Introduction to Economics: The Ten Principles

2. The Cost of Something Is What You Give Up to Get It

Because of trade-offs, making decisions requires comparing the costs and benefits of different actions. However, the cost is not always just a monetary figure. Economists use the term opportunity cost to describe the value of the next best alternative that you must forgo to pursue a certain action.

If you spend an hour studying economics, the opportunity cost is not just the effort spent, but the value of the next best thing you could have done with that hour, such as working a job or sleeping.

3. Rational People Think at the Margin

Economists assume that people are rational—meaning they systematically and purposefully do the best they can to achieve their objectives given their circumstances.

Rational decision-makers do not usually make "all or nothing" decisions. Instead, they make marginal changes, which are small, incremental adjustments to an existing plan of action. To decide whether to take such an action, they compare the marginal benefit (the additional benefit gained) against the marginal cost (the additional cost incurred).

Worked Example: The Standby Passenger Imagine an airline is flying a 200-seat plane. The total cost of the flight is $$100,000$, making the average cost per seat: $\frac{\$100,000}{200} = \$500$

If the plane is about to take off with 10 empty seats, and a standby passenger offers to pay $$300$ for a seat, should the airline sell the ticket?

While the average cost is $$500$, the marginal cost of adding one more passenger is extremely low—perhaps just the cost of a snack or a drink for that passenger. Since the marginal benefit ($$300$) exceeds the marginal cost (the snack), a rational airline will sell the ticket.

4. People Respond to Incentives

Since rational people weigh costs and benefits, their behavior changes when those costs or benefits change. An incentive is anything—such as a reward or a punishment—that induces a person to act. For instance, if the price of gasoline rises, people have a stronger incentive to drive smaller cars or use public transportation.

How People Interact and How the Economy Works

The remaining six principles look beyond the individual to how people interact in markets and how the broader economy functions.

Interaction and Markets

Trade and markets are the engines of economic interaction. Trade can make all parties involved better off by allowing people to specialize in what they do best. In most cases, markets—which are decentralized groups of buyers and sellers—are the most efficient way to organize economic activity. However, markets are not perfect; governments can sometimes intervene to improve outcomes, such as by enforcing property rights or correcting market failures.

The Macroeconomic View

Finally, we look at the economy as a whole. A nation's standard of living is not accidental; it depends heavily on its ability to produce goods and services.

On a systemic level, two major issues often arise:

1. Inflation: When a government prints too much money, the value of money falls, causing prices to rise.
2. The Inflation-Unemployment Trade-off: In the short run, society often faces a trade-off where policies intended to reduce inflation may lead to higher unemployment, and vice versa.

Summary Table: The Ten Principles