Introduction
Life is about choices, and economics is about how incentives affect those choices and shape our lives. Choices about our 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, 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 for how societies work.
The economic way of thinking involves integrating key concepts into your thought processes. This section presents twelve concepts that are crucial for the understanding of economics and will help you understand why some countries grow and achieve high income levels while others stagnate and remain poor. You will learn such things as the true meaning of costs, why prices matter, how trade enhances prosperity, and why production of things people value underpins our standard of living. In the subsequent parts of the book, these concepts will be used to address other vitally important topics.
1. Incentives matter: Changes in benefits and costs will influence choices in predictable ways.
All of economics rests on one simple principle: Changes in incentives influence human behavior in predictable ways. Both monetary and nonmonetary factors influence incentives. If something becomes more costly, people will be less likely to choose it. Correspondingly, when the benefits of an option increase, 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 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 gas prices will reduce the number of gallons 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 they know the material will be on the exam. 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 change incentives in ways that work 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 will want to purchase less, 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 sellers want to supply more than buyers are willing to purchase? If sellers cannot sell all of a good at the current price, they will cut the price. In turn, the lower price will encourage people to buy more—but it will also discourage producers from producing as much, since it is less attractive to them to supply the product at the new, lower price. Again, the price change works to bring the amount demanded by consumers into balance with the amount produced by suppliers.
Consider what happens when strong demand pushes a price up. Take gasoline, for example. The higher price will make it more costly to purchase gasoline. Consumers will respond by driving less, combining trips, and carpooling more often. In time, consumers will also shift to electric-powered and smaller, more fuel-efficient vehicles to reduce expenditures on gasoline. At the same time, the higher price will entice sellers to produce more. If not restricted, producers of gasoline will increase their drilling, develop new techniques such as fracking to recover more oil from existing wells, and intensify their search for new oil fields. This combination of forces will bring the amount demanded by consumers into balance with the amount supplied by producers. Over time, the larger supply will reverse the price increases. Price signals provide both buyers and sellers with incentives to make adjustments and bring their choices into harmony.
Just as incentives influence choices in the marketplace, they also influence political choices. Voters will be more likely to support those candidates and policies they think will provide them with the most personal benefits, net of their costs. Voters will tend to oppose policies when the personal costs are high relative to the expected benefits. For example, senior citizens consistently vote against candidates and proposals that would reduce their Social Security or Medicare benefits. Similarly, polls indicate that students disproportionally support candidates promising loan forgiveness and “free” education. Producers in businesses ranging from sugarcane and beet farming to steel and lumber tend to support candidates that favor trade restrictions, pushing up the prices of the goods they sell and reducing foreign competition. As discussed later, social programs and trade policies can often be counterproductive once costs are compared to the benefits.
There’s no way to get around the importance of incentives. They are a part of human nature. 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 paid according to the tons of sheet glass produced. Because their revenues depended on the weight of the glass, sheet glass at some factories was so thick that you could hardly see through it. In response, the rules were changed so that compensation was based on the number of square meters of glass produced. Under these new rules, Soviet firms made glass so thin that it broke easily.1
Some people think that incentives matter only when people are greedy and selfish. This is untrue. People act for a variety of reasons, some selfish and some charitable. But the choices of both the self-centered and the altruistic will be influenced by changes in personal costs and benefits. For example, both the selfish and the altruistic person 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 gently used clothes rather than their best ones.
Even though no one would have accused the late Mother Teresa of greediness, her self-interest caused her to respond to incentives, too. Consider Mother Teresa’s organization, the Missionaries of Charity. It attempted to open a shelter for the homeless in New York City, but the city government required expensive (and, in Mother Teresa’s view, 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 increased, Mother Teresa searched for alternative locations where her resources could do more good compared to costs.2 Changes in incentives influence everyone’s choices and drive decisions, regardless of the mix of greedy, materialistic goals on the one hand and compassionate, altruistic goals on the other.
2. All choices involve costs.
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 new smartphone? How about more time for leisure, recreation, and travel? Do you dream of driving your brand-new electric sports car into the driveway of your home? 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.
In the late nineteenth century, many taverns offered a “free lunch” to anyone who bought a drink. Of course, since you had to buy a drink, the lunch wasn’t actually free—in addition (the story goes), the lunch had salty foods like ham, cheese, and peanuts, causing customers to buy more drinks. Thus, they paid in full for their “free lunches.”
This led to a phrase popular among economists: “There is no such thing as a free lunch.” We cannot have as much of everything as we would like. So we choose among alternatives. The choice to do one thing requires sacrificing the opportunity to do something else. This is why all costs are opportunity costs, and all choices involve forgoing other opportunities.
Many costs are measured in terms of money, but these, too, are opportunity costs. The money you spend one way is not available to spend in other ways or for savings. The opportunity cost of your purchase reflects the value you place on the options you have given up because of your initial purchase. Even when you don’t have to spend money to do something, the action is not costless. You don’t spend money to take a walk and enjoy a beautiful sunset, but there is an opportunity cost to taking the walk. The time you spend walking could be used to do something else you value, like visiting a friend, working out, or reading.
Everyone has heard people claim that some things are so important that costs do not matter. Making such a statement may sound reasonable at first and may be an effective way to encourage people to spend more money on things that we value (and for which we would like others to help pay). But the unreasonableness of ignoring cost becomes obvious once the costs of the forgone alternatives are considered. Saying that something should be done without considering the costs is really saying that we should do it without considering the value of the alternatives. When we choose between mutually exclusive alternatives, the least-cost alternative is the most valuable one.
The choices of both consumers and producers involve costs. As 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. If we do not consider the costs, we will probably end up using our income to purchase the “wrong” things. You know—buyer’s remorse. You bought something without seriously considering the more valuable alternatives.
Producers face costs, too—the costs of the resources used to make a product or to provide a service. For example, using resources such as labor, lumber, steel, and Sheetrock to build new houses takes resources away from the production of other goods, such as hospitals and schools. High 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, such as seeking out less costly substitutes.
Government policies can distort and override these signals; they can introduce taxes or subsidies that help those interest groups inconvenienced by the competitive prices that emerge 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, government officials, and lobbyists often speak of “free education,” “free medical care,” or “free housing.” This terminology is deceptive. These things are not free. Production of each requires the use of scarce resources that could have been used to produce other things. For example, the buildings, labor, and other resources used to produce schooling could have been used to produce more food or recreation, protect the environment, or provide health care. The cost of the schooling is the value of those goods that must be sacrificed. Governments may be able to shift costs, but they cannot eliminate them.
Opportunity cost is an important concept. Everything in life is about opportunity cost. Everyone lives in a world of scarcity and, therefore, must make choices. By looking at opportunity costs, we can better understand the world in which we live. Let us consider the impact of opportunity cost on workforce participation, the birth rate, and population growth, topics many would consider outside the realm of opportunity-cost application.
Have you ever thought about why women with more education are more likely to work outside the home than their less-educated counterparts? Opportunity cost provides the answer. The more highly educated women will have better earning opportunities in the workforce, and therefore it will be more costly for them to stay at home. The data are consistent with this view. In 2019, 81 percent of women aged twenty-five to sixty-four with a college education (or more) were in the labor force, compared to only 64 percent of their counterparts with only a high school education and 47 percent of the women with less than twelve years of schooling.3 Just as economic theory predicts, when being out of the labor force is more costly, fewer women (and men) will choose this option.
What do you think happens to the birth rate as an economy grows and earnings rise? Time spent on household responsibilities reduces the time available for market work. As earnings rise, the opportunity cost of having children and raising a large family increases. Therefore, the predicted result is a reduction in the birth rate and slower population growth. During the past two centuries, as the per capita income of a country increased, a reduction in the birth rate and a slowdown in population growth soon followed. Moreover, this pattern has occurred in every country. Even though there are widespread cultural, religious, ethnic, and political differences among countries, nonetheless the higher opportunity cost of having children exerted the same impact on the birth rate in all cases.
Opportunity cost is a powerful tool. It will be applied again and again throughout this book. If you integrate this tool into your thought process, it will greatly enhance your ability to understand the real-world behavior of consumers, producers, business owners, political figures, and other decision-makers. Even more important, the concept will also help you make better personal choices.
3. Decisions are made at the margin.
To get the most value from our scarce resources, economics provides a simple rule: Pursue those actions that generate more benefits than costs; avoid those actions that generate more costs than benefits. 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 cost of producing or consuming 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, an additional investment, or even an expenditure of time, as in the case of a student choosing how to spend some more time among competing activities after pulling back from others. All these decisions are marginal because they involve consideration of additional costs and benefits.
People do not make “all-or-nothing” decisions, such as choosing between eating or wearing clothes. Instead they compare the marginal benefits (a little more food) with the marginal costs (a little less clothing or doing without as much of something else). In making decisions individuals don’t compare the total value of food and the total value of clothing and choose one or the other. Rather, they compare their marginal values—a little more of one item and a little less of others. Incentives guide us to choose options only when their marginal benefits exceed the marginal costs.
Similarly, 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 expenses of constructing the new building and sacrifice of other things). If not, the executive and the company are better off without the new factory.
Effective political actions also require marginal decision-making. Consider the policy decision of how much effort and resources to put into cleaning up pollution. If asked how much pollution is acceptable, many people would respond “none.” In other words, pollution levels need to move 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 quite likely to exceed the marginal cost of the 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 would be able to see distant mountains), but this benefit is not nearly as valuable as protecting our lungs. Before the pollution disappears 100 percent, the additional benefit of pollution reduction approaches zero.
As the marginal benefit of reducing pollution by an additional unit goes down, the marginal cost rises. As more and more resources are diverted away from other viable uses, the cost of cleaner air becomes higher. The marginal cost is the value of things that are sacrificed to reduce pollution a little bit more. Spending in health care, education, improved infrastructure, and other expenditures are but a few examples. They must be considered when evaluating the wisdom of reducing pollution to still lower levels. Once the marginal cost of a cleaner atmosphere exceeds the marginal benefit, additional pollution reduction is wasteful and counterproductive. It would simply not be worth the cost.
To continue with the pollution example, consider the following hypothetical situation: Assume 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 we need more information before drawing a conclusion.
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 next steps, 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 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, waterskiing, or other recreational activities.
But as people become wealthier, the opportunity cost of acquiring food declines. Although food remains vital to life, continuing to spend most of their money on more food would be foolish. At higher levels of affluence, people find that at the margin—as they make decisions about how to spend each additional dollar—food is often worth less than recreation. So as Americans and others become wealthier, they spend a smaller portion of their income on food and a larger portion of their income on recreation.4
The concept of marginalism reveals that marginal costs and marginal benefits are relevant to sound decision-making. If we want to get the most value out of our resources, only actions for which the marginal benefits are greater than marginal costs must be undertaken. Both individuals and nations are more prosperous when personal and policy choices reflect the implications of marginalism.
4. Voluntary trade promotes economic progress.
The foundation of voluntary trade is mutual gain. People agree to an exchange because they expect it to improve their well-being. Voluntary trade is a win-win transaction. Both parties gain more than they give up; if they did not, they would not agree to the exchange. This positive-sum activity permits each of the trading partners to get more of what they value at a relatively low cost. 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. Thus, trade can increase the value of goods even when nothing new is produced. For example, when used goods are bought and sold, the exchanges do not increase the quantity of goods available (as new products do). But the trades do create value by moving products toward the buyers who value them more than the sellers. Both gain. Otherwise, the voluntary 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 artificial intelligence 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 AI book to the engineer and the painting to the art collector will increase the net benefit derived from both goods. The trade will increase the wealth of both people and also of 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 to create value.
Second, trade expands production and consumption possibilities. Trading partners will be able to produce a larger output when each specializes in production of items they can produce at a low opportunity cost and acquires everything else through trade. When people specialize, they can then sell these products to others. Revenues received can be used to purchase items that would be costly to produce themselves. This specialization and voluntary exchange makes it possible for people to produce larger quantities of goods and services than would be otherwise possible. Economists refer to this principle as the law of comparative advantage. This law applies to trade among individuals, businesses, regions, and nations.
The law of comparative advantage is just common sense. If someone can provide you with a product at a lower cost (remember, all costs are opportunity costs) than you can supply it yourself, voluntary trade makes sense. You can then use your time and resources to produce more of the things for which you are a low-cost provider. In other words, produce what you produce best, and trade for the rest. The result is that you and your trading partners will mutually gain from specialization and trade, leading to greater total production, higher incomes, and elevated standards of living. In contrast, trying to produce everything yourself and being self-sufficient requires using your time, talents, and treasures to produce many things for which you are a high-cost provider. This would result in lower production and income while sacrificing the items and benefits others can offer.
For example, even though most doctors might be good at recordkeeping and arranging appointments, hiring someone to perform these services is generally in everyone’s best interest. The time doctors use to keep records is time they could spend caring for patients. Because the time with patients is worth a lot, the opportunity cost of doctors keeping records will be high. Thus, doctors will almost always find that hiring specialists to manage their records is advantageous for themselves, their office staff, and, most important, their patients. Moreover, when doctors specialize in the provision of physician services and hire others with comparative advantages in recordkeeping and office management, costs will be lower, services will be better, and combined output in health care will be larger.
Copyright © 2005, 2010, 2016, 2024 by James D. Gwartney, Dwight R. Lee, Tawni Hunt Ferrarini, Joseph P. Calhoun, and Jane Shaw Stroup
