Section 1
Basic Economic Principles
1
Overview
What is Economics?
 Basic terms and definitions
 The ten key elements of economics
 Four pitfalls to avoid when engaging in
sound economic reasoning

2
Is Life Getting Better or Worse?
“the first 10 years of this century will very
likely go down as the most dispiriting and
disillusioning decade Americans have lived
through in the post WWII era” – Times
Magazine, from article End of the 2000’s:
Goodbye to the Decade from Hell
3
Is Life Getting Better or Worse?
NBC/Wallstreet Journal Poll: Rate this last decade:
Awful: 36%
Not Good: 31%
Fair: 18%
Good: 10%
Great: 5%


Was this decade the worst in recent history?
Is life getting worse?
4
Is Life Getting Better or Worse?
What objective measures should we
analyze?.....
Life Expectancy
Health
Income
Education
Entertainment
5
Is Life Getting Better or Worse?
6
Who’s got the better mustache?
7
Is Life Getting Better or Worse?
Just look at the changes in….
 Our transportation
8
Is Life Getting Better or Worse?
Just look at the changes in….
 Our technology
9
Is Life Getting Better or Worse?

our medicine

our entertainment
10
Is Life Getting Better or Worse?
11
The Study of Economics
Economics is the science of how
individuals make choices under
scarcity
Science: developing and testing objective
theories
 Individuals: a person or group of people
 Choice: The act of selecting among
alternatives

12
The Study of Economics

Scarcity: The concept that there is less of
something freely available from nature
than people would like.
ex. time, money, cars, etc.
13
Scarcity
1. Scarcity is not the same thing as poverty
14
Scarcity
2. Scarcity necessitates rationing
a. Rationing – Allocating scarce goods
to those who want them.
b. In a market economy, price is used
to ration goods
15
Scarcity
3. Scarcity leads to competitive behavior…
…. And competition is good!
16
What do we do in the face of
scarcity?
When will the world run out of oil?
17
Resources
Resources: An input used to produce an
economic good
1. Human resources (human capital)
2. Physical resources (physical capital)
3. Natural resources
Capital: Human-made resources used to
produce other goods and services.
18
Example of Human Capital
19
Ten Key Elements of Economics
Using the Economic way of thinking, things
are not always as they appear:
20
#1 Incentives Matter

Incentives matter: choice is influenced in a
predictable way by changing incentives
ex.
ex.
ex.
ex.
Money Game
Killer Seatbelts
5th grade spelling tests
Prices
21
#1 Incentives Matter
22
#1 Incentives Matter
This economic principle influences all people

Students

Politicians

Altruists

Criminals
23
#1 Incentives Matter
Individuals are rational: they try to get the
most from their limited resources.
“greatest benefit at least possible cost”
Note: What is rational for one person may
not be rational for everyone
24
#1 Incentives Matter
Utility: The subjective benefit or
satisfaction a person expects from a
choice or course of action.
25
#2 There is No Such Thing as a
Free Lunch
Because resources are scarce, trade-offs
must be made.
Even if it is free to you, it is not free to
society!
26
#2 There is No Such Thing as a
Free Lunch
Opportunity Cost: The highest valued
alternative that must be sacrificed when
choosing an option
ex. An hour of your time
ex. how you spend your next $15
ex. Airbags vs. AIDS research
27
#2 There is No Such Thing as a
Free Lunch
Opportunity Cost:
“With every choice you risk the life you
would have had; with every decision, you
lose it.” – Richard Bach
28
#2 There is No Such Thing as a
Free Lunch
What is usually the biggest cost of getting your
college degree?
Foregone Earnings!
29
#2 There is No Such Thing as a
Free Lunch
Failure to understand this principle is one of the
biggest mistakes made in economic reasoning.
Ex. Government bailout and stimulus package
Ex. Some Recycling Programs
30
#3 Decisions Are Made at the
Margin
Marginal: Describes the effect of a change
in the current situation.
Marginal = Change or Additional
ex. Ponderosa Buffet
ex. Supersizing your extra value meal
ex. Drive or Fly
31
#3 Decisions Are Made at the
Margin
The Diamond-Water Paradox:
Don’t confuse total value with marginal value!
32
#3 Decisions Are Made at the
Margin
Law of Diminishing Marginal Utility: as
consumption increases, the marginal utility
derived from additional consumption will
eventually decline
Banana Eating Contest Results:
33
#3 Decisions Are Made at the
Margin
This helps us answer questions about our
world:
1. Why do top pro-wrestlers and actors
typically make more than top nurses and
teachers?
>
34
#3 Decisions Are Made at the
Margin
2. Why do people cheat on their spouses?
35
#3 Decisions Are Made at the
Margin
Marginal thinking may also be why a
stepwise criminal justice punishment
system might be more effective than a
capital punishment system
36
#3 Decisions Are Made at the
Margin
*Cost-benefit analysis: when making a decision
one compares the marginal benefits and the
marginal costs*
To be economically efficient:
1. All actions generating more benefits then costs
should be undertaken
2. No actions generating more costs then benefits
should be undertaken
37
#3 Decisions Are Made at the
Margin
38
#3 Decisions Are Made at the
Margin
This is why people will rationally choose to
not be fully informed when making
decisions.
ex. New car vs. New pencil
39
#4 Voluntary Trade Promotes
Economic Progress
Voluntary vs. Coerced
Coercion: Someone will devote resources to
make you worse off if you don’t comply
40
#4 Voluntary Trade Promotes
Economic Progress
A. Because the value of a good or service is
subjective, voluntary trade moves goods
from people who value them less to
people who value them more
Ex. The Candy Game
41
#4 Voluntary Trade Promotes
Economic Progress
B. Trade makes larger output and
consumption levels possible because it
allows us to specialize in what we do best
How much of what you have or use
everyday do you make yourself?
42
#4 Voluntary Trade Promotes
Economic Progress
The Law of Comparative Advantage:
individuals, economies, and nations should
produce that which they can make at a
lower opportunity cost and trade for
everything else.
ex. Should LeBron James clean his own
house?
ex. Who should mow the lawn
43
#4 Voluntary Trade Promotes
Economic Progress
C. Voluntary Exchange makes it possible for
firms to achieve lower per-unit costs by
adopting mass production methods.
44
#5 Transaction Costs Are an
Obstacle to Trade
Transaction Costs: The time, effort, and
other resources needed to search out and
complete an exchange.
45
#5 Transaction Costs Are an
Obstacle to Trade
Leaves a role for middleman....
Middleman: A person who buys and sells
goods or services or arranges trades. A
middleman reduces transaction costs.
46
#6 Profits direct businesses toward
activities that increase wealth
Profit: An excess of sales revenue relative to the
opportunity cost of production.
A profit occurs only when the value of the good
produced is greater than the value of the
resources used for its production.
47
#6 Profits direct businesses toward
activities that increase wealth
Loss: A deficit of sales revenue relative to the
opportunity cost of production
Losses are penalties imposed on those who
produce goods that are valued less than the
resources required for their production
48
#6 Profits direct businesses toward
activities that increase wealth
Are profits a bad thing?
Are losses a bad thing?
49
#6 Profits direct businesses toward
activities that increase wealth
50
#6 Profits direct businesses toward
activities that increase wealth
The economic philosophy of business
failure:
“The mark of your ignorance is the depth of
your belief in injustice and tragedy. What
the caterpillar calls the end of the world,
the master calls a butterfly” – Richard
Bach
51
#7 People Earn Income by Helping
Others
The process by which some people become
rich will make everybody richer.
Ex. Bill Gates
Wrong
Right!
52
#7 People Earn Income by Helping
Others
53
#8 Economic progress comes primarily through
trade, investment, better ways of doing things,
and sound economic institutions
1. Investments in productive assets and in
the skills of workers enhance our ability
to produce goods and services
54
#8 Economic progress comes primarily through
trade, investment, better ways of doing things,
and sound economic institutions
However, investment requires us to give up
consumption
VS.
55
#8 Economic progress comes primarily through
trade, investment, better ways of doing things,
and sound economic institutions
56
#8 Economic progress comes primarily through
trade, investment, better ways of doing things,
and sound economic institutions
2. Improvements in technology spur economic
progress.
As a student can you do more with:
Computer, printer, internet
or
paper, pencil, and books
57
#8 Economic progress comes primarily through
trade, investment, better ways of doing things,
and sound economic institutions
Creative Destruction: The replacement of
old products and production methods by
innovative new ones that consumers judge
to be superior.
58
#8 Economic progress comes primarily through
trade, investment, better ways of doing things,
and sound economic institutions
3. Improvements in economic organization
can promote growth
Growth comes from a legal system that
promotes:
 Private property rights
 Competition
 Personal and economic freedom
59
#9 The invisible hand directs people toward
activities that promote the general welfare
The Invisible Hand Principle: The
tendency for people, while pursuing their
own interests, to promote the economic
well-being of society.
Ex. Lines at Walmart
60
#9 The invisible hand directs people toward
activities that promote the general welfare
Prices and market order:
1. Prices communicate information to decision
makers
2. Prices coordinate the actions of market
participants
3. Prices motivate economic players
61
#9 The invisible hand directs people toward
activities that promote the general welfare
62
#10 Long-term consequences, or the secondary
effects, of an action are often ignored
A person
“…must trace not merely the immediate results but
the results in the long run, not merely the
primary consequences but the secondary
consequences, and not merely the effects on
some special group but the effects on everyone”
- Henry Hazlitt, 1979
Economics in One Lesson
63
#10 Long-term consequences, or the secondary
effects, of an action are often ignored
Secondary effect: the indirect impact of
an event or policy that may not be easily
and immediately observable.
ex. Yacht tax
ex. Trade restrictions
64
4 Pitfalls to avoid in economic
thinking
Don’t make these mistakes when trying to
engage in correct economic thinking
65
4 Pitfalls to avoid in economic
thinking
1. Violation of ceteris paribus principle
ceteris paribus: other things constant
ex. Buying Roses
66
4 Pitfalls to avoid in economic
thinking
2. The belief that good intentions guarantee
desirable outcomes
ex. Endangered species act
ex. Anti-depressant medication
67
4 Pitfalls to avoid in economic
thinking
3. Fallacy of composition: belief that what is
true for one might be true for all
ex. Standing at a football game
68
4 Pitfalls to avoid in economic
thinking
3. The belief that association is causation
ex. Initials and performance
ex. Superstitions
69
The Economic Way of Thinking
70
Review


Know what is meant by the term scarcity
10 key elements of economics
1. Incentives matter
2. No such thing as a free lunch (opp. cost)
3. Decisions are made at the margin
4. Trade promotes economic progress
5. Transaction costs and middlemen
6. The economic role of profits and losses
7. Productive activity creates wealth
8. Growth comes from investment, technology, and good
institutions
9. The invisible hand and the role of prices
10. Secondary effects.
71
Review

Know the 4 pitfalls to avoid in economic
thinking:
1. violation of the ceteris paribus principle
2. The belief that good intentions
guarantee good outcomes
3. The fallacy of composition
4. The belief that association = causation
72