At the core of economics lies the notion of individual choice, meaning that economics assumes that all individuals make decisions on what to do and what not to do. Additionally, we can find four principles that build up this notion:
People must make choices because resources are scarce
The first principle assumes that resources—anything that can be used to produce something else—are always scarce, as there are simply not enough resources to satisfy all of the world’s demands. The most important resources are land, labor, capital, and human capital; nevertheless, there are many more to name, such as clean air, which has been made a scarce resource due to pollution. It could be that an individual wants to buy a house close to his/her work (time); however, the only affordable house (money) in the area is next to a factory (clean air). The individual will have to make a choice on what s/he finds most important, due to the scarcity of resources. Sometimes we can find decisions that are better not left at the choices individuals make, which will be discussed in the later chapters.
The opportunity cost of an item is its true cost
The opportunity cost is what we give up in order to get an item we want. This can be money, such as in situations where you ‘give up’ money in order to buy a new car, but this can also be time or something else. It can be helpful to think of an opportunity cost as an addition to the monetary cost of an item, as it entails everything that is given up in order to acquire a specific item. If in the aforementioned situation, the individual had to choose between going on holiday and buying a new car, the opportunity cost would be not going on holiday.
“How much” decisions require making trade-offs at the margin
As resources are scarce, decisions on how much of a specific resource to use have to be made. A trade-off is a comparison of costs and benefits of using a specific resource, and the decision made after the comparison is called a marginal decision—a decision at the margin.
People usually respond to incentives—opportunities to make themselves better off
The final principle is one of the main assumptions made by economists; in fact, it underlies all analyses made by them. It is assumed, that if given the chance, people will always choose for the better option, no matter what. This also means that economists assume that if there is no change in incentive, people’s behavior will not change either.
Choices made by individuals both depend, and affect choices made by other individuals and therefore have consequences on a larger scale than just for one individual. This notion also has several principles that underlie it:
There are gains from trade
Economists assume that in order for everyone to become better off, trade—providing goods and services to others and receiving goods and services in return—is necessary. This is because in order to trade, people need to divide tasks; in turn, dividing tasks allows for specialization in those tasks that they can do best. If everyone does what they do best the economy as a whole can produce more, in effect increasing everyone’s standards of life. As there will always be people with different specializations, we can assume that we will have access to all goods and services necessary.
Because people respond to incentives, markets move toward equilibrium
When people respond to incentives to get the best opportunity they can get, there will be a point when there are no more gains to be had. This particular point is called equilibrium—an economic situation when no individual would be better off doing something different. Usually equilibrium is reached through a change in prices, which can either rise or fall and as a result, eliminating individuals’ opportunities as they all have achieved the best they can get.
Resources should be used as efficiently as possible to achieve society’s goals
This principle entails that full efficiency can only be reached if it makes everyone better off and no one worse off. Economies can only be fully efficient when all resources are used in such a way that there are no more opportunities to be gained and everyone is better off. However, there are cases where efficiency conflicts with other goals societies have made: most societies are also concerned with issues of equity, and policies that promote equity usually lead to a loss of efficiency. Examples of this are policies such as minimum wage and rent ceilings, which will be discussed in later chapters.
Because people usually exploit gains from trade, markets usually lead to efficiency
At the heart of this principle is the assumption that when people gain from trade they will not choose to do something from which they will not gain. If an individual can specialize, and therefore gain, the individual will not attempt to undermine this gain. As a result s/he will his his/her resources in such a manner that will lead to the best opportunities s/he can get. Finally, through looking at principle seven, this would mean that everyone would become better off and market efficiency will be reached.
When markets don’t achieve efficiency, government intervention can improve society’s welfare
There are three main ways on why markets fail: side effects of individual’s decisions (air pollution), one party preventing mutual benefits (monopolistic behavior), and the nature of some goods being inefficient for market control (national defense). Governments usually intervene by changing incentives, because incentives are what usually change an individual’s decision.
Besides interaction between economies it is also important to see the bigger picture of how the economy behaves. This leads us to the final three principles:
One person’s spending is another person’s income
A market economy assumes a type of domino effect: when one person buys a house this money would go to the agency selling the house; however, before this, the agency bought the house from a contractor who in turn hired builders, plumbers, and maybe even an architect. In a market economy everything is commodified; everything has a price and as a result every penny spend or not spend, leads to either an increase or decrease of another’s income.
Overall spending sometimes gets out of line with the economy’s productive capacity
The economy is never stagnant. There are always, and always will be, periods when overall spending increases or decreases. When overall spending is too high an economy experiences inflation: this happens when there are many people spending, however there is not enough being produced and therefore producers will raise their prizes if there are still customers willing to buy. This can also happen the other way around causing deflation.
Government policies can change spending
As discussed before, government policies can change incentives that influence individuals’ decisions. Furthermore, government’s themselves can also choose to spend, which they usually do on things such as education, military equipment, and infrastructure to name a few. Finally, the government also controls the money supply—the total amount of money in circulation— that also influences total spending.
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