The management of society’s resources is important because resources are scarce. Scarcity means that society has limited resources and therefore cannot produce all the goods and services people wish to have. Just as a household cannot give every member everything he or she wants, a society cannot give every individual the highest standard of living to which he or she might aspire.
Economics is the study of how society manages its scarce resources. In most societies, resources are allocated not by a single central planner but through the combined actions of millions of households and firms. Economists therefore study how people make decisions: how much they work, what they buy, how much they save, and how they invest their savings. Economists also study how people interact with one another. For instance, they examine how the multitude of buyers and sellers of a good together determine the price at which the good is sold and the quantity that is sold. There is no mystery to what an “economy” is. Whether we are talking about the economy of Colombo of Sri Lanka, or of the whole world, an economy is just a group of people interacting with one another as they go about their lives. Because the behavior of an economy reflects the behavior of the individuals who make up the economy.
Economics with four principles of individual decision making will help to get a brief idea of what we are talking.
PRINCIPLE #1: PEOPLE FACE TRADEOFFS
To get one thing that we like, we usually have to give up another thing that we like. Making decisions requires trading off one goal against another. When people are grouped into societies, they face different kinds of tradeoffs. The classic tradeoff is between “guns and butter.” The more we spend on national defense to protect our shores from foreign aggressors (guns), the less we can spend on consumer goods to raise our standard of living at home (butter).
Another tradeoff society faces is between efficiency and equity. Efficiency means that society is getting the most it can from its scarce resources. Equity means that the benefits of those resources are distributed fairly among society’s members. In other words, efficiency refers to the size of the economic pie, and equity refers to how the pie is divided. Often, when government policies are being designed, these two goals conflict.
PRINCIPLE #2: THE COST OF SOMETHING IS WHAT YOU GIVE UP TO GET IT
Because people face tradeoffs, making decisions requires
comparing the costs and benefits of alternative courses of action. In many cases, however, the cost of some action is not as obvious as it might first appear. The opportunity cost of an item is what you give up to get that item. When making any decision, decision makers should be aware of the opportunity costs that accompany each possible action. In fact, they usually are.PRINCIPLE #3: RATIONAL PEOPLE THINK AT THE MARGIN
Economists use the term marginal changes to describe small incremental adjustments to an existing plan of action. Keep in mind that “margin” means “edge,” so marginal changes are adjustments around the edges of what you are doing.
PRINCIPLE #4: PEOPLE RESPOND TO INCENTIVES
Because people make decisions by comparing costs and benefits, their behavior may change when the costs or benefits change. That is, people respond to incentives. Public policymakers should never forget about incentives, for many policies change the costs or benefits that people face and, therefore, alter behavior.
