PrintReading Assignment
Please note that we will not go into further detail in the course notes on budget constraints or production possibilities frontiers, and therefore this material will not be on any quizzes or tests.
Economics is a social science. What exactly does that term mean? "Social" means that is about examining the way the people organize their interactions with each other in societies. "Science" means that the "scientific method" is used as a way of thinking about and studying social organization. We have some other social sciences, such as sociology, anthropology, education, history, and law. These disciplines all look at different aspects of societies or examine them from a certain perspective. Economics is the social science that concerns itself with how people make consumption and production choices in a world of endless wants and limited means.
Economics is not an ideology or a set of political beliefs; it is merely one of the ways in which people try to understand the society we live in, and how it works. It is a way of looking at the world, what we call the "economic way of thinking." This has proven to be a useful tool for understanding and explaining a great deal of human behavior. It explains how people do many of the things they do, and why, and it allows us to predict, with a reasonable degree of confidence, what the effects of some action taken by a government or a group of individuals will be.
Note that I said, "reasonable degree of confidence." That could be taken as a set of meaningless weasel words, with terms like "reasonable" and "confidence" not being clearly defined. However, what I am trying to do when I make this statement is to avoid being too sure about our knowledge of the outcomes. While it is true that people behave in a way that is "generally" predictable, you must always remember that when we study societies, we are talking about people, and people do not uniformly behave in a predictable manner. In mathematical terms, there are too many variables, and we cannot isolate and correct them all. So, what I am saying here is the "soft-sell" on economics: it is a helpful and pretty reliable way of understanding the world, just not a perfect or strictly deterministic way. Note that the "economic way of thinking" has been applied to many other social science disciplines, most famously law and sociology, and it has done a great deal to explain behavior in these areas. If you are interested, you may want to read more about the works of people like Richard Posner in law and economics, and Gary Becker in sociology. Economics also has strong ties to the field of psychology. Several of the recent Nobel Prizes in economics have been awarded to scholars or teams studying economic behavior from a psychological perspective. This should be unsurprising: both disciplines have the goal of trying to figure out how and why people make the decisions and choices that they make.
A great many economics textbooks have been written, and they all strive to start at the same place, laying out what the "fundamental principles" are. One of the best attempts is by Gregory Mankiw, a professor at Harvard University and former chair of the President's Council of Economic Advisors. He has laid out a list of ten "principles of economics" that is broadly accepted as a good summary of the main points that I will try to make here.
Actually, it's more like "7 Principles," because the last three pertain to macroeconomic issues, which is an area of study that will not be addressed in this course. Instead, we will examine microeconomics, which is the study of individual economic actors: people, and firms, and their interactions in markets. Included as an agent in this study will be governments, which play a large role in the economic lives of every individual and every firm.
A good understanding of these seven points will provide you with a very solid grounding for how to think about economic problems throughout this course and throughout the rest of your lives. I will list them below, with some explication. Before I list them, I want to add three "axiomatic" statements that have to be considered before we move on. An axiom is an assumed statement, sort of a "first principle" that is not, or need not be proved. It is a basic understanding of how things happen.
Axiom 1: Things that we want to consume more of are called economic goods or, usually, just "goods". The opposite of a good is a "bad," which is something that we want less of. However, there are very few things that are universally bad - almost every economic bad is somebody else's good. For example, we might think of pollution from burning coal as bad, and it certainly has a detrimental effect on many people, especially those who live near power plants. But the more pollution a plant operator can put into the air, the more electricity he sells, and the more money he makes.
Axiom 2: All goods are scarce. It is important to understand what "scarce" means in this context. There are quite a few words that have one meaning when used in general conversation, and a narrower, more specific definition when used in economic analysis. In general usage, "scarce" usually refers to something that is in short supply, or is running out, or is hard to find. In economics, scarce simply means that something is not limitless. Another way of thinking about it is this: a good is considered scarce if we have to give something up to consume it. When viewed in this light, the phrase "all goods are scarce" makes a bit more sense. Bottles of orange juice or episodes of TV shows are not scarce in the general sense, but they certainly are in the economic sense.
Axiom 3: Wants are unlimited. This is perhaps a polite way of saying "people are greedy" in the sense that people almost always prefer to consume more goods than less. If they reach a limit to how much of some good they want to consume, it is not hard to find another good they would like to consume more of. It is important to consider that things like leisure, rest, and peace of mind can be seen as goods.
Now, moving on to Mankiw's list:
Principle 1: People face tradeoffs.
This means that we have to make choices in a world of unlimited wants and scarce resources. If you want something, you will have to give something else up. You have to make a choice. Perhaps, in a perfect world, we would not have to make choices – we could have all that we want without having to give up anything else, but this is not the world we live in. From the desert island example, we had a simple trade-off: if you wanted more coconuts, you had to give up fish, and vice versa. If you wanted more leisure time, you had to give up some food to get it.
Principle 2: The cost of something is what you give up to get it.
In everyday life, we think of costs generally in terms of money, or perhaps time or effort. However, whenever you make an economic choice, what you give up are all of the choices that you didn’t make. This is what we call an “opportunity cost.” Ask the average man on the street what the cost of a bag of Doritos is, and he will say “99 cents.” Ask an economist, and he will tell you “every other thing that I could have spent 99 cents on." Or maybe, “the most valuable thing I could have spent 99 cents on, but did not because I spent it on Doritos.” Needless to say, this causes a lot of people to avoid having conversations with economists at parties but, nonetheless, thinking about costs in this way helps us better understand economic decision making. This contains a secondary point: money is only a tool, a store of value or a method of accounting. Money is only basically good for one thing: exchanging for goods that we consume. So, the cost of one consumption choice is the most valuable consumption choice we could have had, but chose not to make. Likewise, the opportunity cost of an investment, of either time or money, is the best other investment we could have made with that time and/or money. For example, the opportunity cost of going to an 8 am class is probably an hour of sleep for most people. Once again, think back to the desert island economy: it took you an hour to catch a fish, or half an hour to get a coconut. So what was the cost of a fish? Well, you can look at it two ways: first, you could say that it cost you an hour. This is true, but, really, an hour was only good for one of two things: catching fish or harvesting coconuts. So, if you spent an hour catching a fish, you were giving up two coconuts. We say that the opportunity cost of the fish is two coconuts - 2 coconuts is what you have to give up to gain an extra fish.
Opportunity cost is all the other things you give up to get something else. For example, let’s say you buy a car for 25 thousand dollars. If you don't spend your money on buying the car, you could invest your money (for example: deposit it into a savings account and receive interest or buy stocks, ...). When you buy the car, you give up all the other things that you could have done with the 25 thousand dollars. In economics, you should consider all of those. For example, if investing the money would give you interest, then, the opportunity cost of buying the car would be 25 thousand dollars plus lost interest of given up investment.
Another example: When you are a full-time student, the opportunity cost would be: the tuition that you pay plus money that you could have made if you were working and not spending your time at school.
Another example: Let's assume you are living in Pittsburgh and you want to buy a TV. There is a store in Pittsburgh that sells the TV for 500 dollars. However, you find a store in New York that has a TV on sale for 300 dollars. But there is no shipping service. So, you need to go there and pick it up there. What would you do? The true cost of buying the TV from the store in New York is \$300 plus all the other costs that you don't need to pay if buy the TV from the Pittsburgh store. If you decide to buy the TV from New York:
- You need to rent a car (if you use your own car, you should consider the wear and tear costs of driving to New York and back).
- You need to pay for gas.
- If you work, you need to take a day off and lose the money that you could have earned.
Next is a short video with more explanation.
Video: What is Opportunity Cost? (2:45)
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[Narrator] What is opportunity cost? Opportunity cost refers to the value a person could have received but passed up in pursuit of another option. So if you were to wait in line for free ice cream, you actually give up the opportunity to do something else with your time, like working at a job or reading a book. So that ice cream really isn't free. Economists even use the concept of opportunity cost to determine if people can benefit from trading with one another. Let's look at a simple example -- just two people, Bob and Ann, who produce just two goods, bananas and fish. Because of the concept of opportunity costs, Ann and Bob are worse off when they try to do everything themselves. Here's what Bob can do if he spends all of his time producing only one good. Bob can either gather 10 bananas, or he can catch 10 fish. And Ann can either gather 10 bananas or catch 30 fish. Bob has to choose to gather bananas or catch fish. When he chooses to gather 1 banana, he gives up 1 fish. In essence, Bob trades with himself. He can use that time to gather bananas or trade that time to catch fish, and the cost of that trade is 1 fish per banana. That's Bob's opportunity cost. The same holds true for Ann, but her cost of producing 1 banana is 3 fish. In the amount of time that it takes Ann to gather 1 banana, she could have caught 3 fish. She trades with herself 1 banana for 3 fish. So Bob only has to give up 1 fish to produce 1 banana, but Ann must give up 3 fish to produce 1 banana. Ann's opportunity cost of gathering a banana is higher than Bob's. If Ann and Bob are allowed to trade with one another, they may be able to gain from specialization if Ann focuses on catching fish, and Bob focuses on gathering bananas. Because our time is valuable, any decision we make has a cost. If we focus our time on tasks we're good at, like Ann and Bob, then we end up in a better position than if we try to do everything ourselves.
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To learn more about the role of specialization in trade, click here. Or, to test your knowledge on opportunity cost, click here.
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Still here? Check out Marginal Revolution University's other popular videos.
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Principle 3: Rational people think at the margin.
“Thinking at the margin” means that we think about the next decision we need to make, and the incremental effects of that decision. Put another way, people have to be forward-looking, because the past is in the past, and nothing can be done to change it.
Principle 4: People respond to incentives.
I will talk about this in more depth in the next section when we address rationality and utility maximization. This principle is intuitively very obvious: every child understands the notion of the carrot and the stick: positive and negative incentives designed to modify behavior. A further examination of this topic leads us to discover that people usually act in their own best interest, so when governments design policies, they have to be sure that they are incentivizing the “right” behavior. An interesting topic has arisen recently: the Estate Tax, which is applied to inheritances, is set to be reinstated at the beginning of 2011 after having lapsed at the end of 2009. This means that a wealthy person dying a few minutes after the coming New Year will leave his or her heirs with a significantly larger tax bill than if he died a few minutes before midnight. Thus, the heirs perhaps have an incentive to see to it that a terminally ill parent dies a little bit earlier. This is what is called a “perverse incentive,” because our society generally frowns upon people trying to cause others to die earlier than they otherwise might. Whenever you participate in an economic transaction, it always helps to think about what incentives the other person in the transaction faces.
Principle 5: Trade can make everyone better off.
I might be inclined to make a stronger statement: that trade MUST make everybody better off, but we can go with Mankiw’s weaker statement for now. The fundamental notion behind voluntary trade is that each party is giving up something in exchange for something that they place a higher value upon. If this were not the case, the person would choose to not make the trade. For example, when I buy a bag of Doritos, the shopkeeper will voluntarily make the trade because I am paying him more money than he paid for the chips, so he’s better off, and I will voluntarily make the trade because I get more happiness from consuming the chips than anything else I could spend that 99 cents on. We’re both made better off by the transaction. We will look at applications of this notion in much more depth later on.
Principle 6: Markets are usually a good way to organize economic activity.
This is another statement that could be made a little more forcefully, but we can let it be. Markets refer to institutions (not just places) that allow people to voluntarily and willingly participate in trades to improve their lives. People sell their labor and brain power to firms, which use it to help them make profits for the owners of those firms. People use the money they earn to purchase goods and services to help them live their lives in a way that best makes them happy. In a truly free-market system, we have millions of individual, voluntary economic transactions taking place every day. In reality, sometimes (or, perhaps, always) markets do not work in this idealized manner, which leads to the next principle.
Principle 7: Governments can sometimes improve market outcomes.
When markets do not work well, we speak of “market failure” (there will be much more on this later in the course). Sometimes a government can intervene in a market, by setting rules or restrictions that enable a better outcome for society than would be obtained through an unfettered free market. Many people believe, for example, that product safety laws or workplace safety rules are unambiguous improvements upon unregulated outcomes. However, the government cannot fix every problem, and sometimes government intervention in a market can end up making things worse for society. This is what is called “government failure,” and we will also look at this in much more depth later on in the course.
The last three principles, which I will simply list below, pertain to macroeconomic issues that will not be addressed in this course.