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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-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 decision making 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.
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.
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.
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.
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.” 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,
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.
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
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. Definition 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.
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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.
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 profits the firms
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. Definition of marginal change: a small incremental adjustment to a plan of
action.
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
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.
a. When the price of a good rises, consumers will buy less of it because its cost has risen.
Chapter 1/Ten Principles of Economics ❖ 5
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.
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, 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, 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 answer to
the first 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?
2. Who worked to produce your clothes?
3. What things do you consider when buying a garment?
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
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. 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.
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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
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.
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.
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.
Chapter 1/Ten Principles of Economics ❖ 9
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 firms to hire additional workers.
b. An increase in the demand for goods and services leads to higher prices over time.
3. Definition of business cycle: fluctuations in economic activity, such as employment
and production.
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.
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 inflation.
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
Chapter Quick Quiz
1. a
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Questions for Review
1. Examples of trade-offs include time trade-offs (such as studying one subject over another or studying
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
4. Policymakers need to think about incentives so they can understand how people will respond to the
policies they put in place. The text’s example of seat belt laws shows that policy actions can have
5. Trade among countries is not a game with some losers and some winners because trade can make
6. The “invisible hand” of the marketplace represents the idea that even though individuals and firms
7. The two main causes of market failure are externalities and market power. An externality is the effect
8. Productivity is important because a country’s standard of living depends on its ability to produce
9. Inflation is an increase in the overall level of prices in the economy. Inflation is caused by increases
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
up going on vacation for the next two years. Also, fuel efficient cars are more expensive but
Chapter 1/Ten Principles of Economics ❖ 11
regular cars require spending more on gas. Smaller cars are less expensive, but bigger cars
mean saving time by avoiding multiple trips.
d. In deciding how much to prepare for class, a professor faces a trade-off between the value
of improving the quality of the lecture compared to other things she could do with her time,
such as working on additional research or enjoying some leisure time.
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
benefits. One is to compare the vacation with what you would do in its place. If you did not go on
vacation, would you buy something like a new set of golf clubs? Then you can decide if you would
3. If you are thinking of going skiing instead of working at your part-time job, the cost of skiing includes
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
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8. a. If everyone were guaranteed the best healthcare possible, much more of our nation’s output
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
9. Because average income in the United States has roughly doubled every 35 years, we are likely to
have a better standard of living than our parents, and a much better standard of living than our
10. If Americans save more and it leads to more spending on factories, there will be an increase in
production and productivity, because the same number of workers will have more equipment to work