Feel clueless about economics?(Read article summary)
There's no free lunch, but here - at no cost* - find the nine fundamental principles of economics. It's like Economics 101 without the college tuition.
A small set of ideas does most of the heavy lifting in economics. “Ten Principles of Economics” or “Ten Big Ideas” or “Ten Key Elements of Economics” are pretty standard in most introductory economics books. Here’s my version, based on Chapter 1 of The Economic Way of Thinking.
1. People Act. People choose goals (ends), and they choose ways to achieve those goals (means). One of your goals, presumably, is to obtain a well-rounded liberal education. Taking econ 100 is one of the means you have chosen to that end. This also implies subsidiary means-ends relationships. Suppose one of your goals is “pass econ 100.” Reading the textbook, doing the assignments, coming to class, visiting office hours, and visiting the peer tutor are means to that end.
2. Every Action Has a Cost. When you do one thing, you give up the opportunity to do another. For example, you have an almost limitless range of options right now. You could be eating, sleeping, working, or chatting with your friends, but you have chosen instead to read this assignment. Your next best alternative is the cost you have incurred in order to read the assignment. If preparing for the first class takes five hours and your next best alternative is working for $8 per hour, then preparing for class has cost you the opportunity to earn $40 (we will shorten this periodically and say that “preparing for class” cost you $40). You will also hear people say “there is no such thing as a free lunch,” and indeed, free stuff isn’t free. If you spend thirty minutes in line waiting for a slice of free pizza and your next best alternative would be working for $8 per hour, then that slice of pizza has cost you the opportunity to earn $4.
3. People Respond to Incentives. Incentives motivate people to action. People will do more of something as the cost falls, and they will do less of it as the cost rises (the law of demand). Similarly, they will try to supply more of something that gets more remunerative and less of something that gets less remunerative (the law of supply). Prices are some of the most important incentives in economics. The price is the number of dollars that have to be traded for something ($2 for a cup of coffee, for example). Market prices emerge from the interactions of buyers and sellers.
4. People make decisions at the margin. People make trade-offs. Economic analysis is incremental: when people make decisions, they compare the costs and benefits of a little bit more or a little bit less of something. You don’t usually make sweeping categorical decisions about what is good or what is bad. You generally won’t decide that studying economics is Always Good (otherwise, you would study economics 24 hours a day) or Always Bad (otherwise, you would not study economics at all). You will compare, for example, the cost of an additional evening spent studying physics to the benefit of and additional evening studying economics. Generally, people will do everything for which the marginal benefit exceeds the marginal cost and nothing for which the marginal cost exceeds the marginal benefit. The decisions you should make ultimately depend on your goals and values. Economics as such cannot tell you whether you should spend the next minute, the next hour, or the next day studying economics, studying physics, updating your Facebook page, or sleeping, but it can tell you that you’re making a trade-off.
5. Trade makes people better off. Trade is a kind of voluntary cooperation, and it makes us wealthier. This happens in two ways. First, we know that since people act, they will only do things if they expect it to make them better off. If you trade $100 for a ticket to see the Jonas Brothers and Hannah Montana, we infer that it is because you expect to prefer the concert to anything else you could have done with the $100. This is not to say that people won’t make mistakes from time to time—we have all rented a terrible movie or ordered something at a restaurant that we didn’t like—but in general, trade will make us better off. The second way trade makes us better off is by increasing our productivity. According to the law of comparative advantage, when people specialize and trade, they can produce more output with the same inputs. Similarly, they can produce the same outputs with fewer inputs. In either case, people have more resources with which to attain their goals. This has an important implication that echoes a thought originally expressed by Adam Smith: people are more likely to help you achieve your goals if you help them achieve theirs.
6. People are Rational. This is a lot more controversial than it should be. When we say that people are rational, we mean that they will tend to do things that they expect to provide them with net benefits. We don’t mean that they will always make the right decision, that they have complete information, or that they will never make mistakes. We mean that they have goals, they tend to choose the means that they believe are appropriate to achieve them, they respond to incentives, and they learn from mistakes.
7. Using markets is costly, but using government can be costlier still. Transaction costs are the costs of measuring the valuable attributes of goods and services as well as the costs of specifying and enforcing contracts. Since trade is costly, there may be situations in which people do not make trades that would have made them better off. In principle, governments can correct these “market failures.” However, people working for the government respond to incentives, as well. Government policies like price controls, taxes, and subsidies also prevent people from making trades. Because of the incentives they face, government actors often have incentives to make things worse whether they intend to do so or not.
8. Profits tell businesses that they are helping others, while losses tell businesses that they are wasting resources. When private property rights are secure, profits and losses are the market’s feedback mechanism. You earn profits by providing people with goods and services they want at prices they find attractive. You earn losses when you provide people with goods and services they don’t want at prices they find unattractive. The invisible hand of the marketplace will tend to weed out businesses that make people worse off: it tells these businesses that the resources they are using could be better used in another enterprise. Resources will tend to flow of out of enterprises that are unprofitable and toward enterprises that are profitable.
9. We shouldn’t ignore the long-term and unintended consequences of policies and actions. Careful economic analysis is, in part, the process of asking “and then what?” about any policy or action. In his book Applied Economics, Thomas Sowell calls this “thinking past stage one,” and in his classic Economics in One Lesson, Henry Hazlitt defined “the art of economics” as tracing the effects of actions and policies and seeing how they affect everyone rather than just particular groups. The Economic Way of Thinking defines economics as “a theory of choice and its unintended consequences,” and indeed, most applied economic analysis consists of isolating and exploring the unintended consequences—whether they are good or bad—of actions and policies.
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