WHAT’S NEW IN THE EIGHTH EDITION:
There is a new case study “Adam Smith Would Have Loved Uber.”
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
that economics is about the allocation of scarce resources.
that individuals face trade-o s.
the meaning of opportunity cost.
how to use marginal reasoning when making decisions.
how incentives a ect people’s behavior.
why trade among people or nations can be good for everyone.
why markets are a good, but not perfect, way to allocate resources.
what determines some trends in the overall economy.
CONTEXT AND PURPOSE:
Chapter 1 is the (rst chapter in a three-chapter section that serves as the introduction to the
text. Chapter 1 introduces ten fundamental principles on which the study of economics is
based. In a broad sense, the rest of the text is an elaboration on these ten principles.
Chapter 2 will develop how economists approach problems while Chapter 3 will explain how
individuals and countries gain from trade.
The purpose of Chapter 1 is to lay out ten economic principles that will serve as building
blocks for the rest of the text. The ten principles can be grouped into three categories: how
people make decisions, how people interact, and how the economy works as a whole.
Throughout the text, references will be made repeatedly to these ten principles.
1TEN PRINCIPLES OF
ECONOMICS
KEY POINTS:
The fundamental lessons about individual decision making are that people face
trade-o s among alternative goals, that the cost of any action is measured in terms of
forgone opportunities, that rational people make decisions by comparing marginal costs
and marginal bene(ts, and that people change their behavior in response to the
incentives they face.
The fundamental lessons about interactions among people are that trade and
interdependence can be mutually bene(cial, that markets are usually a good way of
coordinating economic activity among people, and that the government can potentially
improve market outcomes by remedying a market failure or by promoting greater
economic equality.
The fundamental lessons about the economy as a whole are that productivity is the
ultimate source of improving living standards, that growth in the quantity of money is the
ultimate source of in6ation, and that society faces a short-run trade-o between in6ation
and unemployment.
CHAPTER OUTLINE:
I. Introduction
A. The word “economy” comes from the Greek word oikonomos meaning “one who
manages a household.”
B. Both households and economies face many decisions about how to allocate
resources.
C. Resources are scarce so they must be managed carefully.
D. De(nition of scarcity: the limited nature of society’s resources.
E. De(nition of economics: the study of how society manages its scarce
resources.
As you discuss the ten principles, make sure that students realize that it is
okay if they do not grasp each of the concepts completely or (nd each of
the arguments fully convincing. These ideas will be explored more
completely throughout the text.
Because most college freshmen and sophomores have limited
experiences with viewing the world from a cause-and-e ect perspective,
do not underestimate how challenging these principles will be for the
You will want to start the semester by explaining to students that part of
learning economics is understanding a new vocabulary. Economists
generally use very precise (and sometimes di erent) de(nitions for words
that are commonly used outside of the economics discipline. Therefore, it
will be helpful to students if you follow the de(nitions provided in the text
as much as possible.
Begin by pointing out that economics is a subject that students must
confront in their daily lives. Point out that they already spend a great deal
of their time thinking about economic issues: changes in prices, buying
decisions, use of their time, concerns about employment, etc.
II. How People Make Decisions
A. Principle #1: People Face Trade-o s
1. “There ain’t no such thing as a free lunch.” To get something that we like, we
usually have to give up, or trade for, something else that we also like.
2. Examples include how students spend their time, how a family decides to spend
its income, how the U.S. government spends tax dollars, and how regulations may
protect the environment at a cost to (rm owners.
3. An important trade-o that society faces is the trade-o between e@ciency and
equality.
a. De(nition of e/ciency: the property of society getting the most it can
from its scarce resources.
b. De(nition of equality: the property of distributing economic prosperity
uniformly among the members of society.
c. For example, tax dollars paid by wealthy Americans and then distributed to
those less fortunate may improve equality but lower the return to hard work
and therefore reduce the level of output produced by our resources.
d. This implies that the cost of this increased equality is a reduction in the
e@cient use of our resources.
4. Recognizing that trade-o s exist does not indicate what decisions should or will
be made.
B. Principle #2: The Cost of Something Is What You Give Up to Get It
1. Making decisions requires individuals to consider the bene(ts and costs of some
action.
2. What are the costs of going to college?
a. We should not count room and board (unless they are more expensive at
college than elsewhere) because the student would have to pay for food and
shelter even if she were not in school.
b. We should count the value of the student’s time because she could be working
for pay instead of attending classes and studying.
3. De(nition of opportunity cost: whatever must be given up in order to
obtain some item.
One of the hardest ideas for students to grasp is that “free” things are
not truly free. Provide students with many examples of such “free”
things with hidden costs, especially the value of time. Suggested
examples include the time students spend waiting in line for “free”
sporting event tickets at their universities, time spent relaxing in the sun
outside their residence halls, or driving on a road with no tolls but lots of
congestion.
C. Principle #3: Rational People Think at the Margin
1. Economists generally assume that people are rational.
a. De(nition of rational people: people who systematically and
purposefully do the best they can to achieve their objectives.
b. Consumers want to purchase the goods and services that allow them the
greatest level of satisfaction given their incomes and the prices they face.
c. Firm managers want to produce the level of output that maximizes the pro(ts
the (rms earn.
2. Many decisions in life involve incremental decisions: Should I remain in school this
semester? Should I take another course this semester? Should I study another
hour for tomorrow’s exam?
a. De(nition of marginal change: a small incremental adjustment to a
plan of action.
b. Example: Suppose that you are considering calling a friend on your cell phone
and the marginal bene(t of the 10-minute call is $7.00. Your cell phone costs
you $40 per month plus an additional $0.50 per minute. You typically talk for
100 minutes and have a monthly bill of $90. If you consider the average cost
of a call, you would decide that the bene(t of this 10-minute call does not
exceed its cost ($9.00). However, the marginal cost of the call is only $5.00 so
the marginal bene(t of the call does outweigh its marginal cost. Cell phone
users who have unlimited minutes (free at the margin) often make long and
frivolous phone calls.
c. Suppose that 6ying a 200-seat plane across the country costs the airline
$100,000, which means that the average cost of each seat is $500. Suppose
that the plane is minutes from departure and a passenger is willing to pay
$300 for a seat. Should the airline sell the seat for $300? In this case, the
marginal cost of an additional passenger is very small.
d. Another example: Why is water so cheap while diamonds are expensive? The
marginal bene(t of a good depends on how many units a person already has.
Because water is plentiful, the marginal bene(t of an additional cup is small.
Because diamonds are rare, the marginal bene(t of an extra diamond is high.
3. A rational decision maker takes an action if and only if the marginal bene(t is at
least as large as the marginal cost.
D. Principle #4: People Respond to Incentives
1. De(nition of incentive: something that induces a person to act.
2. Because rational people make decisions by weighing costs and bene(ts, their
decisions may change in response to incentives.
a. When the price of a good rises, consumers will buy less of it because its cost
has risen.
b. When the price of a good rises, producers will allocate more resources to the
production of the good because the bene(t from producing the good has
risen.
3. Many public policies change the costs and bene(ts that people face. Sometimes
policymakers fail to understand how policies alter incentives and behavior and a
policy may lead to unintended consequences.
4. Example: Seat belt laws increase the use of seat belts but lower the incentives of
individuals to drive safely. This leads to an increase in the number of car
accidents. This also leads to an increased risk for pedestrians.
III. How People Interact
A. Principle #5: Trade Can Make Everyone Better O
1. Trade is not like a sports contest, where one side gains and the other side loses.
2. Consider trade that takes place inside your home. Your family is likely to be
involved in trade with other families on a daily basis. Most families do not build
their own homes, make their own clothes, or grow their own food.
3. Countries bene(t from trading with one another as well.
4. Trade allows for specialization in products that countries (or families) can do best.
If you include any incentive-based criteria on your syllabus, discuss it now.
For example, if you reward class attendance (or penalize students who do
not attend class), explain to students how this change in the marginal
bene(t of attending class (or marginal cost of missing class) can be
expected to alter their behavior.
Activity 1—Getting Dressed in the Global Economy
Type: In-class assignment
Topics: Specialization, interdependence, self-interest, consumer
choice, trade
Materials needed: None
Time: 20 minutes
Class limitations: Works in any class size
Purpose
The advantages of specialization and division of labor are very clear in this
example. The worldwide links of the modern economy are also illustrated. We
depend on thousands of people we don’t know, won’t see, and don’t think about
to get dressed each morning. Self-interest follows naturally from interdependence.
Wages, pro(ts, and rents give people the incentive to perform these varied tasks.
We depend on them to clothe us and they depend on our purchases for their
incomes.
Instructions
Ask the class to answer the following questions. Give them time to write an
answer to each question, then discuss their answers before moving on to the next
question. The answer to the (rst question can be brief. The second question is the
core of the assignment and takes several minutes. Ask them to list as many
categories of workers as possible. The third question introduces demand concepts;
you can introduce most of the determinants of demand during this discussion. For
the fourth question, ask the class to look at the country-of-origin tags sewn in
their garments.
1. Where did your clothes come from?
2. Who worked to produce your clothes?
3. What things do you consider when buying a garment?
4. In what countries were your clothes produced?
Common Answers and Points for Discussion
1. Where did your clothes come from?
There are many possible ways to answer, but many students will say “the mall” or
another retail outlet. Some may say “a factory,” “a sweatshop,” or “a foreign
country.”
Mention the importance of markets. Ask “Is anyone wearing something made by
themselves, a friend, or a relative?” and discuss distribution versus production.
2. Who worked to produce your clothes?
There are many possible answers; garment and textile workers are obvious but
most students will also list workers dealing with raw materials, transportation,
management, design, or machinery. Some may think more broadly to investors,
road crews, bankers, engineers, or accountants.
3. What things do you consider when buying a garment?
Most answers focus on preferences ((t, style, quality, color). Price is cited less
frequently. Ask about the importance of price until someone volunteers that
income is important. Prices of substitute goods and expectations of price changes
B. Principle #6: Markets Are Usually a Good Way to Organize Economic Activity
1. Many countries that once had centrally planned economies have abandoned this
system and are trying to develop market economies.
2. De(nition of market economy: an economy that allocates resources
through the decentralized decisions of many 9rms and households as
they interact in markets for goods and services.
3. Market prices re6ect both the value of a product to consumers and the cost of the
resources used to produce it.
4. When a government interferes in a market and prevents price from adjusting,
household and (rm decisions become distorted.
5. Centrally planned economies failed because they did not allow the market to
work.
6. FYI: Adam Smith and the Invisible Hand
a. Adam Smith’s 1776 work suggested that although individuals are motivated
by self-interest, an invisible hand guides this self-interest into promoting
society’s economic well-being.
b. Smith’s insights are at the center of modern economics and will be analyzed
more fully in the chapters to come.
7. Case Study: “Adam Smith Would Have Loved Uber”
C. Principle #7: Governments Can Sometimes Improve Market Outcomes
1. The invisible hand will only work if the government enforces property rights.
a. De(nition of property rights: the ability of an individual to own and
exercise control over scarce resources.
2. There are two broad reasons for the government to interfere with the economy:
the promotion of e@ciency and equality.
3. Government policy can improve e@ciency when there is market failure.
4. In what countries were your clothes produced?
A large number of countries will be represented, even in small classes. Asia is
always well represented. Latin American and European goods appear in smaller
numbers. African products are conspicuously absent.
Explain to students that when households and (rms do what is best for
themselves, they often end up doing what is best for society, as if guided
by market forces—or an invisible hand. Spend some time and emphasize
the magic of the market. Use numerous examples to show students that
the market most often allocates resources to their highest valued use.
a. De(nition of market failure: a situation in which a market left on its
own fails to allocate resources e/ciently.
4. Examples of Market Failure
a. De(nition of externality: the impact of one person’s actions on the
well-being of a bystander.
b. De(nition of market power: the ability of a single economic actor (or
small group of actors) to have a substantial in>uence on market
prices.
c. Because a market economy rewards people for their ability to produce things
that other people are willing to pay for, there will be an unequal distribution of
economic well-being.
5. Note that the principle states that the government can improve market outcomes.
This is not saying that the government always does improve market outcomes.
IV. How the Economy as a Whole Works
A. Principle #8: A Country’s Standard of Living Depends on Its Ability to Produce Goods
and Services
1. Di erences in living standards from one country to another are quite large.
2. Changes in living standards over time are also great.
3. The explanation for di erences in living standards lies in di erences in
productivity.
4. De(nition of productivity: the quantity of goods and services produced by
each unit of labor input.
5. High productivity implies a high standard of living.
6. Thus, policymakers must understand the impact of any policy on our ability to
produce goods and services.
B. Principle #9: Prices Rise When the Government Prints Too Much Money
1. De(nition of in>ation: an increase in the overall level of prices in the
economy.
2. When the government creates a large amount of money, the value of money falls,
leading to price increases.
3. Examples: Germany after World War I (in the early 1920s) and the United States
in the 1970s.
C. Principle #10: Society Faces a Short-Run Trade-o between In6ation and
Unemployment
1. Most economists believe that the short-run e ect of a monetary injection is lower
unemployment and higher prices.
a. An increase in the amount of money in the economy stimulates spending and
increases the quantity of goods and services sold in the economy. The
increase in the quantity of goods and services sold will cause (rms to hire
additional workers.
b. An increase in the demand for goods and services leads to higher prices over
time.
2. The short-run trade-o between in6ation and unemployment plays a key role in
the analysis of the business cycle.
3. De(nition of business cycle: >uctuations in economic activity, such as
employment and production.
4. Policymakers can exploit this trade-o by using various policy instruments, but
the extent and desirability of these interventions is a subject of continuing
debate.
5. This debate heated up during the early years of Obama’s presidency. The severe
downturn in the economy led policymakers to try to stimulate demand, but some
feared that the end result would be in6ation.