ECONOMIC

PRINCIPLES
Think like an economist
 Thinking like an Economist
◦ we need to understand some of the key principles (or what some might call economic “laws”)
that economists bring to the table when they enter a discussion. In short, we must learn to
“think like an economist.”

◦ The ten economic principles constitute a particular way of viewing the world. They give us a
lens or filter through which the economist interprets not just narrowly construed “economic”
matters—such as jobs, gross domestic product (GDP), and prices

◦ the following principles will seem straightforward and obvious at first, their implications are
not obvious.
Economic
Principles
1- Incentives Matter
2 – Always Tradeoffs
3- Decisions on the Margin
4- Positive-Sum Game
5- Wealthy by helping others
6- Consume more if they produce more
7- Invest today for prosperity tomorrow
8- Prices give information to buyers
and sellers
9- Profit harness self-interest to use
scare resources efficiently
10- Policymakers must consider unseen
consequences.
 Incentives matter
◦ This principle relies on the fact that people have goals that they are trying to achieve,
and that they will therefore act differently, depending on the circumstances. An
incentive is simply anything that induces action or motivates effort. In other words,
they are the costs and benefits you pay or receive from a particular decision.

◦ But in economics, we must always keep in mind that the objects of our study are
thinking individuals who have their own purposes, and that they may suddenly change
their behaviour in response to a new environment.
 There are always tradeoffs—
there’s no such thing as a free lunch
This popular expression simply means that there are always tradeoffs, that if we
institute a new policy in order to make things better in one respect, we are probably
making things worse in other respects.

Economic analysis plays a critical role in highlighting the most serious drawbacks from
a proposed change.

If the government mandates a new benefit, the economist has been trained to look for
the tradeoff involved—a cut in some other government program, a tax or fee increase,
increased public debt. To repeat, identifying the relevant tradeoffs doesn’t mean that the
policy is bad or unjustified; it just helps us make an informed decision.
 People make decisions on the margin
◦ This phrase means that the choices only change things “at the edge”—think of
the margin on a piece of paper—and they should be evaluated in this light.
◦ We need to engage in marginal analysis, and realize that people will buy
additional of X until their “marginal cost” is higher than their “marginal
benefit,” at which point he will stop.
◦ Diamond-Water Paradox (Paradox of Value). an interesting puzzle famously discussed by Adam
Smith. The alleged paradox is the high market value of diamonds, compared to water, when
diamonds are a mere luxury item. In contrast, life itself depends on an adequate water supply.

◦ Here again marginal thinking solves the problem. When someone is offered a choice between a
diamond and a bottle of water, she is not choosing between all diamonds versus all water. Rather,
she is being offered a choice between this particular diamond and that particular bottle of water.

◦ Think at the margin, about the cost of the next extra unit.

◦ Economists here say that we are comparing marginal utility to total utility—the usefulness of the
next extra unit that we consume to its total usefulness.
 Voluntary Trade - Win-win
◦ Voluntary trade means that both parties consented to the exchange
◦ It is a positive-sum game, where one person’s gain can correspond to someone else’s gain, too.
Because of the underlying harmony of interests, the market fosters social bonds of
cooperation.
◦ “private enterprise” is a network of voluntary exchanges of property among the members of
society. If we seek to make people happier according to their own reckoning, then voluntary
trades are a great way to proceed.
 People earn income and become wealthy by
helping others
◦ Because all transactions in a market economy must be voluntary, the only way to persuade others to give
up their money is to provide something that they value even more.

◦ As Adam Smith remarked, “It is not from the benevolence of the butcher, the brewer, or the baker, that
we can expect our dinner, but from their regard to their own interest.”

◦ Moreover, this ingenious arrangement works. As Smith famously explained: “By directing that industry
in such a manner as its produce may be of greatest value, he intends only his own gain, and he is in this,
as in many other cases, led by an invisible hand to promote an end which was no part of his intention.”
 Workers can only consume more if they first
produce more
◦ Typically, each person in her role as a consumer doesn’t buy exactly the goods and services
that she produces in her role as a worker. Rather, because of the benefits of specialization and
trade (which we spelled out earlier), a worker will focus on producing large amounts of a few
things in which she has expertise, in order to earn money with which she then goes into the
market to buy small amounts of the many things she wants to consume. Yet even here, it is still
true that measured in terms of money and in the long run, an individual can ultimately only
take out of the market as a consumer what he contributes to it as a worker.
 Saving and investment today allow for
greater prosperity in the future
◦ Eventually, the person who saves a large fraction of her income can spend more than would
have been possible on a trajectory that involved no saving. Thus, saving and investment brings
short-term pain, but long-term gain,

◦ This pattern holds true at the national level, too. If Canadians as a whole decide to save a
larger fraction of their income, this will cause an immediate drop in total consumption
spending. But the correspondingly higher investment spending will lead to faster GDP growth
than otherwise would have occurred. Eventually, Canadians will enjoy a higher standard of
living
 A savings example

Year 1 Year 2 Year 8 Year 18 Year 24 Year 35

Harry $100,000 $100,000 $100,000 $100,000 $100,00 $100,000

Harry $0 $0 $0 $0 $0 $0
Savings
Mary $80,000 $80,800 $103,297 $210,422 $319,639 $615,621

Mary $20,000 $40,200 $167,624 $394,406 $541,710 $835, 705

Savings
 Prices provide valuable information to
buyers and sellers
◦ Market prices provide a valuable source of information that guides both buyers and sellers.
◦ Intuitively, the higher the price for a certain type of labour or finished product, the more scarce it is; at least
some members of society are “voting with their dollars” to say that this type of labour or good is very important
and other people should really think about providing more of it.
◦ In a free market economy, individuals are free to choose their occupations and can purchase whatever types of
goods and services they want. However, budgets impose discipline on this freedom—people can’t spend more
than they earn (at least not in the long run).
◦ The wages or salaries offered by various jobs, and the prices attached to various items for sale, help guide
people in making their decisions in a way that reflects the desires of others, as well as the physical constraints
imposed by the scarcity of resources and technological know-how.
 Profits harness self-interest to guide
entrepreneurs in using scarce resources efficiently
◦ In a market economy profits are a mechanism to guide entrepreneurs—acting in their self-interest—to use scarce
resources efficiently. Generally speaking, it’s a good thing when a business turns a profit, because it’s a signal that
the people running it have channeled scarce resources into the areas where they are most needed.
◦ The entrepreneurs must make decisions on what quantities of various inputs—labour, natural resources, and capital
equipment—to buy, in order to produce goods and services for sale to their customers.
◦ The profit and loss system doesn’t stifle output in general, it merely ensures that scarce resources get channeled
into the appropriate lines of production. If an entrepreneur suffers losses, it’s the market’s way of telling him that
he squandered resources that consumers wish had been devoted elsewhere.
◦ Every industry is always susceptible to the gales of what economist Joseph Schumpeter called “creative
destruction,” in which a bold innovator introduces a new product or technique and disrupts the old ways of doing
business
 Policymakers must consider the long-term
and “unseen” consequences of their actions
◦ In his famous book Economics In One Lesson, Henry Hazlitt (echoing the wisdom of Bastiat) wrote:
[T]he whole of economics can be reduced to a single lesson, and that lesson can be reduced to a single
sentence. The art of economics consists in looking not merely at the immediate but at the longer effects of
any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all
groups. (Emphasis in original.)