Ten Core Principles of Economics Explained

Economy: From the Greek word for "one who manages a household".

It is the study of how society manages its scarce resources.

Scarcity: The limited nature of society's resources.

How Individuals Make Decisions

1st Principle: People Face Trade-offs

To get something we like, we usually have to give up something else we also like.

Society also faces a trade-off between efficiency and equity.

• Efficiency: Society getting the maximum benefits from its scarce resources.
• Equity: Distributing economic prosperity fairly among the members of society.

2nd Principle: The Cost of Something Is What You Give Up

Opportunity cost: Whatever must be given up to obtain some item.

3rd Principle: Rational People Think at the Margin

Marginal changes: Small incremental adjustments to an existing plan of action.

A rational decision-maker takes action if and only if the marginal benefit of the action exceeds the marginal cost.

4th Principle: People Respond to Incentives

People make decisions by comparing costs and benefits. Their behavior may change when the costs or benefits change (e.g., choosing between apples and pears based on price).

How People Interact

5th Principle: Trade Can Make Everyone Better Off

Trade allows countries and families to specialize in what they do best and to enjoy a greater variety of goods and services.

6th Principle: Markets Organize Economic Activity Well

In a market economy, decisions are made by millions of firms and households. Firms decide whom to hire and what to produce. Households decide which firms to work for and what to buy with their incomes.

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, often guided by an "invisible hand".

7th Principle: Governments Can Improve Market Outcomes

Governments intervene in the economy to promote efficiency and equity. The "invisible hand" can fail to allocate resources efficiently, leading to:

Market failure: A situation in which a market left on its own fails to allocate resources efficiently.

This can be caused by:

• Externalities: The impact of one person's actions on the well-being of a bystander (e.g., pollution).
• Market power: The ability of a single economic actor (or small group of actors) to have a substantial influence on market prices (e.g., a monopoly).

How the Economy as a Whole Works

8th Principle: Living Standards Depend on Productivity

This is primarily due to differences in Productivity: The quantity of goods and services produced from each unit of labor input.

Higher productivity leads to higher incomes and a better standard of living.

9th Principle: Prices Rise When Money Supply Increases

When a government creates large quantities of the nation's money, the value of the money falls, causing inflation: An increase in the overall level of prices in the economy.

10th Principle: Inflation & Unemployment Short-Run Trade-off

Reducing inflation often causes a temporary rise in unemployment. This trade-off is depicted by the Phillips curve.