IN THIS CHAPTER YOU WILL . . . Learn that economics is about the allocation of scarce resources Examine some of the tradeoffs that people face Learn the meaning of opportunity cost See how to use marginal reasoning when making decisions Discuss how incentives affect T E N P R I N C I P L E S people’s behavior O F E C O N O M I C S Consider why trade among people or The word economy comes from the Greek word for “one who manages a house- nations can be good hold.” At first, this origin might seem peculiar. But, in fact, households and for everyone economies have much in common. A household faces many decisions. It must decide which members of the household do which tasks and what each member gets in return: Who cooks din- Discuss why markets ner? Who does the laundry? Who gets the extra dessert at dinner? Who gets to are a good, but not choose what TV show to watch? In short, the household must allocate its scarce re- perfect, way to sources among its various members, taking into account each member’s abilities, allocate resources efforts, and desires. Like a household, a society faces many decisions. Asociety must decide what jobs will be done and who will do them. It needs some people to grow food, other people to make clothing, and still others to design computer software. Once soci- Learn what ety has allocated people (as well as land, buildings, and machines) to various jobs, determines some trends in the overall economy 3 4 PART ONE INTRODUCTION it must also allocate the output of goods and services that they produce. It must decide who will eat caviar and who will eat potatoes. It must decide who will drive a Porsche and who will take the bus. The management of society’s resources is important because resources are scarcity scarce. Scarcitymeans that society has limited resources and therefore cannot pro- the limited nature of society’s duce all the goods and services people wish to have. Just as a household cannot resources give every member everything he or she wants, a society cannot give every indi- vidual the highest standard of living to which he or she might aspire. economics Economicsis the study of how society manages its scarce resources. In most the study of how society manages its societies, resources are allocated not by a single central planner but through the scarce resources combined actions of millions of households and firms. Economists therefore study how people make decisions: how much they work, what they buy, how much they save, and how they invest their savings. Economists also study how people inter- act with one another. For instance, they examine how the multitude of buyers and sellers of a good together determine the price at which the good is sold and the quantity that is sold. Finally, economists analyze forces and trends that affect theeconomy 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. Although the study of economics has many facets, the field is unified by sev- eral central ideas. In the rest of this chapter, we look at Ten Principles of Economics. These principles recur throughout this book and are introduced here to give you an overview of what economics is all about. You can think of this chapter as a “pre- view of coming attractions.” HOW PEOPLE MAKE DECISIONS There is no mystery to what an “economy” is. Whether we are talking about the economy of Los Angeles, of the United States, or of the whole world, an economy is just a group of people interacting with one another as they go about their lives. Because the behavior of an economy reflects the behavior of the individuals who make up the economy, we start our study of economics with four principles of in- dividual decisionmaking. PRINCIPLE #1: PEOPLE FACE TRADEOFFS The first lesson about making decisions is summarized in the adage: “There is no such thing as a free lunch.” To get one thing that we like, we usually have to give up another thing that we like. Making decisions requires trading off one goal against another. Consider a student who must decide how to allocate her most valuable re- source—her time. She can spend all of her time studying economics; she can spend all of her time studying psychology; or she can divide her time between the two fields. For every hour she studies one subject, she gives up an hour she could have used studying the other. And for every hour she spends studying, she gives up an hour that she could have spent napping, bike riding, watching TV, or working at her part-time job for some extra spending money. CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 5 Or consider parents deciding how to spend their family income. They can buy food, clothing, or a family vacation. Or they can save some of the family income for retirement or the children’s college education. When they choose to spend an extra dollar on one of these goods, they have one less dollar to spend on some other good. When people are grouped into societies, they face different kinds of tradeoffs. The classic tradeoff is between “guns and butter.” The more we spend on national defense to protect our shores from foreign aggressors (guns), the less we can spend on consumer goods to raise our standard of living at home (butter). Also important in modern society is the tradeoff between a clean environment and a high level of income. Laws that require firms to reduce pollution raise the cost of producing goods and services. Because of the higher costs, these firms end up earning smaller profits, paying lower wages, charging higher prices, or some combination of these three. Thus, while pollution regulations give us the benefit of a cleaner environ- ment and the improved health that comes with it, they have the cost of reducing the incomes of the firms’ owners, workers, and customers. Another tradeoff society faces is between efficiency and equity. Efficiency efficiency means that society is getting the most it can from its scarce resources. Equity the property of society getting the means that the benefits of those resources are distributed fairly among society’s most it can from its scarce resources members. In other words, efficiency refers to the size of the economic pie, and equity equity refers to how the pie is divided. Often, when government policies are being the property of distributing economic designed, these two goals conflict. prosperity fairly among the members Consider, for instance, policies aimed at achieving a more equal distribution of of society economic well-being. Some of these policies, such as the welfare system or unem- ployment insurance, try to help those members of society who are most in need. Others, such as the individual income tax, ask the financially successful to con- tribute more than others to support the government. Although these policies have the benefit of achieving greater equity, they have a cost in terms of reduced effi- ciency. When the government redistributes income from the rich to the poor, it re- duces the reward for working hard; as a result, people work less and produce fewer goods and services. In other words, when the government tries to cut the economic pie into more equal slices, the pie gets smaller. Recognizing that people face tradeoffs does not by itself tell us what decisions they will or should make. Astudent should not abandon the study of psychology just because doing so would increase the time available for the study of econom- ics. Society should not stop protecting the environment just because environmen- tal regulations reduce our material standard of living. The poor should not be ignored just because helping them distorts work incentives. Nonetheless, ac- knowledging life’s tradeoffs 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 tradeoffs, 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. Consider, for example, the decision whether to go to college. The benefit is in- tellectual enrichment and a lifetime of better job opportunities. But what is the cost? To answer this question, you might be tempted to add up the money you 6 PART ONE INTRODUCTION spend on tuition, books, room, and board. Yet this total does not truly represent what you give up to spend a year in college. The first problem with this answer is that it includes some things that are not really costs of going to college. Even if you quit school, you would need a place to sleep and food to eat. Room and board are costs of going to college only to the ex- tent that they are more expensive at college than elsewhere. Indeed, the cost of room and board at your school might be less than the rent and food expenses that you would pay living on your own. In this case, the savings on room and board are a benefit of going to college. The second problem with this calculation of costs is that it ignores the largest cost of going to college—your time. When you spend a year listening to lectures, reading textbooks, and writing papers, you cannot spend that time working at a job. For most students, the wages given up to attend school are the largest single cost of their education. opportunity cost The opportunity costof an item is what you give up to get that item. When whatever must be given up to obtain making any decision, such as whether to attend college, decisionmakers should be some item aware of the opportunity costs that accompany each possible action. In fact, they usually are. College-age athletes who can earn millions if they drop out of school and play professional sports are well aware that their opportunity cost of college is very high. It is not surprising that they often decide that the benefit is not worth the cost. PRINCIPLE #3: RATIONAL PEOPLE THINK AT THE MARGIN Decisions in life are rarely black and white but usually involve shades of gray. When it’s time for dinner, the decision you face is not between fasting or eating like a pig, but whether to take that extra spoonful of mashed potatoes. When ex- ams roll around, your decision is not between blowing them off or studying 24 hours a day, but whether to spend an extra hour reviewing your notes instead of marginal changes watching TV. Economists use the term marginal changesto describe small incre- small incremental adjustments to a mental adjustments to an existing plan of action. Keep in mind that “margin” plan of action means “edge,” so marginal changes are adjustments around the edges of what you are doing. In many situations, people make the best decisions by thinking at the margin. Suppose, for instance, that you asked a friend for advice about how many years to stay in school. If he were to compare for you the lifestyle of a person with a Ph.D. to that of a grade school dropout, you might complain that this comparison is not helpful for your decision. You have some education already and most likely are deciding whether to spend an extra year or two in school. To make this decision, you need to know the additional benefits that an extra year in school would offer (higher wages throughout life and the sheer joy of learning) and the additional costs that you would incur (tuition and the forgone wages while you’re in school). By comparing these marginal benefitsand marginal costs,you can evaluate whether the extra year is worthwhile. As another example, consider an airline deciding how much to charge passen- gers who fly standby. Suppose that flying a 200-seat plane across the country costs the airline $100,000. In this case, the average cost of each seat is $100,000/200, which is $500. One might be tempted to conclude that the airline should never sella ticket for less than $500. In fact, however, the airline can raise its profits by CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 7 thinking at the margin. Imagine that a plane is about to take off with ten empty seats, and a standby passenger is waiting at the gate willing to pay $300 for a seat. Should the airline sell it to him? Of course it should. If the plane has empty seats, the cost of adding one more passenger is minuscule. Although the averagecost of flying a passenger is $500, the marginalcost is merely the cost of the bag of peanuts and can of soda that the extra passenger will consume. As long as the standby pas- senger pays more than the marginal cost, selling him a ticket is profitable. As these examples show, individuals and firms can make better decisions by thinking at the margin. Arational decisionmaker takes an action if and only if the marginal benefit of the action exceeds the marginal cost. PRINCIPLE #4: PEOPLE RESPOND TO INCENTIVES Because people make decisions by comparing costs and benefits, their behavior may change when the costs or benefits change. That is, people respond to incen- tives. When the price of an apple rises, for instance, people decide to eat more pears and fewer apples, because the cost of buying an apple is higher. At the same time, apple orchards decide to hire more workers and harvest more apples, be- cause the benefit of selling an apple is also higher. As we will see, the effect of price on the behavior of buyers and sellers in a market—in this case, the market for apples—is crucial for understanding how the economy works. Public policymakers should never forget about incentives, for many policies change the costs or benefits that people face and, therefore, alter behavior. Atax on gasoline, for instance, encourages people to drive smaller, more fuel-efficient cars. It also encourages people to take public transportation rather than drive and to live closer to where they work. If the tax were large enough, people would start driving electric cars. When policymakers fail to consider how their policies affect incentives, they can end up with results that they did not intend. For example, consider public pol- icy regarding auto safety. Today all cars have seat belts, but that was not true 40 BASKETBALLSTARKOBEBRYANT years ago. In the late 1960s, Ralph Nader’s book Unsafe at Any Speed generated UNDERSTANDSOPPORTUNITYCOSTAND much public concern over auto safety. Congress responded with laws requiring car INCENTIVES. DESPITEGOODHIGHSCHOOL companies to make various safety features, including seat belts, standard equip- GRADESANDSAT SCORES, HEDECIDED ment on all new cars. TO SKIPCOLLEGEANDGOSTRAIGHTTO THENBA, WHEREHEEARNEDABOUT How does a seat belt law affect auto safety? The direct effect is obvious. With $10 MILLIONOVERFOURYEARS. seat belts in all cars, more people wear seat belts, and the probability of surviving a major auto accident rises. In this sense, seat belts save lives. But that’s not the end of the story. To fully understand the effects of this law, we must recognize that people change their behavior in response to the incentives they face. The relevant behavior here is the speed and care with which drivers op- erate their cars. Driving slowly and carefully is costly because it uses the driver’s time and energy. When deciding how safely to drive, rational people compare the marginal benefit from safer driving to the marginal cost. They drive more slowly and carefully when the benefit of increased safety is high. This explains why peo- ple drive more slowly and carefully when roads are icy than when roads are clear. Now consider how a seat belt law alters the cost–benefit calculation of a ratio- nal driver. Seat belts make accidents less costly for a driver because they reduce the probability of injury or death. Thus, a seat belt law reduces the benefits to slow and careful driving. People respond to seat belts as they would to an improvement 8 PART ONE INTRODUCTION in road conditions—by faster and less careful driving. The end result of a seat belt law, therefore, is a larger number of accidents. How does the law affect the number of deaths from driving? Drivers who wear their seat belts are more likely to survive any given accident, but they are also more likely to find themselves in an accident. The net effect is ambiguous. More- over, the reduction in safe driving has an adverse impact on pedestrians (and on drivers who do not wear their seat belts). They are put in jeopardy by the law be- cause they are more likely to find themselves in an accident but are not protected by a seat belt. Thus, a seat belt law tends to increase the number of pedestrian deaths. At first, this discussion of incentives and seat belts might seem like idle spec- ulation. Yet, in a 1975 study, economist Sam Peltzman showed that the auto-safety laws have, in fact, had many of these effects. According to Peltzman’s evidence, these laws produce both fewer deaths per accident and more accidents. The net re- sult is little change in the number of driver deaths and an increase in the number of pedestrian deaths. Peltzman’s analysis of auto safety is an example of the general principle that people respond to incentives. Many incentives that economists study are more straightforward than those of the auto-safety laws. No one is surprised that people drive smaller cars in Europe, where gasoline taxes are high, than in the United States, where gasoline taxes are low. Yet, as the seat belt example shows, policies can have effects that are not obvious in advance. When analyzing any policy, we must consider not only the direct effects but also the indirect effects that work through incentives. If the policy changes incentives, it will cause people to alter their behavior. QUICK QUIZ: List and briefly explain the four principles of individual decisionmaking. HOW PEOPLE INTERACT The first four principles discussed how individuals make decisions. As we go about our lives, many of our decisions affect not only ourselves but other people as well. The next three principles concern how people interact with one another. PRINCIPLE #5: TRADE CAN MAKE EVERYONE BETTER OFF You have probably heard on the news that the Japanese are our competitors in the world economy. In some ways, this is true, for American and Japanese firms do produce many of the same goods. Ford and Toyota compete for the same cus- tomers in the market for automobiles. Compaq and Toshiba compete for the same customers in the market for personal computers. Yet it is easy to be misled when thinking about competition among countries. Trade between the United States and Japan is not like a sports contest, where one CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 9 side wins and the other side loses. In fact, the opposite is true: Trade between two countries can make each country better off. To see why, consider how trade affects your family. When a member of your family looks for a job, he or she competes against members of other families who are looking for jobs. Families also compete against one another when they go shopping, because each family wants to buy the best goods at the lowest prices. So, in a sense, each family in the economy is competing with all other families. Despite this competition, your family would not be better off isolating itself from all other families. If it did, your family would need to grow its own food, make its own clothes, and build its own home. Clearly, your family gains much from its ability to trade with others. Trade allows each person to specialize in the activities he or she does best, whether it is farming, sewing, or home building. By trading with others, people can buy a greater variety of goods and services at lower cost. Countries as well as families benefit from the ability to trade with one another. Trade allows countries to specialize in what they do best and to enjoy a greater va- riety of goods and services. The Japanese, as well as the French and the Egyptians and the Brazilians, are as much our partners in the world economy as they are our “For $5 a week you can watch competitors. baseball without being nagged to cut the grass!” PRINCIPLE #6: MARKETS ARE USUALLY A GOOD WAY TO ORGANIZE ECONOMIC ACTIVITY The collapse of communism in the Soviet Union and Eastern Europe may be the most important change in the world during the past half century. Communist countries worked on the premise that central planners in the government were in the best position to guide economic activity. These planners decided what goods and services were produced, how much was produced, and who produced and consumed these goods and services. The theory behind central planning was that only the government could organize economic activity in a way that promoted economic well-being for the country as a whole. Today, most countries that once had centrally planned economies have aban- doned this system and are trying to develop market economies. In a market econ- market economy omy,the decisions of a central planner are replaced by the decisions of millions of an economy that allocates resources firms and households. Firms decide whom to hire and what to make. Households through the decentralized decisions decide which firms to work for and what to buy with their incomes. These firms of many firms and households as and households interact in the marketplace, where prices and self-interest guide they interact in markets for goods their decisions. and services At first glance, the success of market economies is puzzling. After all, in a mar- ket economy, no one is looking out for the economic well-being of society as a whole. Free markets contain many buyers and sellers of numerous goods and services, and all of them are interested primarily in their own well-being. Yet, despite decentralized decisionmaking and self-interested decisionmakers, market economies have proven remarkably successful in organizing economic activity in a way that promotes overall economic well-being. In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, economist Adam Smith made the most famous observation in all of economics: Households and firms interacting in markets act as if they are guided by an “in- visible hand” that leads them to desirable market outcomes. One of our goals in 10 PART ONE INTRODUCTION FYI It may be only a coincidence the butcher, the brewer, or Adam Smith that Adam Smith’s great book, the baker that we expect our and the An Inquiry into the Nature and dinner, but from their regard Invisible Hand Causes of the Wealth of Na- to their own interest. . . . tions, was published in 1776, Every individual . . . the exact year American revolu- neither intends to promote tionaries signed the Declara- the public interest, nor knows tion of Independence. But the how much he is promoting two documents do share a it.... He intends only his point of view that was preva- own gain, and he is in this, as lent at the time—that individu- in many other cases, led by als are usually best left to their an invisible hand to promote own devices, without the heavy an end which was no part of ADAMSMITH hand of government guiding their actions. This political phi- his intention. Nor is it always losophy provides the intellectual basis for the market econ- the worse for the society that omy, and for free society more generally. it was no part of it. By pursuing his own interest he Why do decentralized market economies work so frequently promotes that of the society more effectually well? Is it because people can be counted on to treat one than when he really intends to promote it. another with love and kindness? Not at all. Here is Adam Smith’s description of how people interact in a market Smith is saying that participants in the economy are moti- economy: vated by self-interest and that the “invisible hand” of the marketplace guides this self-interest into promoting general Man has almost constant occasion for the help of his economic well-being. brethren, and it is vain for him to expect it from their Many of Smith’s insights remain at the center of mod- benevolence only. He will be more likely to prevail if he ern economics. Our analysis in the coming chapters will al- can interest their self-love in his favor, and show them low us to express Smith’s conclusions more precisely and that it is for their own advantage to do for him what he to analyze fully the strengths and weaknesses of the mar- requires of them. . . . It is not from the benevolence of ket’s invisible hand. this book is to understand how this invisible hand works its magic. As you study economics, you will learn that prices are the instrument with which the invisible hand directs economic activity. Prices reflect both the value of a good to society and the cost to society of making the good. Because households and firms look at prices when deciding what to buy and sell, they unknowingly take into account the social benefits and costs of their actions. As a result, prices guide these indi- vidual decisionmakers to reach outcomes that, in many cases, maximize the wel- fare of society as a whole. There is an important corollary to the skill of the invisible hand in guiding eco- nomic activity: When the government prevents prices from adjusting naturally to supply and demand, it impedes the invisible hand’s ability to coordinate the mil- lions of households and firms that make up the economy. This corollary explains why taxes adversely affect the allocation of resources: Taxes distort prices and thus the decisions of households and firms. It also explains the even greater harm caused by policies that directly control prices, such as rent control. And it explains the failure of communism. In communist countries, prices were not determined in the marketplace but were dictated by central planners. These planners lacked the information that gets reflected in prices when prices are free to respond to market CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 11 forces. Central planners failed because they tried to run the economy with one hand tied behind their backs—the invisible hand of the marketplace. PRINCIPLE #7: GOVERNMENTS CAN SOMETIMES IMPROVE MARKET OUTCOMES Although markets are usually a good way to organize economic activity, this rule has some important exceptions. There are two broad reasons for a government to intervene in the economy: to promote efficiency and to promote equity. That is, most policies aim either to enlarge the economic pie or to change how the pie is divided. The invisible hand usually leads markets to allocate resources efficiently. Nonetheless, for various reasons, the invisible hand sometimes does not work. Economists use the term market failureto refer to a situation in which the market market failure on its own fails to allocate resources efficiently. a situation in which a market left on One possible cause of market failure is an externality. An externalityis the im- its own fails to allocate resources pact of one person’s actions on the well-being of a bystander. The classic example efficiently of an external cost is pollution. If a chemical factory does not bear the entire cost of externality the smoke it emits, it will likely emit too much. Here, the government can raise the impact of one person’s actions on economic well-being through environmental regulation. The classic example of an the well-being of a bystander external benefit is the creation of knowledge. When a scientist makes an important discovery, he produces a valuable resource that other people can use. In this case, the government can raise economic well-being by subsidizing basic research, as in fact it does. Another possible cause of market failure is market power. Market power market power refers to the ability of a single person (or small group of people) to unduly influ- the ability of a single economic actor ence market prices. For example, suppose that everyone in town needs water but (or small group of actors) to have a there is only one well. The owner of the well has market power—in this case a substantial influence on market monopoly—over the sale of water. The well owner is not subject to the rigorous prices competition with which the invisible hand normally keeps self-interest in check. You will learn that, in this case, regulating the price that the monopolist charges can potentially enhance economic efficiency. The invisible hand is even less able to ensure that economic prosperity is dis- tributed fairly. Amarket economy rewards people according to their ability to pro- duce things that other people are willing to pay for. The world’s best basketball player earns more than the world’s best chess player simply because people are willing to pay more to watch basketball than chess. The invisible hand does not en- sure that everyone has sufficient food, decent clothing, and adequate health care. Agoal of many public policies, such as the income tax and the welfare system, is to achieve a more equitable distribution of economic well-being. To say that the government canimprove on markets outcomes at times does not mean that it always will.Public policy is made not by angels but by a political process that is far from perfect. Sometimes policies are designed simply to reward the politically powerful. Sometimes they are made by well-intentioned leaders who are not fully informed. One goal of the study of economics is to help you judge when a government policy is justifiable to promote efficiency or equity and when it is not. QUICK QUIZ: List and briefly explain the three principles concerning economic interactions.