Principles of Economics
Economics deals with people and is a reflection of how they interact with each other as they go about making decisions regarding their lives. We study economics by observing the principles of decision making of the individuals who make up the economy, how they interact with one another and how the economy as a whole works.




I. Principles of Decision Making
There are four economic principles of individual decision making:
1. People Make Tradeoffs

Economic goods and services are limited, while the need to use services of these goods and services seem limitless. There are simply not enough goods and services to satisfy even a small fraction of everyone's consumption desires. Thus, societies must decide how to use these limited resources and distribute them among different people. This means, to get one thing that we like, we usually have to give up another thing that we also like. Making decision requires trading off one goal against another.

Consider a society that decides to spend more on national defense to protect its shores from foreign aggressors: the more the society spends on the national defense, the less it can spend on personal goods to raise its standard of living at home. Or consider the trade-off between a clean air environment and a high level of income. Laws that require firms to reduce pollution have the cost of reducing the incomes of the firm's owners, workers, and customers, while pollution regulations give the society the benefit of a cleaner environment and the improved health that comes with it.
Another trade off society faces is between efficiency and equity. Efficiency deals with a society's ability to get the most effective use o its resources in satisfying people's wants and needs. Equity denotes the fair distribution of benefits of those resources among society's members.
2. When People Choose One Thing They Give Up Something Else
Scarcity of economic resources forces people to make tradeoffs. That is, people must always consider how to spend their own limited incomes or time because resources are limited to satisfy their unlimited needs and wants. Tradeoffs or choosing a one thing means giving up something else. When we give up an item, we lose the benefits of its services to us or incur costs to obtain the benefits of the thing we decided to choose. Thus, making decisions requires comparing the costs and benefits of alternative courses of action. In economics, the term used to reflect whatever must be given up to obtain some item is called opportunity cost.
3. Rational People Think at the Margin
In many situations, decisions in life are made in small incremental or decremental adjustments to the existing plan of action or status quo. Economists call these marginal changes. Imagine a student who is pondering whether she should add one more course next semester. She, as a rational decision-maker, will add the extra course as long as her marginal benefits from carrying one more course exceeds her expected marginal costs. Generally speaking, an individual can make better decisions by thinking at the margin. Likewise, a rational decision-maker takes an action if and only if the marginal benefit of the action exceeds the marginal cost.
4. People Respond to Incentive
Since individuals make decisions by comparing costs or benefits, their behavior may change when the costs or benefits change. That is, people respond to incentives. As an example of this, consider public policy toward seat belts and auto safety. In the 1960s, Ralph Nader's book (Mr. Nader is a well-known personality as an advocate for a consumer's interest and a Green Party presidential candidate in 2000 ) Unsafe at Any Speed influenced the Congress to pass a legislation requiring car companies to make seat belts standard equipment on all cars. The direct effect of this law is to save lives. It is this direct impact that motivated Congress to require seat belts.


It is so obvious that individuals' decisions affect not only themselves but other people as well. The following three principles state how people interact with one another.

5. Trade Can Make Everyone Better Off
Consider a situation in which a family isolates itself from all other families. That particular
family would need to grow its own food, make its own clothes, and build its own home. Clearly
any family gains much from its ability to trade with others. Trade allows each person to
specialize in the activities he or 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.
Just as a family would not be better off isolating itself from all other families, a country too would not be better off if it does not exchange goods and services with the rest of nations. Trade allows countries to specialize in what they do best and to enjoy a greater variety of goods and services.
6. Markets Are Usually a Good Way to Organize Economic Activity
The market possesses the power of resource allocation. Most nations of the world have adopted the use of the market power as a tool for allocating resources rather than other alternatives such as central planning. This is because the market allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services.
Under a market economy, 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 guide their decisions. Prices reflect both the values of a good to society and the cost to society of making the good. Because households and firms look at prices when deciding what to buy and sell, prices guide these individual decision makers to reach outcomes that, in many cases, promote general economic well-being by allocating resources efficiently.
In a centrally planned economy, for example, prices are not determined in the marketplace, but are gauged by central planners. Central planners, however, lack the information that effectively reflects either the value of a good to the society or the cost of the good to the society that gets reflected in prices under market forces. Thus, the pricing mechanism under a central planning system does not take into account the social benefits and costs when exchanging goods and services. As a result, resources are not effectively allocated in a way that maximizes the welfare of society as a whole.
7. Governments Can Improve Market Outcomes

Markets cannot effectively respond to some key societal questions, such as how to protect our precious environment for future generations, or how much of our resources should be devoted to educating the young, or how to correct the extreme imbalances and the unfair sharing of national wealth that exists between the rich and the poor, or how to reduce unemployment in a deep recession.

Due to what is known as market failure, which are the characteristics of the free market system, some times the market on its own fails to allocate resources efficiently. Under these circumstances, intervention by a government into the economy becomes both a desirable and an inevitable outcome. Consider three situations of market failures: externality, market power and unequal distribution of income. A government in a market economy can promote efficiency and equity eliminating problems unresolved or caused by market failure.
An externality is an activity that affects others for better or worse, without those others paying or being compensated for the activity. It exists when private costs or benefits do not equal social costs or benefits. The unregulated market may produce too much air pollution and too little investment in public health or knowledge. Government may use its influence to control harmful externalities. For example, if a chemical factory does not bear the entire cost of smoke it emits, the government can raise economic well-being through environmental regulation. Or it can subsidize activities that are socially beneficial such as education or prenatal care.
The second example of market failure, a market power, reflects the degree of control that a firm or group of firms has over the price and production decisions in an industry. When monopolies or oligopolies, for example, collude to reduce rivalry or drive firms out business, government may apply antitrust policies or regulations to enhance economic efficiency.
The last example refers to the manner in which the total wealth of a nation and income is unfairly and unequally distributed among individuals. Even when a market works to maintain efficiency, it does not ensure that everyone has sufficient food, decent clothing, and adequate health care. People end up being rich or poor depending on their inherited wealth, or on their talents and efforts, and on their gender or the color of their skin. The government can achieve a more equitable distribution of economic well being through public policies, such as the income tax and the welfare system.
III. How the Economy Works

All the decisions that are made by individuals and the interactions they make with one another together make up "the economy". The last three principles reflect the workings of the economy as a whole.

8. A Country's Standard of Living Depends on Its Ability to Produce Goods and Services
The differences in the living standards around the world are astounding. People in countries with the lowest average incomes earn only about one-twentieth as much as people in high-income countries. The average life expectancy is four-fifths that of the average person in an advanced country. Birth rates are high, particularly for the families where women receive no education, but mortality rates are also much higher there than in countries with good health-care systems. A typical works with but one-sixtieth the horsepower of a prosperous industrialized worker. The people in the 40 poorest countries constitute 55 percent of the world population but must divide among each other only 4 percent of the world income.

What explains these large differences in living standards among countries and over time? Almost all variation in living standards is attributable to differences in countries' productivity. Broadly defined, productivity is the quantity of goods and services produced from each hour of a worker's time. In nations where workers can produce large quantities of goods and services per unit of time, most people enjoy a high standard of living; in nations where workers are less productive, most people must endure a more meager existence. Similarity, the growth rate of a nation's productivity determines the growth rate of average income.

The relationship between productivity and living standard also has profound implications for public policy. 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 available technology.
The relationship between productivity and living standard also has profound implications for public policy. 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 available technology.
9. Price Rise when the Government Prints Too Much Money
When an average price increases consistently for a long period of time in the economy, it causes an inflationary condition. Average price increases in the economy are mainly affected by growth in the quantity of money in the long run situation. Therefore, inflation is associated with rapid growth in the quantity of money in the long run circumstances.
10. Society Faces a Short-Run Tradeoff between Inflation and Unemployment
The tradeoff between inflation and unemployment is called the Phillips curve, after the economist who first examined this relationship.
The tradeoff arises because in the short run, prices respond to the quantity of money changes very slowly. Suppose, for example, that the government reduces the quantity of money in the economy. All prices will not be reduced immediately as a result of this change for many reasons. It may take several years before all firms issue new catalogs or all unions make wage concessions. That is prices are said to be sticky in the short run. On the other hand, when the government reduces the quantity of money in the economy, it reduces the amount that people spend. Lower spending, together with prices that are stuck too high, reduce the quantity of goods and services that firms sell. Lower sales, in turn, cause firms to lay off workers. Thus, the reduction in the quantity of money raises unemployment in the short run until prices have fully adjusted to the change.
Policymakers can exploit this tradeoff using various policy instruments. For example, by changing the the amount it spends, the amount it taxes, and the amount of money it prints, Policymakers can influence the combination of inflation and unemployment the economy experiences.