3
T
he word economy comes from the Greek word oikonomos, which means “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. It must decide which household members
do which tasks and what each member receives in return: Who cooks dinner?
Who does the laundry? Who gets the extra dessert at dinner? Who gets to drive
the car? In short, a household must allocate its scarce resources (time, dessert, car
mileage) among its various members, taking into account each member’s abilities,
efforts, and desires.
Like a household, a society faces many decisions. It must find some way
to decide what jobs will be done and who will do them. It needs some people
to grow food, other people to make clothing, and still others to design computer
software. Once society has allocated people (as well as land, buildings,
and machines) to various jobs, it must also allocate the goods and services
Ten Principles
of Economics
Chapter
1
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4	 PART I	 INTRODUCTION
they produce. It must decide who will eat caviar and who will eat potatoes. It
must decide who will drive a Ferrari and who will take the bus.
The management of society’s resources is important because resources are
scarce. Scarcity means that society has limited resources and therefore cannot
produce all the goods and services people wish to have. Just as each member of
a household cannot get everything she wants, each individual in a society cannot
attain the highest standard of living to which she might aspire.
Economics is the study of how society manages its scarce resources. In most societies,
resources are allocated not by an all-powerful dictator but through the combined
choices of millions of households and firms. Economists, therefore, study
how people make decisions: how much they work, what they buy, how much they
save, and how they invest their savings. Economists also study how people interact
with one another. For instance, they examine how the multitude of buyers
and sellers of a good together determine the price at which the good is sold and
the quantity that is sold. Finally, economists analyze forces and trends that affect
the economy as a whole, including the growth in average income, the fraction of
the population that cannot find work, and the rate at which prices are rising.
The study of economics has many facets, but it is unified by several central
ideas. In this chapter, we look at Ten Principles of Economics. Don’t worry if you
don’t understand them all at first or if you aren’t completely convinced. We explore
these ideas more fully in later chapters. The ten principles are introduced
here to give you an overview of what economics is all about. Consider this chapter
a “preview of coming attractions.”
There is no mystery to what an economy is. Whether we are talking about the
economy of Los Angeles, the United States, or the whole world, an economy is
just a group of people dealing with one another as they go about their lives. Because
the behavior of an economy reflects the behavior of the individuals who
make up the economy, we begin our study of economics with four principles
about individual decision making.
1-1a Principle 1: People Face Trade-offs
You may have heard the old saying, “There ain’t no such thing as a free lunch.”
Grammar aside, there is much truth to this adage. To get something that we like,
we usually have to give up something else that we also like. Making decisions
requires trading off one goal against another.
Consider a student who must decide how to allocate her most valuable
­resource—her time. She can spend all of her time studying economics, spend all
of it studying psychology, or divide it between the two fields. For every hour she
studies one subject, she gives up an hour she could have used studying the other.
And for every hour she spends studying, she gives up an hour that she could
have spent napping, bike riding, watching TV, or working at her part-time job for
some extra spending money.
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 for 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.
scarcity
the limited nature of
society’s resources
economics
the study of how society
manages its scarce
resources
1-1 How People Make Decisions
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	 CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 5
When people are grouped into societies, they face different kinds of trade-offs.
One classic trade-off is between “guns and butter.” The more a society spends
on national defense (guns) to protect its shores from foreign aggressors, the less
it can spend on consumer goods (butter) to raise the standard of living at home.
Also important in modern society is the trade-off between a clean environment
and a high level of income. Laws that require firms to reduce pollution raise the
cost of producing goods and services. Because of these higher costs, the firms end
up earning smaller profits, paying lower wages, charging higher prices, or some
combination of these three. Thus, while pollution regulations yield the benefit of a
cleaner environment and the improved health that comes with it, the regulations
come at the cost of reducing the incomes of the regulated firms’ owners, workers,
and customers.
Another trade-off society faces is between efficiency and equality. Efficiency
means that society is getting the maximum benefits from its scarce resources.
Equality means that those benefits are distributed uniformly among society’s
members. In other words, efficiency refers to the size of the economic pie, and
equality refers to how the pie is divided into individual slices.
When government policies are designed, these two goals often conflict. Consider,
for instance, policies aimed at equalizing the distribution of economic
well-being. Some of these policies, such as the welfare system or unemployment
insurance, try to help the members of society who are most in need. Others, such
as the individual income tax, ask the financially successful to contribute more than
others to support the government. Though they achieve greater equality, these policies
reduce efficiency. When the government redistributes income from the rich to
the poor, it reduces the reward for working hard; as a result, people work less and
produce fewer goods and services. In other words, when the government tries to
cut the economic pie into more equal slices, the pie gets smaller.
Recognizing that people face trade-offs does not by itself tell us what decisions
they will or should make. A student should not abandon the study of psychology
just because doing so would increase the time available for the study of economics.
Society should not stop protecting the environment just because environmental
regulations reduce our material standard of living. The poor should not be
ignored just because helping them distorts work incentives. Nonetheless, people
are likely to make good decisions only if they understand the options that are
available to them. Our study of economics, therefore, starts by acknowledging
life’s trade-offs.
1-1b Principle 2: The Cost of Something Is What You
Give Up to Get It
Because people face trade-offs, making decisions requires comparing the costs
and benefits of alternative courses of action. In many cases, however, the cost of
an action is not as obvious as it might first appear.
Consider the decision to go to college. The main benefits are intellectual enrichment
and a lifetime of better job opportunities. But what are the costs? To answer
this question, you might be tempted to add up the money you spend on tuition,
books, room, and board. Yet this total does not truly represent what you give up
to spend a year in college.
There are two problems with this calculation. First, it includes some things that
are not really costs of going to college. Even if you quit school, you need a place
to sleep and food to eat. Room and board are costs of going to college only to
the extent that they are more expensive at college than elsewhere. Second, this
efficiency
the property of society
getting the most it can
from its scarce resources
equality
the property of
distributing economic
prosperity uniformly
among the members of
society
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6	 PART I	 INTRODUCTION
calculation ignores the largest cost of going to college—your time. When you
spend a year listening to lectures, reading textbooks, and writing papers, you cannot
spend that time working at a job. For most students, the earnings they give up
to attend school are the single largest cost of their education.
The opportunity cost of an item is what you give up to get that item. When
making any decision, decision makers should be aware of the opportunity costs
that accompany each possible action. In fact, they usually are. College athletes
who can earn millions if they drop out of school and play professional sports are
well aware that the opportunity cost of their attending college is very high. It is
not surprising that they often decide that the benefit of a college education is not
worth the cost.
1-1c Principle 3: Rational People Think at the Margin
Economists normally assume that people are rational. Rational people systematically
and purposefully do the best they can to achieve their objectives, given the
available opportunities. As you study economics, you will encounter firms that
decide how many workers to hire and how much of their product to manufacture
and sell to maximize profits. You will also encounter individuals who decide how
much time to spend working and what goods and services to buy with the resulting
income to achieve the highest possible level of satisfaction.
Rational people know that decisions in life are rarely black and white but usually
involve shades of gray. At dinnertime, the question you face is not “Should I
fast or eat like a pig?” More likely, you will be asking yourself “Should I take that
extra spoonful of mashed potatoes?” When exams roll around, your decision is
not between blowing them off and studying twenty-four hours a day but whether
to spend an extra hour reviewing your notes instead of watching TV. Economists
use the term marginal change to describe a small incremental adjustment 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. Rational people
often make decisions by comparing marginal benefits and marginal costs.
For example, suppose you are considering calling a friend on your cell phone.
You decide that talking with her for 10 minutes would give you a benefit that you
value at about $7. Your cell phone service costs you $40 per month plus $0.50 per
minute for whatever calls you make. You usually talk for 100 minutes a month,
so your total monthly bill is $90 ($0.50 per minute times 100 minutes, plus the
$40 fixed fee). Under these circumstances, should you make the call? You might
be tempted to reason as follows: “Because I pay $90 for 100 minutes of calling
each month, the average minute on the phone costs me $0.90. So a 10-­minute
call costs $9. Because that $9 cost is greater than the $7 benefit, I am going to
skip the call.” That conclusion is wrong, however. Although the average cost of
a 10-­minute call is $9, the marginal cost—the amount your bill increases if you
make the extra call—is only $5. You will make the right decision only by comparing
the marginal benefit and the marginal cost. Because the marginal benefit of
$7 is greater than the marginal cost of $5, you should make the call. This is a principle
that people innately understand: Cell phone users with unlimited ­minutes
(that is, minutes that are free at the margin) are often prone to make long and
frivolous calls.
Thinking at the margin works for business decisions as well. Consider an airline
deciding how much to charge passengers who fly standby. Suppose that flying
a 200-seat plane across the United States costs the airline $100,000. In this case,
the average cost of each seat is $100,000/200, which is $500. One might be tempted
opportunity cost
whatever must be given
up to obtain some item
marginal change
a small incremental
adjustment to a plan of
action
rational people
people who systematically
and purposefully do the
best they can to achieve
their objectives
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
	 CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 7
to conclude that the airline should never sell a ticket for less than $500. But a rational
airline can increase its profits by thinking at the margin. Imagine that a plane
is about to take off with 10 empty seats and a standby passenger waiting at the
gate is willing to pay $300 for a seat. Should the airline sell the ticket? Of course,
it should. If the plane has empty seats, the cost of adding one more passenger is
tiny. The average cost of flying a passenger is $500, but the marginal cost is 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 cost, selling
the ticket is profitable.
Marginal decision making can help explain some otherwise puzzling economic
phenomena. Here is a classic question: Why is water so cheap, while diamonds
are so expensive? Humans need water to survive, while diamonds are unnecessary;
but for some reason, people are willing to pay much more for a diamond
than for a cup of water. The reason is that a person’s willingness to pay for a
good is based on the marginal benefit that an extra unit of the good would yield.
The marginal benefit, in turn, depends on how many units a person already has.
­Water is ­essential, but the marginal benefit of an extra cup is small because water
is plentiful. By contrast, no one needs diamonds to survive, but because diamonds
are so rare, people consider the marginal benefit of an extra diamond to be large.
A rational decision maker takes an action if and only if the marginal benefit of
the action exceeds the marginal cost. This principle explains why people use their
cell phones as much as they do, why airlines are willing to sell tickets below average
cost, and why people are willing to pay more for diamonds than for water. It
can take some time to get used to the logic of marginal thinking, but the study of
economics will give you ample opportunity to practice.
1-1d Principle 4: People Respond to Incentives
An incentive is something (such as a prospect of a punishment or reward) that induces
a person to act. Because rational people make decisions by comparing costs
and benefits, they respond to incentives. You will see that incentives play a central
role in the study of economics. One economist went so far as to suggest that the
entire field could be summarized as simply “People respond to incentives. The
rest is commentary.”
Incentives are crucial to analyzing how markets work. For example, when the
price of an apple rises, people decide to eat fewer apples. At the same time, apple
orchards decide to hire more workers and harvest more apples. In other words, a
higher price in a market provides an incentive for buyers to consume less and an
incentive for sellers to produce more. As we will see, the influence of prices on the
behavior of consumers and producers is crucial for how a market economy allocates
scarce resources.
Public policymakers should never forget about incentives: Many policies change
the costs or benefits that people face and, as a result, alter their behavior. A tax on
gasoline, for instance, encourages people to drive smaller, more fuel-efficient cars.
That is one reason people drive smaller cars in Europe, where gasoline taxes are
high, than in the United States, where gasoline taxes are low. A higher gasoline
tax also encourages people to carpool, take public transportation, and live closer
to where they work. If the tax were larger, more people would be driving hybrid
cars, and if it were large enough, they would switch to electric cars.
When policymakers fail to consider how their policies affect incentives, they
often end up with unintended consequences. For example, consider public policy
regarding auto safety. Today, all cars have seat belts, but this was not true fifty
“Is the marginal benefit
of this call greater than
the marginal cost?”
©DavidDavisPhotoproductionsRF/Alamy
incentive
something that induces a
person to act
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8	 PART I	 INTRODUCTION
years ago. In the 1960s, Ralph Nader’s book Unsafe at Any Speed generated much
public concern over auto safety. Congress responded with laws requiring seat
belts as standard equipment on new cars.
How does a seat belt law affect auto safety? The direct effect is obvious: When
a person wears a seat belt, the probability of surviving an auto accident rises. But
that’s not the end of the story because the law also affects behavior by altering incentives.
The relevant behavior here is the speed and care with which drivers operate
their cars. Driving slowly and carefully is costly because it uses the driver’s
time and energy. When deciding how safely to drive, rational people compare,
perhaps unconsciously, the marginal benefit from safer driving to the marginal
cost. As a result, they drive more slowly and carefully when the benefit of increased
safety is high. For example, when road conditions are icy, people drive
more attentively and at lower speeds than they do when road conditions are clear.
Consider how a seat belt law alters a driver’s cost–benefit calculation. Seat belts
make accidents less costly because they reduce the likelihood of injury or death.
In other words, seat belts reduce the benefits of slow and careful driving. People
respond to seat belts as they would to an improvement in road conditions—by
driving faster and less carefully. The result of a seat belt law, therefore, is a larger
number of accidents. The decline in safe driving has a clear, adverse impact on
pedestrians, who are more likely to find themselves in an accident but (unlike the
drivers) don’t have the benefit of added protection.
At first, this discussion of incentives and seat belts might seem like idle speculation.
Yet in a classic 1975 study, economist Sam Peltzman argued that autosafety
laws have had many of these effects. According to Peltzman’s evidence,
these laws produce both fewer deaths per accident and more accidents. He concluded
that the net result is little change in the number of driver deaths and an
increase in the number of pedestrian deaths.
Peltzman’s analysis of auto safety is an offbeat and controversial example of
the general principle that people respond to incentives. When analyzing any policy,
we must consider not only the direct effects but also the less obvious indirect
effects that work through incentives. If the policy changes incentives, it will cause
people to alter their behavior.
The Incentive Effects of Gasoline Prices
From 2005 to 2008 the price of oil in world oil markets skyrocketed,
the result of limited supplies together with surging demand from robust
world growth, especially in China. The price of gasoline in the United States
rose from about $2 to about $4 a gallon. At the time, the news was filled with
stories about how people responded to the increased incentive to conserve—
sometimes in obvious ways, sometimes in less obvious ways.
Here is a sampling of various stories:
•	 “As Gas Prices Soar, Buyers Are Flocking to Small Cars”
•	 “As Gas Prices Climb, So Do Scooter Sales”
•	 “Gas Prices Knock Bicycles Sales, Repairs into Higher Gear”
•	 “Gas Prices Send Surge of Riders to Mass Transit”
•	 “Camel Demand Up as Oil Price Soars”: Farmers in the Indian state of
­Rajasthan are rediscovering the humble camel. As the cost of running
gas-­guzzling tractors soars, even-toed ungulates are making a comeback.
•	 “The Airlines Are Suffering, but the Order Books of Boeing and Airbus Are
Bulging”: Demand for new, more fuel-efficient aircraft has never been greater.
case
study
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	 CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 9
Quick Quiz  Describe an important trade-off you recently faced. • Give an example
of some action that has both a monetary and nonmonetary opportunity cost. • Describe an
incentive your parents offered to you in an effort to influence your behavior.
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 people
as well. The next three principles concern how people interact with one another.
1-2a Principle 5: Trade Can Make
Everyone Better Off
You may have heard on the news that the Chinese are our competitors in the
world economy. In some ways, this is true because American and Chinese firms
produce many of the same goods. Companies in the United States and China
compete for the same customers in the markets for clothing, toys, solar panels,
automobile tires, and many other items.
Yet it is easy to be misled when thinking about competition among countries.
Trade between the United States and China is not like a sports contest in which
one side wins and the other side loses. In fact, the opposite is true: Trade between
two countries can make each country better off.
To see why, consider how trade affects your family. When a member of your
family looks for a job, 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. In a
sense, each family in an economy competes with all other families.
The latest versions of the Airbus A320 and Boeing 737, the single-aisle workhorses
for which demand is strongest, are up to 40 percent cheaper to run than
the vintage planes some American airlines still use.
•	 “Home Buying Practices Adjust to High Gas Prices”: In his hunt for a new
home, Demetrius Stroud crunched the numbers to find out that, with gas
prices climbing, moving near an Amtrak station is the best thing for his wallet.
•	 “Gas Prices Drive Students to Online Courses”: For Christy LaBadie, a sophomore
at Northampton Community College, the 30-minute drive from her
home to the Bethlehem, Pa., campus has become a financial hardship now
that gasoline prices have soared to more than $4 a gallon. So this semester she
­decided to take an online course to save herself the trip—and the money.
•	 “Diddy Halts Private Jet Flights Over Fuel Prices”: Fuel prices have grounded
an unexpected frequent-flyer: Sean “Diddy” Combs. . . . The hip-hop mogul
said he is now flying on commercial airlines instead of in private jets, which
Combs said had previously cost him $200,000 and up for a roundtrip between
New York and Los Angeles. “I’m actually flying commercial,” Diddy said
before walking onto an airplane, sitting in a first-class seat and flashing his
boarding pass to the camera. “That’s how high gas prices are.”
Many of these developments proved transitory. The economic downturn that
began in 2008 and continued into 2009 reduced the world demand for oil, and the
price of gasoline declined substantially. No word yet on whether Mr. Combs has
returned to his private jet.
1-2 How People Interact
“For $5 a week you
can watch baseball
without being nagged
to cut the grass!”
FromTheWallStreetJournal-Permission,
CartoonFeaturesSyndicate
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10	 PART I	 INTRODUCTION
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 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. The Chinese, as well as the French and the Egyptians
and the Brazilians, are as much our partners in the world economy as they are our
competitors.
1-2b Principle 6: Markets Are Usually a Good
Way to Organize Economic Activity
The collapse of communism in the Soviet Union and Eastern Europe in the 1980s
was one of the last century’s most important changes. Communist countries operated
on the premise that government officials were in the best position to allocate
the economy’s scarce resources. These central planners decided what goods
and services were produced, how much was produced, and who produced and
consumed these goods and services. The theory behind central planning was that
only the government could organize economic activity in a way that promoted
economic well-being for the country as a whole.
Most countries that once had centrally planned economies have abandoned the
system and are instead developing market economies. In a market economy, the
decisions of a central planner are replaced by the decisions of millions of firms and
households. Firms decide whom 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 economies is puzzling. 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
decision making and self-interested decision makers, market economies have
proven remarkably successful in organizing economic activity to promote overall
economic well-being.
In his 1776 book An Inquiry into the Nature and Causes of 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 desirable market outcomes. One of our goals in
this book is to understand how this invisible hand works its magic.
As you study economics, you will learn that prices are the instrument with
which the invisible hand directs economic activity. In any market, buyers look at
the price when determining how much to demand, and sellers look at the price
when deciding how much to supply. As a result of the decisions that buyers and
sellers make, market prices reflect both the value of a good to society and the
cost to society of making the good. Smith’s great insight was that prices adjust to
guide these individual buyers and sellers to reach outcomes that, in many cases,
maximize the well-being of society as a whole.
Smith’s insight has an important corollary: When a government prevents
prices from adjusting naturally to supply and demand, it impedes the invisible
hand’s ability to coordinate the decisions of the households and firms that make
market economy
an economy that
allocates resources
through the decentralized
decisions of many firms
and households as they
interact in markets for
goods and services
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	 CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 11
up an economy. This corollary explains why taxes adversely affect the allocation
of resources: They distort prices and thus the decisions of households and firms. It
also explains the great harm caused by policies that directly 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 planners.
These planners lacked the necessary information about consumers’ tastes
and producers’ costs, which in a market economy is reflected in prices. Central
planners failed because they tried to run the economy with one hand tied behind
their backs—the invisible hand of the marketplace.
1-2c Principle 7: Governments Can Sometimes
­Improve Market Outcomes
If the invisible hand of the market is so great, why do we need government? One
purpose of studying economics is to refine your view about the proper role and
scope of government policy.
One reason we need government is that the invisible hand can work its magic
only if the government enforces the rules and maintains the institutions that are
Adam Smith and the
Invisible Hand
It may be only a coincidence that Adam Smith’s great book The Wealth
of Nations was published in 1776, the exact year in which American
revolutionaries signed the Declaration of Independence. But the two documents
share a point of view that was prevalent at the time: Individuals
are usually best left to their own devices, without the heavy hand of government
guiding their actions. This political philosophy provides the intellectual
basis for the market economy and for free society more generally.
Why do decentralized market economies work so well? Is it because
people can be counted on to treat one another with love and kindness?
Not at all. Here is Adam Smith’s description of how people interact in a
market economy:
Man has almost constant occasion for the help of his brethren,
and it is in vain for him to expect it from their benevolence only.
He will be more likely to prevail if
he can interest their self-love in his
favour, and show them that it is for
their own advantage to do for him
what he requires of them. . . . Give
me that which I want, and you shall
have this which you want, is the
meaning of every such offer; and
it is in this manner that we obtain
from one another the far greater
part of those good offices which we
stand in need of.
It is not from the
benevolence of the
butcher, the brewer, or
the baker that we expect our dinner,
but from their regard to their own interest.
We address ourselves, not to their humanity but to their
self-love, and never talk to them of our own necessities but
of their advantages. Nobody but a beggar chooses to depend
chiefly upon the benevolence of his fellow-citizens. . . .
Every individual . . . neither intends to promote the public
interest, nor knows how much he is promoting it. . . . 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. Nor is it always the worse for the society that it was no
part of it. By pursuing his own interest he frequently promotes
that of the society more effectually than when he really intends
to promote it.
Smith is saying that participants in the economy are motivated by selfinterest
and that the “invisible hand” of the marketplace guides this
self-interest into promoting general economic well-being.
Many of Smith’s insights remain at the center of modern economics.
Our analysis in the coming chapters will allow us to express Smith’s
conclusions more precisely and to analyze more fully the strengths and
weaknesses of the market’s invisible hand.
FYI
Adam Smith
Bettmann/Corbis
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12	 PART I	 INTRODUCTION
key to a market economy. Most important, market economies need institutions
to enforce property rights so individuals can own and control scarce resources.
A farmer won’t grow food if she expects her crop to be stolen; a restaurant won’t
serve meals unless it is assured that customers will pay before they leave; and
an entertainment company won’t produce DVDs if too many potential customers
avoid paying by making illegal copies. We all rely on government-provided
police and courts to enforce our rights over the things we produce—and the invisible
hand counts on our ability to enforce our rights.
Yet there is another reason we need government: The invisible hand is ­powerful,
but it is not omnipotent. There are two broad reasons for a ­government to intervene
in the economy and change the allocation of resources that people would
choose on their own: to promote efficiency or to promote equality. That is, most
policies aim either to enlarge the economic pie or to change how the pie is divided.
Consider first the goal of efficiency. Although the invisible hand usually leads
markets to allocate resources to maximize the size of the economic pie, this is not
always the case. Economists use the term market failure to refer to a situation in
which the market on its own fails to produce an efficient allocation of resources.
As we will see, one possible cause of market failure is an externality, which is
the impact of one person’s actions on the well-being of a bystander. The classic
example of an externality is pollution. When the production of a good pollutes
the air and creates health problems for those who live near the factories, the market
left to its own devices may fail to take this cost into account. Another possible
cause of market failure is market power, which refers to the ability of a single
person or firm (or a small group) to unduly influence market prices. For example,
if everyone in town needs water but there is only one well, the owner of the
well is not subject to the rigorous competition with which the invisible hand normally
keeps self-interest in check; she may take advantage of this opportunity by
­restricting the output of water so she can charge a higher price. In the presence of
externalities or market power, well-designed public policy can enhance economic
efficiency.
Now consider the goal of equality. Even when the invisible hand yields efficient
outcomes, it can nonetheless leave sizable disparities in economic well-being. A
market economy rewards people according to their ability to produce things that
other people are willing to pay for. The world’s best basketball player earns more
than the world’s best chess player simply because people are willing to pay more
to watch basketball than chess. The invisible hand does not ensure that everyone
has sufficient food, decent clothing, and adequate healthcare. This inequality
may, depending on one’s political philosophy, call for government intervention.
In practice, many public policies, such as the income tax and the welfare system,
aim to achieve a more equal distribution of economic well-being.
To say that the government can 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 leaders who
are not fully informed. As you study economics, you will become a better judge of
when a government policy is justifiable because it promotes efficiency or equality
and when it is not.
Quick Quiz  Why is a country better off not isolating itself from all other countries?
• Why do we have markets, and according to economists, what roles should government play
in them?
market failure
a situation in which a
market left on its own
fails to allocate resources
efficiently
externality
the impact of one
person’s actions on the
well-being of a bystander
market power
the ability of a single
economic actor (or small
group of actors) to have a
substantial influence on
market prices
property rights
the ability of an
individual to own and
exercise control over
scarce resources
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
	 CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 13
1-3 How the Economy as a Whole Works
productivity
the quantity of goods and
services produced from
each unit of labor input
We started by discussing how individuals make decisions and then looked at how
people interact with one another. All these decisions and interactions together
make up “the economy.” The last three principles concern the workings of the
economy as a whole.
1-3a 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 2011, the
average American had an income of about $48,000. In the same year, the average
Mexican earned about $9,000, the average Chinese about $5,000, and the average
Nigerian only $1,200. Not surprisingly, this large variation in average income is
reflected in various measures of quality of life. Citizens of high-income countries
have more TV sets, more cars, better nutrition, better healthcare, and a longer life
expectancy than citizens of low-income countries.
Changes in living standards over time are also 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, average income doubles every 35 years.
Over the past century, average U.S. income has risen about eightfold.
What explains these large differences in living standards among countries and
over time? The answer is surprisingly simple. Almost all variation in living standards
is attributable to differences in countries’ productivity—that is, the amount
of goods and services produced by each unit of labor input. In nations where
workers can produce a large quantity of goods and services per hour, most people
enjoy a high standard of living; in nations where workers are less productive,
most people endure a more meager existence. Similarly, 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 determinant
of living standards, other explanations must be of secondary importance.
For example, it might be tempting to credit labor unions or minimum-wage laws
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 example,
some commentators have claimed that increased competition from Japan and
other countries explained the slow growth in U.S. incomes during the 1970s and
1980s. Yet the real villain was not competition from abroad but flagging productivity
growth in the United States.
The relationship between productivity and living standards also has profound
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 produce goods
and services. To boost living standards, policymakers need to raise productivity
by ensuring that workers are well educated, have the tools they need to produce
goods and services, and have access to the best available technology.
1-3b Principle 9: Prices Rise When the
Government Prints Too Much Money
In January 1921, a daily newspaper in Germany cost 0.30 marks. Less than
two years later, in November 1922, the same newspaper cost 70,000,000 marks.
All other prices in the economy rose by similar amounts. This episode is one of
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14	 PART I	 INTRODUCTION
The Dismal Science?
Hardly!
By Robert D. McTeer, Jr.
My take on training in economics is that
it becomes increasingly valuable as you
move up the career ladder. I can’t imagine a
better major for corporate CEOs, congressmen,
or American presidents. You’ve learned
a systematic, disciplined way of thinking that
will serve you well. By contrast, the economically
challenged must be perplexed about how
it is that economies work better the fewer
people they have in charge. Who does the
planning? Who makes decisions? Who decides
what to produce?
For my money, Adam Smith’s invisible
hand is the most important thing you’ve
learned by studying economics. You understand
how we can each work for our own selfinterest
and still produce a desirable social
outcome. You know how uncoordinated activity
gets coordinated by the market to enhance
the wealth of nations. You understand the
magic of markets and the dangers of tampering
with them too much. You know better what
you first learned in kindergarten: that you
shouldn’t kill or cripple the goose that lays
the golden eggs. . . .
Economics training will help you understand
fallacies and unintended consequences.
In fact, I am inclined to define
economics as the study of how to anticipate
unintended consequences. . . .
Little in the literature seems more relevant
to contemporary economic debates than what
usually is called the broken window fallacy.
Whenever a government program is justified
not on its merits but by the jobs it will create,
remember the broken window: Some teenagers,
being the little beasts that they are, toss a
brick through a bakery window. A crowd gathers
and laments, “What a shame.” But before
you know it, someone suggests a silver lining
to the situation: Now the baker will have to
spend money to have the window repaired. This
will add to the income of the repairman, who
will spend his additional income, which will
add to another seller’s income, and so on. You
know the drill. The chain of spending will multiply
and generate higher income and employment.
If the broken window is large enough, it
might produce an economic boom! . . .
Most voters fall for the broken window
fallacy, but not economics majors. They will
say, “Hey, wait a minute!” If the baker hadn’t
spent his money on window repair, he would
have spent it on the new suit he was saving
to buy. Then the tailor would have the
new income to spend, and so on. The broken
window didn’t create net new spending;
it just diverted spending from somewhere
else. The broken window does not create new
­activity, just different activity. People see
the activity that takes place. They don’t see
the activity that would have taken place.
The broken window fallacy is perpetuated
in many forms. Whenever job creation or
retention is the primary objective I call it the
job-counting fallacy. Economics majors understand
the non-intuitive reality that real progress
comes from job destruction. It once took
90 percent of our population to grow our food.
Now it takes 3 percent. Pardon me, ­Willie, but
are we worse off because of the job losses in
agriculture? The would-have-been farmers are
now college professors and computer gurus. . . .
So instead of counting jobs, we should
make every job count. We will occasionally hit
a soft spot when we have a mismatch of supply
and demand in the labor market. But that
is temporary. Don’t become a Luddite and destroy
the machinery, or become a protectionist
and try to grow bananas in New York City.
Source: Reprinted with permission of The Wall Street
Journal, Copyright © 2003 Dow Jones & Company, Inc. All
Rights Reserved Worldwide.
Why You Should Study
Economics
In the News
In this excerpt from a commencement address, the former president
of the Federal Reserve Bank of Dallas makes the case for studying
economics.
history’s most spectacular examples of inflation, an increase in the overall level of
prices in the economy.
Although the United States has never experienced inflation even close to that
of Germany in the 1920s, inflation has at times been an economic problem. During
the 1970s, for instance, when the overall level of prices more than doubled,
President Gerald Ford called inflation “public enemy number one.” By contrast,
inflation in the first decade of the 21st century ran about 21⁄2 percent per year; at
this rate, it would take almost 30 years for prices to double. Because high inflation
imposes various costs on society, keeping inflation at a low level is a goal of
­economic policymakers around the world.
inflation
an increase in the overall
level of prices in the
economy
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	 CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 15
What causes inflation? In almost all cases of large or persistent inflation, the
culprit is growth in the quantity of money. When a government creates large quantities
of the nation’s money, the value of the money falls. In Germany in the early
1920s, when prices were on average tripling every month, the quantity of money
was also tripling every month. Although less dramatic, the economic history of the
United States points to a similar conclusion: The high inflation of the 1970s was associated
with rapid growth in the quantity of money, and the low inflation of more
recent experience was associated with slow growth in the quantity of money.
1-3c Principle 10: Society Faces a Short-Run
Trade-off between Inflation and Unemployment
Although a higher level of prices is, in the long run, the primary effect of increasing
the quantity of money, the short-run story is more complex and controversial.
Most economists describe the short-run effects of monetary injections as follows:
•	 Increasing the amount of money in the economy stimulates the overall level of
spending and thus the demand for goods and services.
•	 Higher demand may over time cause firms to raise their prices, but in the
meantime, it also encourages them to hire more workers and produce a larger
quantity of goods and services.
•	 More hiring means lower unemployment.
This line of reasoning leads to one final economy-wide trade-off: a short-run
trade-off between inflation and unemployment.
Although some economists still question these ideas, most accept that society
faces a short-run trade-off between inflation and unemployment. This simply means
that, over a period of a year or two, many economic policies push inflation and unemployment
in opposite directions. Policymakers face this trade-off regardless of
whether inflation and unemployment both start out at high levels (as they did in the
early 1980s), at low levels (as they did in the late 1990s), or someplace in between.
This short-run trade-off plays a key role in the analysis of the business cycle—the
irregular and largely unpredictable fluctuations in economic activity, as measured by
the production of goods and services or the number of people employed.
Policymakers can exploit the short-run trade-off between inflation and unemployment
using various policy instruments. By changing the amount that
the government spends, the amount it taxes, and the amount of money it prints,
­policymakers can influence the overall demand for goods and services. Changes
in demand in turn influence the combination of inflation and unemployment that
the economy experiences in the short run. Because these instruments of economic
policy are potentially so powerful, how policymakers should use these instruments
to control the economy, if at all, is a subject of continuing debate.
This debate heated up in the early years of Barack Obama’s presidency. In 2008
and 2009, the U.S. economy, as well as many other economies around the world,
experienced a deep economic downturn. Problems in the financial system, caused
by bad bets on the housing market, spilled over into the rest of the economy,
causing incomes to fall and unemployment to soar. Policymakers responded in
various ways to increase the overall demand for goods and services. President
Obama’s first major initiative was a stimulus package of reduced taxes and increased
government spending. At the same time, the nation’s central bank, the
Federal Reserve, increased the supply of money. The goal of these policies was to
reduce unemployment. Some feared, however, that these policies might over time
lead to an excessive level of inflation.
“Well it may have been
68 cents when you got
in line, but it’s 74 cents
now!”
TribuneMediaServices,Inc.AllRights
Reserved.Reprintedwithpermission.
business cycle
fluctuations in
economic activity, such
as employment and
production
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
16	 PART I	 INTRODUCTION
Quick Quiz  List and briefly explain the three principles that describe how the economy
as a whole works.
1-4 Conclusion
You now have a taste of what economics is all about. In the coming chapters, we develop
many specific insights about people, markets, and economies. Mastering these
insights will take some effort, but it is not an overwhelming task. The field of economics
is based on a few big ideas that can be applied in many different situations.
Throughout this book, we will refer back to the Ten Principles of Economics highlighted
in this chapter and summarized in Table 1. Keep these building blocks in
mind: Even the most sophisticated economic analysis is founded on the ten principles
introduced here.
Ten Principles of Economics
Table 1 How People Make Decisions
  1: People Face Trade-offs
  2: The Cost of Something Is What You Give Up to Get It
  3: Rational People Think at the Margin
  4: People Respond to Incentives
How People Interact
  5: Trade Can Make Everyone Better Off
  6: Markets Are Usually a Good Way to Organize Economic Activity
  7: Governments Can Sometimes Improve Market Outcomes
How the Economy as a Whole Works
 8: A Country’s Standard of Living Depends on Its Ability to Produce
Goods and Services
  9: Prices Rise When the Government Prints Too Much Money
10: Society Faces a Short-Run Trade-off between Inflation and
Unemployment
•	 The fundamental lessons about individual decision
making are that people face trade-offs among alternative
goals, that the cost of any action is measured in
terms of forgone opportunities, that rational people
make decisions by comparing marginal costs and marginal
benefits, and that people change their behavior in
response to the incentives they face.
•	 The fundamental lessons about interactions among
people are that trade and interdependence can be mutually
beneficial, that markets are usually a good way
of coordinating economic activity among people, and
that the government can potentially improve market
outcomes by remedying a market failure or by promoting
greater economic equality.
•	 The fundamental lessons about the economy as a
whole are that productivity is the ultimate source
of living standards, that growth in the quantity of
money is the ultimate source of inflation, and that society
faces a short-run trade-off between inflation and
unemployment.
Summary
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	 CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 17
  1.	 Economics is best defined as the study of
a.	 how society manages its scarce resources.
b.	 how to run a business most profitably.
c.	 how to predict inflation, unemployment, and
stock prices.
d.	 how the government can stop the harm from unchecked
self-interest.
  2.	 Your opportunity cost of going to a movie is
a.	 the price of the ticket.
b.	 the price of the ticket plus the cost of any soda and
popcorn you buy at the theater.
c.	 the total cash expenditure needed to go to the
movie plus the value of your time.
d.	 zero, as long as you enjoy the movie and consider it
a worthwhile use of time and money.
  3.	 A marginal change is one that
a.	 is not important for public policy.
b.	 incrementally alters an existing plan.
c.	 makes an outcome inefficient.
d.	 does not influence incentives.
  4.	 Adam Smith’s “invisible hand” refers to
a.	 the subtle and often hidden methods that businesses
use to profit at consumers’ expense.
b.	 the ability of free markets to reach desirable
outcomes, despite the self-interest of market
participants.
c.	 the ability of government regulation to benefit consumers,
even if the consumers are unaware of the
regulations.
d.	 the way in which producers or consumers in
unregulated markets impose costs on innocent
bystanders.
  5.	 Governments may intervene in a market economy in
order to
a.	 protect property rights.
b.	 correct a market failure due to externalities.
c.	 achieve a more equal distribution of income.
d.	 All of the above.
  6.	 If a nation has high and persistent inflation, the most
likely explanation is
a.	 the central bank creating excessive amounts of
money.
b.	 unions bargaining for excessively high wages.
c.	 the government imposing excessive levels of
taxation.
d.	 firms using their monopoly power to enforce excessive
price hikes.
Quick Check Multiple Choice
scarcity, p. 4
economics, p. 4
efficiency, p. 5
equality, p. 5
opportunity cost, p. 6
rational people, p. 6
marginal change, p. 6
incentive, p. 7
market economy, p. 10
property rights, p. 12
market failure, p. 12
externality, p. 12
market power, p. 12
productivity, p. 13
inflation, p. 14
business cycle, p. 15
Key Concepts
  1.	 Give three examples of important trade-offs that you
face in your life.
  2.	 What items would you include to figure out the opportunity
cost of a vacation to Disneyworld?
  3.	 Water is necessary for life. Is the marginal benefit of a
glass of water large or small?
  4.	 Why should policymakers think about incentives?
  5.	 Why isn’t trade among countries like a game with
some winners and some losers?
  6.	 What does the “invisible hand” of the marketplace do?
  7.	 Explain the two main causes of market failure and
give an example of each.
  8.	 Why is productivity important?
  9.	 What is inflation and what causes it?
10.	 How are inflation and unemployment related in the
short run?
Questions for Review
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
18	 PART I	 INTRODUCTION
  1.	 Describe some of the trade-offs faced by each of the
following:
a.	 a family deciding whether to buy a new car
b.	 a member of Congress deciding how much to
spend on national parks
c.	 a company president deciding whether to open a
new factory
d.	 a professor deciding how much to prepare for class
e.	 a recent college graduate deciding whether to go to
graduate school
  2.	 You are trying to decide whether to take a vacation.
Most of the costs of the vacation (airfare, hotel, and
forgone wages) are measured in dollars, but the benefits
of the vacation are psychological. How can you
compare the benefits to the costs?
  3.	 You were planning to spend Saturday working at your
part-time job, but a friend asks you to go skiing. What
is the true cost of going skiing? Now suppose you had
been planning to spend the day studying at the library.
What is the cost of going skiing in this case? Explain.
  4.	 You win $100 in a basketball pool. You have a choice
between spending the money now and putting it
away for a year in a bank account that pays 5 percent
interest. What is the opportunity cost of spending the
$100 now?
  5.	 The company that you manage has invested $5 million
in developing a new product, but the development is
not quite finished. At a recent meeting, your sales‑
people report that the introduction of competing
products has reduced the expected sales of your new
product to $3 million. If it would cost $1 million to finish
development and make the product, should you
go ahead and do so? What is the most that you should
pay to complete development?
  6.	 The Social Security system provides income for people
over age 65. If a recipient of Social Security decides to
work and earn some income, the amount received in
Social Security benefits is typically reduced.
a.	 How does the provision of Social Security affect
people’s incentive to save while working?
b.	 How does the reduction in benefits associated with
higher earnings affect people’s incentive to work
past age 65?
  7.	 A 1996 bill reforming the federal government’s antipoverty
programs limited many welfare recipients to
only two years of benefits.
a.	 How does this change affect the incentives for
working?
b.	 How might this change represent a trade-off
­between equality and efficiency?
  8.	 Explain whether each of the following government
activities is motivated by a concern about equality or
a concern about efficiency. In the case of efficiency,
­discuss the type of market failure involved.
a.	 regulating cable TV prices
b.	 providing some poor people with vouchers that
can be used to buy food
c.	 prohibiting smoking in public places
d.	 breaking up Standard Oil (which once owned
90 percent of all oil refineries) into several smaller
companies
e.	 imposing higher personal income tax rates on
people with higher incomes
f.	 instituting laws against driving while intoxicated
  9.	 Discuss each of the following statements from the
standpoints of equality and efficiency.
a.	 “Everyone in society should be guaranteed the best
healthcare possible.”
b.	 “When workers are laid off, they should be able
to collect unemployment benefits until they find a
new job.”
10.	 In what ways is your standard of living different from
that of your parents or grandparents when they were
your age? Why have these changes occurred?
11.	 Suppose Americans decide to save more of their incomes.
If banks lend this extra saving to businesses,
which use the funds to build new factories, how might
this lead to faster growth in productivity? Who do you
suppose benefits from the higher productivity? Is society
getting a free lunch?
12.	 During the Revolutionary War, the American colonies
could not raise enough tax revenue to fully fund
the war effort; to make up the difference, the colonies
decided to print more money. Printing money to cover
expenditures is sometimes referred to as an “inflation
tax.” Who do you think is being “taxed” when more
money is printed? Why?
Go to CengageBrain.com to purchase access to the proven,
critical Study Guide to accompany this text, which features
additional notes and context, practice tests, and much more.
Problems and Applications
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