Principles of Economics: A Comprehensive Guide

Principles of Economics

Scarcity and Economics

Scarcity refers to the limited nature of society's resources. Economics is the study of how society manages its scarce resources.

How People Make Decisions

1. People Face Tradeoffs

Every decision involves tradeoffs. A significant tradeoff society faces is between:

• Efficiency: When society gets the most from its scarce resources.
• Equality: When prosperity is distributed uniformly among society's members.

Tradeoff Example: To achieve greater equality, income could be redistributed from the wealthy to the poor. However, this can reduce the incentive to work and produce, shrinking the overall economy.

2. The Cost of Something Is What You Give Up to Get It

Decision-making requires comparing the costs and benefits of different choices. The opportunity cost of any item is whatever must be given up to obtain it.

3. Rational People Think at the Margin

Rational people systematically and purposefully do their best to achieve their objectives. They make decisions by evaluating the costs and benefits of marginal changes, which are incremental adjustments to an existing plan.

4. People Respond to Incentives

An incentive is something that induces a person to act. Rational people respond to incentives.

How People Interact

5. Trade Can Make Everyone Better Off

Instead of being self-sufficient, people can specialize in producing one good or service and exchange it for other goods. Countries also benefit from trade and specialization:

1. They can get better prices abroad for the goods they produce.
2. They can buy other goods more cheaply from abroad than they could be produced domestically.

6. Markets Are Usually a Good Way to Organize Economic Activity

A market is a group of buyers and sellers (not necessarily in a single location). Organizing economic activity means determining:

1. What goods to produce
2. How to produce them
3. How much of each to produce
4. Who gets them

A market economy allocates resources through the decentralized decisions of many households and firms as they interact in markets.

As famously described by Adam Smith in The Wealth of Nations (1776), each household and firm acts as if "led by an invisible hand" to promote general economic well-being. The invisible hand works through the price system:

1. The interaction of buyers and sellers determines prices.
2. Each price reflects the good's value to buyers and the cost of producing the good.
3. Prices guide self-interested households and firms to make decisions that, in many cases, maximize society's economic well-being.

7. Governments Can Sometimes Improve Market Outcomes

An important role for government is to enforce property rights (with police and courts).

Market failure occurs when the market fails to allocate society's resources efficiently. Causes of market failure include:

1. Externalities, when the production or consumption of a good affects bystanders (e.g., pollution).
2. Market power, when a single buyer or seller has substantial influence on market price (e.g., a monopoly).

Public policy may promote efficiency. Government may also alter market outcomes to promote equity. If the market's distribution of economic well-being is not desirable, tax or welfare policies can change how the economic "pie" is divided.

How the Economy as a Whole Works

8. A Country's Standard of Living Depends on Its Ability to Produce Goods and Services

There is huge variation in living standards across countries and over time. The most important determinant of living standards is productivity, the amount of goods and services produced per unit of labor. Productivity depends on the equipment, skills, and technology available to workers.

9. Prices Rise When the Government Prints Too Much Money

Inflation is an increase in the general level of prices. In the long run, inflation is almost always caused by excessive growth in the quantity of money, which causes the value of money to fall. The faster the government creates money, the greater the inflation rate.

10. Society Faces a Short-Run Tradeoff Between Inflation and Unemployment

In the short run (1-2 years), many economic policies push inflation and unemployment in opposite directions. This is known as the Phillips curve.