Chapter 1 Ten Principles of Economics

What is economics?

The study of how society manages scarce resources.

What is scarcity?

Resources such as time, money, and labor are limited relative to people's wants.

What three questions do economists study?

How people make decisions; how people interact; how the economy as a whole works.

Principle 1: People face trade-offs

To get one thing, you usually give up another.

Efficiency

Getting the greatest possible benefit from scarce resources; the size of the economic pie.

Equality

Distributing economic prosperity relatively evenly; how the economic pie is divided.

Principle 2: The cost of something is what you give up to get it

Consider the opportunity cost of your choice, including what you forgo.

Opportunity cost

The value of the next-best alternative you give up when you make a choice.

What is a major opportunity cost of attending college?

The earnings you give up because you spend time studying instead of working.

Principle 3: Rational people think at the margin

They compare the additional benefit and additional cost of a small change in a plan.

Marginal change

A small incremental adjustment to an existing plan, such as studying one more hour.

When should you take one more action?

When its marginal benefit is greater than its marginal cost.

Principle 4: People respond to incentives

Changes in rewards or penalties change people's behavior.

Incentive

Something that induces a person to act, such as a reward or punishment.

Why should policymakers consider incentives?

A policy changes people's costs and benefits, which can change behavior in unexpected ways.

Principle 5: Trade can make everyone better off

Specialization and exchange let people obtain more goods and services than self-sufficiency.

Specialization

Focusing on producing a good or service you do well, then trading for other things.

Principle 6: Markets are usually a good way to organize economic activity

Households and firms make decentralized decisions, coordinated through prices.

Market economy

An economy in which households and firms make decisions about what to buy, sell, and produce through markets.

Invisible hand

Adam Smith's idea that market prices guide self-interested buyers and sellers and can promote overall economic well-being.

How do prices coordinate buyers and sellers?

Prices give signals that affect how much buyers demand and sellers supply.

Principle 7: Governments can sometimes improve market outcomes

Government can enforce rules and property rights, address market failures, or promote equality.

Property rights

The ability to own and control scarce resources.

Market failure

A situation in which a market on its own fails to allocate resources efficiently.

Externality

The effect of one person's actions on a bystander's well-being, such as pollution.

Market power

The ability of one person, firm, or small group to substantially influence market prices.

Why might government intervene when there is pollution?

Pollution harms bystanders; a market may not account for that external cost.

Principle 8: A country's standard of living depends on its ability to produce goods and services

Higher productivity tends to support higher income and living standards.

Productivity

The amount of goods and services produced per hour of a worker's time.

Principle 9: Prices rise when the government prints too much money

Persistent, excessive growth in the money supply is associated with inflation in the long run.

Inflation

An increase in the overall level of prices in an economy.

Principle 10: Society faces a short-run trade-off between inflation and unemployment

Increased spending can temporarily boost production and hiring while also putting upward pressure on prices.

What is the short-run effect of an increase in spending in the Chapter 1 model?

Firms may produce more and hire more workers, lowering unemployment in the short run; prices may rise.

Fiscal policy

Government decisions about spending and taxes.

Monetary policy

Central-bank actions affecting the supply of money and financial conditions.