Individual Choice: The Core of Economics Individual choice is the decision by an individual of what to do, which necessarily involves a decision of what not to do. TABLE 1-1 Principles That Underlie the Economics of Individual Choice 1. Resources are scarce. 2. The real cost of something is what you must give up to get it. 3. “How much?” is a decision at the margin. 4. People usually exploit opportunities to make themselves better off.

Individual Choice: The Core of Economics Resources Are Scarce Resources are scarce—the quantity available isn’t large enough to satisfy all productive uses. Rarely enough for everyone to have all they want This means competition for those resources Is there any such thing as a “free” lunch? A resource is anything that can be used to produce something else. Land - can produce trees, corn, iron ore, water, oil… Labor – produces work and services Capital – machines, ideas, time, technology, entrepreneurship Money? No, just a means to get resources

Individual Choice: The Core of Economics Opportunity Cost: The Real Cost of Something Is What You Must Give Up to Get It The real cost of an item is its opportunity cost: what you must give up in order to get it. - A measure of alternatives foregone - Price you pay? Not just about money - The highest valued alternative given up when a choice is made. - Vacation (fun) or work (money)? - Work (money now) or School (more money later)? College vs Fame & BIG Bucks? Tiger Woods understood the concept of opportunity cost. The rest is history.

Individual Choice: The Core of Economics “How Much?” Is a Decision at the Margin You make a trade-off when you compare the costs with the benefits of doing something. Decisions about whether to do a bit more or a bit less of an activity are marginal decisions. The study of such decisions is known as marginal analysis.

Individual Choice: The Core of Economics “How Much?” Is a Decision at the Margin Value or “worth” of something is: Different for each individual Relative to the situation Rarely the same each time What are a latte, chocolate bar, or granola bar worth? Is the first cup (or bar) worth the same as the fourth? Is the price charged the same for each cup? Decision on whether to pay $3 for a fourth cup compares costs & benefits – MARGINAL ANALYSIS!

Individual Choice: The Core of Economics People Usually Exploit Opportunities to Make Themselves Better Off An incentive is anything that offers rewards to people who change their behavior. This usually means getting them to do, not do, or keep doing, something they would not otherwise have done. The test: Remove the incentive and see what happens Expecting people to give up resources or change their behavior with NO incentives may not be productive Would paying people not to pollute be a useful incentive? Do people need a reward to invest for the future?

Individual Choice: The Core of Economics Individual Choice: Summing It Up We have just seen that there are four basic principles of individual choice: ■ Resources are scarce. It is always necessary to make choices. ■ The real cost of something is what you must give up to get it. All costs are opportunity costs. ■ “How much?” is a decision at the margin. Usually the question is not “whether,” but “how much. And that is a question whose answer hinges on the costs and benefits of doing a bit more. ■ People usually exploit opportunities to make themselves better off. As a result, people will respond to incentives.

Interaction: How Economies Work Economics: The study of economies at the level of the individual and society as a whole or the study of the production, distribution, and consumption of goods and services. Economics: More Practical Definition: Study of systems in a society for deciding what to make, who gets it, when, and how, in a world of scarcity and competition.

Interaction: How Economies Work Interaction of choices—my choices affect your choices, and vice versa—is a feature of most economic situations. The results of this interaction are often quite different from what the individuals intend. Individuals choices create, alter, and destroy options for others TABLE 1-2 Principles That Underlie the Interaction of Individual Choices 1. There are gains from trade. 2. Markets move toward equilibrium. Resources should be used as efficiently as possible to achieve society’s goals. 4. Markets usually lead to efficiency. 5. When markets don’t achieve efficiency, government intervention can improve society’s welfare.

Interaction: How Economies Work There Are Gains from Trade “I hunt and she gathers-otherwise we couldn’t make ends meet.”

Interaction: How Economies Work There Are Gains from Trade In a market economy, individuals engage in trade: They provide goods and services to others and receive goods and services in return. There are gains from trade: people can get more of what they want through trade than they could if they tried to be self-sufficient. This increase in output is due to specialization: each person specializes in the task that he or she is good at performing.

Interaction: How Economies Work There Are Gains from Trade Imagine how life would be if you decided to rely only on what you or your family produced on their own, buying nothing from others. What would you have? Would it be more or less than you have now? Would you be able to make any “extra” that could be sold or traded to non-family members? Would any one want to buy your extras?

Interaction: How Economies Work Markets Market Economy: An economy in which decisions about production and consumption are made by individual producers and consumers. How many producers and consumers are there in the US? Is there another type of economy? The Invisible Hand (from Adam Smith) refers to the way in which the individual pursuit of self-interest can lead to good results for society as a whole.

Interaction: How Economies Work Markets Move Toward Equilibrium An economic situation is in equilibrium when no individual would be better off doing something different. Markets are predictable and can (usually) be depended upon to supply what people most want (plus more). Price Signals Witness equilibrium in action at the checkout lines in your neighborhood supermarket. Why?

Interaction: How Economies Work Resources Should Be Used as Efficiently as Possible to Achieve Society’s Goals Is efficiency the most important thing for a society? An economy is efficient if it takes all opportunities to make some people better off without making other people worse off. An efficient economy produces the maximum gains from trade and specialization given the resources available

Interaction: How Economies Work Resources Should Be Used as Efficiently as Possible to Achieve Society’s Goals Society, through its political process, may have decided on goals that require less than perfect efficiency. One consideration is equity, without which political leaders risk rebellion or being voted out of office. Another goal might be quality of the natural environment or preservation of other species Equity means that everyone gets his or her fair share. Since people can disagree about what’s “fair,” equity isn’t as well-defined a concept as efficiency.

Interaction: How Economies Work Markets Usually Lead to Efficiency The incentives built into a market economy already ensure that resources are usually put to good use, that opportunities to make people better off are not wasted. The economy as a whole benefits if each individual specializes in a task, performs it more efficiently than most others, and trades with those others for their capabilities. General knowledge of and agreement to follow the rules facilitates social cooperation and exchange. Property rights are part of those rules, and a key incentive. Things or areas that nobody “owns” or everybody owns in “common” can lead to a “tragedy of the commons”

Interaction: How Economies Work When Markets Don’t Achieve Efficiency, Government Intervention Can Improve Society’s Welfare A very important branch of economics is devoted to studying why markets fail and what policies should be adopted to improve social welfare. They fail for three principal reasons: ■ Individual actions have side effects that are not always taken into account by the market, such as pollution or global warming. ■ One party prevents mutually beneficial trades from occurring in the attempt to capture a greater share of resources for itself, such as monopoly, tariffs, subsidies or rent control. ■ Some goods, by their very nature, are unsuited for efficient management by markets, such as public goods (roads…)

Interaction: How Economies Work Markets Usually Lead to Efficiency From Adam Smith, in his 1776 book, Wealth of Nations (short title): “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.” What does this mean? Why do people trade? Is Smith’s analysis accurate?

Some Questions? What does it mean to be “poor” or in “poverty”? What is a “fair” wage? What is a “living” wage? What is a “fair” price? What is a “fair” profit and is there a “fair” loss? Should all the buyers and sellers in the “market” collectively make these decisions or should government do it? Does income equality have political ramifications?

“Wealth” of All Households (1950) vs “Wealth” of All Households (1950) vs. “Wealth” of Poor Households (1997)

Rich vs. Poor (2001; U.S. Data) Updated Data on Inequality

Why Trade and Work for an Efficient Market?: US Family Income