Chapter 1: Ten principles of economics
The Economic Problem
These decisions can be summarized as representing the economic problem.
There are three questions that any society has to face:
What goods and services should be produced?
How should these goods and services be produced?
Who should get the goods and services that have been produced?
Resources can be broadly classified into three categories:
1. Land – all the natural resources of the earth.
2. Labour – the human effort both mental and physical that goes in to
production.
3. Capital – the equipment and structures used to produce goods and
services.
The management of society’s resources is important because resources are
scarce.
Scarcity means that society has limited resources.
Therefore cannot produce all the goods and services people wish to have.
Economics is the study of how society manages its scarce resources.
Economists:
Study how people make decisions: how much they work, what they buy,
how much they save and how they invest their savings.
Study how people interact with one another.
Analyse 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.
How people make decisions
The economy refers to all the production and exchange activities that take place
every day – all the buying and selling.
1
, The level of economic activity is how much buying and selling goes on in the
economy over a period of time.
Principle 1: People Face Trade-offs
Making decisions requires trading off the benefits of one goal against those of
another.
When people are grouped into societies, they face different kinds of trade-offs.
The classic trade-off is between spending on defence and spending on food. The
more we spend on national defence to protect our country from foreign
aggressors, the less we can spend on consumer goods to raise our standard of
living at home.
Another trade-off society faces is between efficiency and equity.
Efficiency means that society is getting the most it can (depending how
this is defined) from its scarce resources.
Equity means that the benefits of those resources are distributed fairly
among society’s members.
In other words, efficiency refers to the size of the economic cake, and equity
refers to how the cake is divided.
Often, when government policies are being designed, these two goals
conflict.
Recognizing that people face trade-offs does not by itself tell us what decisions
they will or should make. But acknowledging life’s trade-offs is important because
people are likely to make good decisions only if they understand the options that
they have available.
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
some action is not as obvious as it might first appear.
The opportunity cost is whatever must be given up to obtain some item; the
value of the benefits foregone (sacrificed)
When making any decision, such as whether to go to university, decision
makers should be aware of the opportunity costs that accompany each
possible action.
Principle 3: Rational People Think at the Margin
Economists use the term marginal changes to describe small incremental
adjustments to an existing plan of action. ‘Margin’ means ‘edge’, so marginal
changes are adjustments around the edges of what you are doing.
People usually make the best decisions by thinking at the margin.
A rational decision maker takes an action if and only if the marginal benefit
of the action exceeds the marginal cost.
Principle 4: People Respond to Incentives
2
The Economic Problem
These decisions can be summarized as representing the economic problem.
There are three questions that any society has to face:
What goods and services should be produced?
How should these goods and services be produced?
Who should get the goods and services that have been produced?
Resources can be broadly classified into three categories:
1. Land – all the natural resources of the earth.
2. Labour – the human effort both mental and physical that goes in to
production.
3. Capital – the equipment and structures used to produce goods and
services.
The management of society’s resources is important because resources are
scarce.
Scarcity means that society has limited resources.
Therefore cannot produce all the goods and services people wish to have.
Economics is the study of how society manages its scarce resources.
Economists:
Study how people make decisions: how much they work, what they buy,
how much they save and how they invest their savings.
Study how people interact with one another.
Analyse 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.
How people make decisions
The economy refers to all the production and exchange activities that take place
every day – all the buying and selling.
1
, The level of economic activity is how much buying and selling goes on in the
economy over a period of time.
Principle 1: People Face Trade-offs
Making decisions requires trading off the benefits of one goal against those of
another.
When people are grouped into societies, they face different kinds of trade-offs.
The classic trade-off is between spending on defence and spending on food. The
more we spend on national defence to protect our country from foreign
aggressors, the less we can spend on consumer goods to raise our standard of
living at home.
Another trade-off society faces is between efficiency and equity.
Efficiency means that society is getting the most it can (depending how
this is defined) from its scarce resources.
Equity means that the benefits of those resources are distributed fairly
among society’s members.
In other words, efficiency refers to the size of the economic cake, and equity
refers to how the cake is divided.
Often, when government policies are being designed, these two goals
conflict.
Recognizing that people face trade-offs does not by itself tell us what decisions
they will or should make. But acknowledging life’s trade-offs is important because
people are likely to make good decisions only if they understand the options that
they have available.
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
some action is not as obvious as it might first appear.
The opportunity cost is whatever must be given up to obtain some item; the
value of the benefits foregone (sacrificed)
When making any decision, such as whether to go to university, decision
makers should be aware of the opportunity costs that accompany each
possible action.
Principle 3: Rational People Think at the Margin
Economists use the term marginal changes to describe small incremental
adjustments to an existing plan of action. ‘Margin’ means ‘edge’, so marginal
changes are adjustments around the edges of what you are doing.
People usually make the best decisions by thinking at the margin.
A rational decision maker takes an action if and only if the marginal benefit
of the action exceeds the marginal cost.
Principle 4: People Respond to Incentives
2
