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WHAT’S NEW IN THE SEVENTH EDITION:
There is an additional example about marginal benefits and marginal costs.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
➢ that economics is about the allocation of scarce resources.
➢ that individuals face trade-offs.
➢ the meaning of opportunity cost.
➢ how to use marginal reasoning when making decisions.
➢ how incentives affect 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 first 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.
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TEN PRINCIPLES OF ECONOMICS
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KEY POINTS:
• The fundamental lessons about individual decisionmaking are that people face trade-offs 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 benefits, 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 beneficial, 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.
CHAPTER OUTLINE:
I. Introduction
A. The word “economy” comes from the Greek word
oikonomos
meaning “one who manages a
household.”
D. Definition of scarcity: the limited nature of society’s resources.
E. Definition of economics: the study of how society manages its scarce resources.
Because most college freshmen and sophomores have limited experiences with
viewing the world from a cause-and-effect perspective, do not underestimate how
challenging these principles will be for the student.
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 different) definitions for words that are commonly used outside of
the economics discipline. Therefore, it will be helpful to students if you follow the
definitions 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.
Chapter 1/Ten Principles of Economics ❖ 3
II. How People Make Decisions
A. Principle #1: People Face Trade-offs
1. “There ain’t no such thing as a free lunch.” Making decisions requires trading one goal for
another.
3. An important trade-off that society faces is the trade-off between efficiency and equality.
a. Definition of efficiency: the property of society getting the most it can from its
scarce resources.
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 efficient use of
our resources.
4. Recognizing that trade-offs 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 benefits 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
3. Definition of opportunity cost: whatever must be given up in order to obtain some
item.
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 find each of the arguments
fully convincing. These ideas will be explored more completely throughout the text.
4 ❖ Chapter 1/Ten Principles of Economics
C. Principle #3: Rational People Think at the Margin
1. Economists generally assume that people are rational.
a. Definition of rational people: people who systematically and purposefully do the
best they can to achieve their objectives.
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?
b. Example: Suppose that you are considering calling a friend on your cell phone and the
marginal benefit 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
benefit 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 benefit 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 flying 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
3. A rational decision maker takes an action if and only if the marginal benefit is at least as
large as the marginal cost.
D. Principle #4: People Respond to Incentives
One of the hardest ideas for students to grasp is that “free” things are not truly free.
Thus, you will need to provide students with numerous 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 dinner in
a restaurant with their parents.
Chapter 1/Ten Principles of Economics ❖ 5
1. Definition of incentive: something that induces a person to act.
2. Because rational people make decisions by weighing costs and benefits, their decisions may
change in response to incentives.
3. Many public policies change the costs and benefits 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.
5.
Case Study: The Incentive Effects of Gasoline Prices
III. How People Interact
A. Principle #5: Trade Can Make Everyone Better Off
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.
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 benefit of attending class
(or marginal cost of missing class) can be expected to alter their behavior.
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Activity 1—Getting Dressed in the Global Economy
Type: In-class assignment
Topics: Specialization, interdependence, self-interest, consumer choice,
international 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 of in order to get dressed each morning.
Self-interest follows naturally from interdependence. Wages, profits, 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 first question
can be answered with a brief phrase. 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; most of the determinants of demand can be
introduced 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. Where were your clothes produced (what countries)?
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.”
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 (fit, style, quality, color). Price is cited less frequently. Ask
Chapter 1/Ten Principles of Economics ❖ 7
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.
4. When a government interferes in a market and prevents price from adjusting, household and
firm 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.
C. Principle #7: Governments Can Sometimes Improve Market Outcomes
1. The invisible hand will only work if the government enforces property rights.
a. Definition of property rights: the ability of an individual to own and exercise
control over scarce resources.
Explain to students that when households and firms 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.
4. Where were your clothes produced (what countries)?
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.
This pattern shows the limits of simple explanations such as “cheap labor.” Briefly discuss the
importance of comparative advantage and specialization.
8 ❖ Chapter 1/Ten Principles of Economics
a. Definition of market failure: a situation in which a market left on its own fails to
allocate resources efficiently.
4. Examples of Market Failure
a. Definition of externality: the impact of one person’s actions on the well–being of
a bystander.
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. Differences in living standards from one country to another are quite large.
2. Changes in living standards over time are also great.
7.
In the News: Why You Should Study Economics
B. Principle #9: Prices Rise When the Government Prints Too Much Money
1. Definition of inflation: 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.
Chapter 1/Ten Principles of Economics ❖ 9
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-off between Inflation and Unemployment
1. Most economists believe that the short-run effect of a monetary injection is lower
unemployment and higher prices.
b. An increase in the demand for goods and services leads to higher prices over time.
2. The short-run trade-off between inflation and unemployment plays a key role in the analysis
of the business cycle.
4. Policymakers can exploit this trade-off by using various policy instruments, but the extent
and desirability of these interventions is a subject of continuing debate.
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SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1. There are many possible answers.
2. A country is better off by trading because trade allows more goods and services to be produced
through specialization. Markets allow the “invisible hand” to guide self-interested individuals into
3. The three principles that describe how the economy, as a whole, works are: (1) a country’s standard
of living depends on its ability to produce goods and services; (2) prices rise when the government
Chapter 1/Ten Principles of Economics ❖ 11
2. To figure out the opportunity cost of a vacation to Disney World, you would include the monetary
costs of: admission, travel, souvenirs. You would also include the cost of time spent on vacation. The
3. The marginal benefit of a glass of water depends on your circumstances. If you have just run a
7. The two main causes of market failure are externalities and market power. An externality is the effect
Quick Check Multiple Choice
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Problems and Applications
1. a. A family deciding whether to buy a new car faces a trade-off between the cost of the car and
other things they might want to buy. For example, buying the car might mean they must give
b. For a member of Congress deciding how much to spend on national parks, one trade-off is
c. When a company president decides whether to open a new factory, the decision is based on
e. In deciding whether to go to graduate school, the student faces a trade-off between his
2. When the benefits of something are psychological, such as going on a vacation, it is not easy to
compare benefits to costs to determine if it is worth doing. But there are two ways to think about the
vacation were worth the psychological cost of working.
3. If you are thinking of going skiing instead of working at your part-time job, the cost of skiing includes
Chapter 1/Ten Principles of Economics ❖ 13
5. The fact that you have already sunk $5 million is not relevant to your decision anymore, because that
money is gone. What matters now is the chance to earn profits at the margin. If you spend another
6. a. The provision of Social Security benefits lowers an individual’s incentive to save for retirement.
b. The loss of benefits means that someone who cannot find a job will get no income at all, so the
8. a. Efficiency: The market failure comes from the market power of the cable TV firm.
9. a. If everyone were guaranteed the best healthcare possible, much more of our nation’s output
would be devoted to medical care than is now the case. Would that be efficient? If you believe
b. When workers are laid off, equality considerations argue for the unemployment benefits system
to provide them with some income until they can find new jobs. After all, no one plans to be laid
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10. Because average income in the United States has roughly doubled every 35 years, we are likely to
11. If Americans save more and it leads to more spending on factories, there will be an increase in