Life is about choices, and economics is about how incentives affect those choices and shape our lives. Choices about education, how we spend and invest, what we do in the workplace, and many other personal decisions will influence our well-being and quality of life. Moreover, the choices we make as voters and citizens affect the laws or “rules of the game,” and these rules exert an enormous impact on our freedom and prosperity. To choose intelligently, both for ourselves and for society generally, we must understand some basic principles about how people choose, what motivates their actions, and how their actions influence their personal welfare and that of others. Thus, economics is about human decision making, the analysis of the forces underlying choice, and the implications with regard to how societies work.
The following section introduces twelve key concepts that are crucial to the understanding of how our economy works. The reader will learn such things as the true meaning of costs, why prices matter, how trade furthers prosperity, and why production of things people value underpins our standard of living. In a fraction of the time devoted to Economics 101, you can pick up most of its important lessons. In subsequent sections you will use these concepts to address other vitally important topics.
1. Incentives Matter.
All of economics rests on one simple principle: Changes in incentives influence human behavior in predictable ways. Both monetary and non-monetary factors influence incentives. If something becomes more costly, people will be less likely to choose it. Correspondingly, when an option becomes more attractive, people will be more likely to choose it. This simple idea, sometimes called the basic postulate of economics, is a powerful tool because it applies to almost everything that we do.
People will be less likely to choose an option as it becomes more costly. Think about the implications of this proposition. When late for an appointment, a person will be less likely to take time to stop and visit with a friend. Fewer people will go picnicking on a cold and rainy day. Higher prices will reduce the number of units sold. Attendance in college classes will be below normal the day before spring break. In each case, the explanation is the same: As the option becomes more costly, less is chosen.
Similarly, when the payoff derived from a choice increases, people will be more likely to choose it. A person will be more likely to bend over and pick up a quarter than a penny. Students will attend and pay more attention in class when the material is covered extensively on exams. Customers will buy more from stores that offer low prices, high quality service, and a convenient location. Employees will work harder and more efficiently when they are rewarded for doing so. All of these outcomes are highly predictable and they merely reflect the “incentives matter” postulate of economics.
This basic postulate explains how changes in market prices alter incentives in a manner that works to coordinate the actions of buyers and sellers. If buyers want to purchase more of an item than producers are willing (or able) to sell, its price will soon rise. As the price increases, sellers will be more willing to provide the item while buyers purchase fewer, until the higher price brings the amount demanded and the amount supplied into balance. At that point the price stabilizes.
What happens if it starts out the other way? If an item’s price is too high, suppliers will have to lower the price in order to sell it. The lower price will encourage people to buy more—but it will also discourage producers from producing as much, since at the new, lower price it will be less profitable to supply the product. Again, the price change works to bring the amount demanded by consumers into balance with the amount produced by suppliers. At that point there is no further pressure for a price change.
Remember the record high nominal gas prices in the summer of 2008? While a lot of people felt the pain of higher prices at the pump, there was no panic in the streets or lines at the gas pumps. Why? When the higher prices made it more costly to purchase gasoline, most consumers eliminated some less important trips. Others arranged more carpooling. With time, consumers also shifted to smaller, more fuel-efficient cars in order to reduce their gasoline bills. As buyers reacted to higher gas prices, so did sellers. The oil companies supplying gasoline increased their drilling, adopted new techniques to recover more oil from existing wells, and intensified their search for new oil fields. The higher price helped to keep the quantity supplied in line with the quantity demanded. Eventually, the prices of both crude oil and gasoline fell as supply expanded over time.
Incentives also influence political choices. There is little reason to believe that a person making choices in the voting booth will behave much differently than when making choices in the shopping mall. In most cases voters are more likely to support political candidates and policies that they believe will provide them with the most personal benefits, net of their costs. They will tend to oppose political options when the personal costs are high compared to the benefits they expect to receive. For example, polls indicated that nonunion members were overwhelmingly opposed to exempting union members from health care taxes that non-members and others were required to pay. Similarly, senior citizens have voted numerous times against candidates and proposals that would reduce their Medicare benefits.
There’s no way to get around the importance of incentives. It’s a part of human nature. Interestingly, incentives matter just as much under socialism as under capitalism. In the former Soviet Union, managers and employees of glass plants were at one time rewarded according to the tons of sheet glass they produced. Because their revenues depended on the weight of the glass, most factories produced sheet glass so thick that you could hardly see through it. The rules were changed so that the managers were compensated according to the number of square meters of glass they could produce. Under these rules, Soviet firms made glass so thin that it broke easily.
Some people think that incentives matter only when people are greedy and selfish. That’s not true. People act for a variety of reasons, some selfish and some charitable. The choices of both the self-centered and altruistic will be influenced by changes in personal costs and benefits. For example, both the selfish and the altruistic will be more likely to attempt to rescue a child in a shallow swimming pool than in the rapid currents approaching Niagara Falls. And both are more likely to give a needy person their hand-me-downs rather than their best clothes.
Even though no one would have accused the late Mother Teresa of greediness, her self-interest caused her to respond to incentives, too. When Mother Teresa’s organization, the Missionaries of Charity, attempted to open a shelter for the homeless in New York City, the city required expensive (but unneeded) alterations to its building. The organization abandoned the project. This decision did not reflect any change in Mother Teresa’s commitment to the poor. Instead, it reflected a change in incentives. When the cost of helping the poor in New York went up, Mother Teresa decided that her resources would do more good in other uses.1 Changes in incentives influence everyone’s choices, regardless of the mix of greedy materialistic goals on the one hand and compassionate, altruistic goals on the other, that drive a specific decision.
2. There Is No Such Thing as a Free Lunch.
The reality of life on our planet is that productive resources are limited, while the human desire for goods and services is virtually unlimited. Would you like to have some new clothes, a luxury boat, or a vacation in the Swiss Alps? How about more time for leisure, recreation, and travel? Do you dream of driving your brand-new Porsche into the driveway of your oceanfront house? Most of us would like to have all of these things and many others! However, we are constrained by the scarcity of resources, including a limited availability of time.
Because we cannot have as much of everything as we would like, we are forced to choose among alternatives. There is no free lunch. Doing one thing makes us sacrifice the opportunity to do something else we value. This is why economists refer to all costs as opportunity costs.
Many costs are measured in terms of money, but these too are opportunity costs. The money you spend on one purchase is money that is not available to spend on other things. The opportunity cost of your purchase is the value you place on the items that must now be given up because you spent the money on the initial purchase. But just because you don’t have to spend money to do something does not mean the action is costless. You don’t have to spend money to take a walk and enjoy a beautiful sunset, but there is an opportunity cost to the walk. The time you spend walking could have been used to do something else you value, like visiting a sick friend or reading a book.
We often hear it said that some things are so important that we should do them without considering the cost. Making such a statement may sound reasonable at first thought, and may be an effective way to encourage government to spend more money on things that you value and would like others to help pay for. But the unreasonableness of ignoring cost becomes obvious once we recognize that costs are the value of forgone alternatives. Saying that we do something without considering the cost just says that we should do it without considering the alternatives.
The choices of both consumers and producers involve costs. For consumers, the cost of a good, as reflected in its price, helps us compare our desire for a product against our desire for alternative products that we could purchase instead. If we do not consider the costs, we will probably end up using our income to purchase the wrong things—goods that we do not value as much as other things that we might have bought.
Producers face costs too—the costs of the resources they use to make a product or provide a service. The use of resources such as lumber, steel, and sheet rock to build a new house, for example, takes resources away from the production of other goods, such as hospitals and schools. High production costs signal that the resources have other highly valued uses, as judged by buyers and sellers in other markets. Profit-seeking firms will heed those signals and act accordingly. However, government policies can override these signals with taxes or subsidies enacted to help those inconvenienced by changing prices in free and open markets. But such policies reduce the ability of market incentives to guide resources to where consumers ultimately, on balance, value them most highly.
Politicians and the lobbyists who seek their favors often speak of “free education,” “free medical care,” or “free housing.” This terminology is deceptive. These things are not free. Scarce resources are required to produce each of them. The buildings, labor, and other resources used to produce schooling could, instead, produce more food or recreation or environmental protection or medical care. The cost of the schooling is the value of those goods that must now be given up. Governments may be able to shift costs, but they cannot avoid them.
With the passage of time, people often discover better ways of doing things and improve our knowledge of how to transform scarce resources into desired goods and services. During the last 250 years, economies with open markets have used this process to relax the grip of scarcity and improve their participants’ quality of life. This has occurred to the greatest extent when and where the signals of open markets have been allowed to influence market participants, guiding their actions to the benefit of all, rather than those signals being defeated by politically potent groups seeking to avoid market discipline in order to enhance their own special interests.
3. Decisions Are Made at the Margin.
If we want to get the most out of our resources, we should undertake actions that generate more benefits than costs and refrain from actions that are more costly than they are worth. This principle of sound decision making applies to individuals, businesses, government officials, and society as a whole.
Nearly all choices are made at the margin. That means that they almost always involve additions to, or subtractions from, current conditions, rather than all-or-nothing decisions. The word “additional” is a substitute for “marginal.” We might ask, “What is the marginal (or additional) cost of producing or purchasing one more unit?” Marginal decisions may involve large or small changes. The “one more unit” could be a new shirt, a new house, a new factory, or even an expenditure of time, as in the case of a high school student choosing among various activities. All these decisions are marginal because they involve additional costs and additional benefits.
We don’t make all-or-nothing decisions, such as choosing between eating or wearing clothes—dining in the nude so we can buy lots of food. Instead we choose between having a little more food at the cost of a little less clothing or a little less of something else. In making decisions we don’t compare the total value of food and the total value of clothing, but rather we compare their marginal values. A business executive planning to build a new factory will consider whether the marginal benefits of the new factory (for example, additional sales revenues) are greater than the marginal costs (the expense of constructing the new building). If not, the executive and his company are better off without the new factory.
Effective political actions will also reflect marginal decision making. Consider the political decision on how much effort should go into cleaning up pollution. If asked how much pollution we should allow, many people would respond none—in other words, we should reduce pollution to zero. In the voting booth they might vote that way. But marginal thinking reveals that this would be extraordinarily wasteful.
When there is a lot of pollution—so much, say, that we are choking on the air we breathe—the marginal benefit of reducing pollution is very high and is likely to outweigh the marginal cost of that reduction. But as the amount of pollution goes down, so does the marginal benefit—the value of the additional improvement in the air. There is still a benefit to an even cleaner atmosphere—for example, we will be able to see distant mountains—but this benefit is not nearly as valuable as saving us from choking. At some point before all pollution disappeared, the marginal benefit of eliminating more pollution would decline to almost zero.
But while the marginal benefit of reducing pollution is going down, the marginal cost is going up and becomes very high before all pollution is eliminated. The marginal cost is the value of other things that have to be sacrificed to reduce pollution a little bit more. Once the marginal cost of a cleaner atmosphere exceeds the marginal benefit, additional pollution reduction would be wasteful. It would simply not be worth the cost.
To continue with the pollution example, consider the following hypothetical situation. Assume that we know that pollution is doing $100 million worth of damage, and only $1 million is being spent to reduce pollution. Given this information, are we doing too little, or too much, to reduce pollution? Most people would say that we are spending too little. This may be correct, but it doesn’t follow from the information given.
The $100 million in damage is total damage, and the $1 million in cost is the total cost of cleanup. To make an informed decision about what to do next, we need to know the marginal benefit of cleanup and the marginal cost of doing so. If spending another $10 on pollution reduction would reduce damage by more than $10, then we should spend more. The marginal benefit exceeds the marginal cost. But if an additional $10 spent on antipollution efforts would reduce damages by only a dollar, additional antipollution spending would be unwise.
People commonly ignore the implications of marginalism in their comments and votes but seldom in their personal actions. Consider food versus recreation. When viewed as a whole, food is far more valuable than recreation because it allows people to survive. When people are poor and living in impoverished countries, they devote most of their income to securing an adequate diet. They devote little time, if any, to playing golf, water skiing, or other recreational activities.
But as people become wealthier they can obtain food easily. Although food remains vital to life, continuing to spend most of their money on food would be foolish. At higher levels of affluence, they find that at the margin—as they make decisions about how to spend each additional dollar—food is worth much less than recreation. So as Americans become wealthier, they spend a smaller portion of their income on food and a larger portion of their income on recreation.2
The concept of marginalism reveals that it is the marginal costs and marginal benefits that are relevant to sound decision making. If we want to get the most out of our resources, we must undertake only actions that provide marginal benefits that are equal to or greater than marginal costs. Both individuals and nations will be more prosperous when the implications of marginalism are considered.
4. Trade Promotes Economic Progress.
The foundation of trade is mutual gain. People agree to an exchange because they expect it to improve their well-being. The motivation for trade is summed up in the statement: “If you do something good for me, I will do something good for you.” Trade is productive because it permits each trading partner to get more of what he or she wants. There are three major sources of gains from trade.
First, trade moves goods from people who value them less to people who value them more. Trade increases the value obtained from goods even though nothing new is produced. When secondhand goods are traded at flea markets, through classified ads, or over the Internet, the exchanges do not increase the quantity of goods available (as new products do). But the trades move products toward people who value them more. Both the buyer and seller gain, or otherwise the exchange would not occur.
People’s preferences, knowledge, and goals vary widely. A product that is virtually worthless to one person may be a precious gem to another. A highly technical book on electronics may be worth nothing to an art collector but valued at hundreds of dollars by an engineer. Similarly, a painting that an engineer cares little for may be cherished by an art collector. Voluntary exchange that moves the electronics book to the engineer and the painting to the art collector will increase the benefit derived from both goods. The trade will increase the wealth of both people and their nation. It is not just the amount of goods and services produced in a nation that determines the nation’s wealth, but how those goods and services are allocated.
Second, trade makes larger outputs and consumption levels possible because it allows each of us to specialize more fully in the things that we do best. When people specialize in the production of goods and services that they can provide at a low cost, they can then sell these products to others and use the revenues to purchase items that would be costly for them to produce for themselves. Together, people who specialize this way will produce a larger total quantity of goods and services than would otherwise be possible—and a combination of goods more varied and more desirable than they could have produced without specialization and trade. Economists refer to this principle as the law of comparative advantage. This law is universal: It applies to trade among individuals, businesses, regions, and nations.
Excerpted from Common Sense Economics by James D. Gwartney Richard L. Stroup Dwight R. Lee Tawni H. Ferrarini.
Copyright 2010 by James D. Gwartney Richard L. Stroup Dwight R. Lee Tawni H. Ferrarini.
Published in 2010 by St. Martin’s Press.
All rights reserved. This work is protected under copyright laws and reproduction is strictly prohibited. Permission to reproduce the material in any manner or medium must be secured from the Publisher.