes in living standards over time are alsq large. In the United States, incomes have historically grown about 2 percent per year (after adjusting for changes in the cost of living). At this rate, averege income doubles every 35 years. In some countries, economic growth has been even more rapid. In Japan, for instance, average income has doubled in the past 20 years, and in South Korea it has doubled in the past 10 years. | What explains these large differences in living standards emong countries and over time? The answer is surprisingly simple. Almost all variation in living standards is attributable to differences in countrics’ productivity—that is, the amount of goods and services produced from each hour of a worker's time. In nations where workers can produce a large quantity of goods and services per unit of time, most people enjoy a high standard of living: in nations where work- ers are less productive, most people must endure a more meager existence. Sin ilarly, the growth rate of a nation’s productivity determines the growth rate of its average income. | The fundamental relationship between productivity and living standards is simple, but its implications are far-reaching. If productivity is the primary deter- minant of living standards, other explanations must be of secondary importance. For example, it might be tempting to credit labor unions or minimum-wage ws for the rise in living standards of American workers over the past century. Yet the real hero of American workers is their rising productivity. As another aam- ple, some commentators have claimed that increased competition from Japan and other countries explains slow growth in US. incomes in recent years. Yet the real villain is not competition from abroad but flagging productivity growth in the United States. The relationship between productivity and living standards also has pro- found implications for public policy. When thinking about how any policy will affect living standards, the key question is how it will affect our ability to pro duce goods and services. To boost living standards, policymakers need to raise productivity by ensuring that workers are well educated, have the tools needed to produce goods and services, and have access to the best available Over the past decade, for example, much debate in the United States has centered on the government's budget deficit—the excess of government spend ing over government revenue. As we will see, concer over the budget deficit is based largely on its adverse impact on productivity. When the government needs to finance a budget deficit, it does so by borrowing in financial markets, much Sie guaetite af gx prataced frome exch aeetr's hawIDUCTION “om A borrow to finance 2 college education or a fire, 4 to fnante 2 new factory. As fe government borrows to finarce 4 polar) reduces the quantity of fans available for: other borrower the r cet deficit thereby reduces investment kath in human capital (the student’, 44 ion) and physical capital (the fre’s factory). Because lower investment i, means lower producti depress growth in living st ‘as a student might dards. PRINCIPLE #9: Prices Rise When the Government Prints Too Mach Money In Germany jin January 1921, 2 daly newspaper cost 030 marks. Less than tw years later, mn November 1922, Se seme newspaper cost 79,000,000 marks. & other prices in the econor Srilar amounts. This episode is one of hi tory’s most spectacular examples of ixBation, an increase in the overéll Jevel « prices in the economy. Although the United States has aerer experienced inflation even close to th. in Germany jin the 1920s, inflation bas at times been an econoznic problem. Du ing the 1970s, for instance, the oveall level of prices more than ‘doubled, an President Ggrald Ford celled inflation “public enemy number one.” By contras in the 1990s, inflation has been zbozt 3 percent per year; at this rate it wou! take over 20 years for prices to zuble. Because high inflation imposes variox costs on society, keeping inflation 2t 2 low level is a goal of economic polic makers around the world. What causes inflation? In most cases of large or persistent inflation, the cu prit tums obit to be the same—groxth in the quantity of money. When 2 go emment creates large quantities @i Sxe nation’s money, the value of the mon« falls. In Gerfrany in the early 1822s, sehen prices were on average tripling eve: month, the quantity of money was also tripling every month. Although less dr matic, the economic history of the United States points to a similar conclusio in the dotame, budget deficits are generally thougns «