As we learned in the Introduction, an economy is a system for coordinating the productive activities of many people. In a market economy like we live in, coordination takes place without any coordinator: each individual makes his or her own choices.

Yet those choices are by no means independent of one another: each individual’s opportunities, and hence choices, depend to a large extent on the choices made by other people. So to understand how a market economy behaves, we have to examine this interaction in which my choices affect your choices, and vice versa.

When studying economic interaction, we quickly learn that the end result of individual choices may be quite different from what any one individual intends. For example, over the past century farmers in the United States have eagerly adopted new farming techniques and crop strains that have reduced their costs and increased their yields. Clearly, it’s in the interest of each farmer to keep up with the latest farming techniques.

But the end result of each farmer trying to increase his or her own income has actually been to drive many farmers out of business. Because American farmers have been so successful at producing larger yields, agricultural prices have steadily fallen. These falling prices have reduced the incomes of many farmers, and as a result fewer people find farming worth doing. That is, an individual farmer who plants a better variety of corn is better off; but when many farmers plant a better variety of corn, the result may be to make farmers as a group worse off.

A farmer who plants a new, more productive corn variety doesn’t just grow more corn. Such a farmer also affects the market for corn through the increased yields attained, with consequences that will be felt by other farmers, consumers, and beyond.

Just as there are four economic principles that underlie individual choice, there are five principles underlying the economics of interaction. These principles are summarized in Table 1-2 and we will now examine each of them more closely.

Why do the choices I make interact with the choices you make? A family could try to take care of all its own needs—growing its own food, sewing its own clothing, providing itself with entertainment, writing its own economics textbooks. But trying to live that way would be very hard.

The key to a much better standard of living for everyone is trade, in which people divide tasks among themselves and each person provides a good or service that other people want in return for different goods and services that he or she wants.

The reason we have an economy, not many self-sufficient individuals, is that there are gains from trade: by dividing tasks and trading, two people (or 6 billion people) can each get more of what they want than they could get by being self-sufficient. This leads us to our fifth principle:

There are gains from trade.

Gains from trade arise from this division of tasks, which economists call specialization—a situation in which different people each engage in a different task, specializing in those tasks that they are good at performing. The advantages of specialization, and the resulting gains from trade, were the starting point for Adam Smith’s 1776 book The Wealth of Nations, which many regard as the beginning of economics as a discipline.

Smith’s book begins with a description of an eighteenth-century pin factory where, rather than each of the 10 workers making a pin from start to finish, each worker specialized in one of the many steps in pin-making:

One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on, is a particular business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations…. Those ten persons, therefore, could make among them upwards of forty-eight thousand pins in a day. But if they had all wrought separately and independently, and without any of them having been educated to this particular business, they certainly could not each of them have made twenty, perhaps not one pin a day….

The same principle applies when we look at how people divide tasks among themselves and trade in an economy. The economy, as a whole, can produce more when each person specializes in a task and trades with others.

The benefits of specialization are the reason a person typically chooses only one career. It takes many years of study and experience to become a doctor or to become a commercial airline pilot. Many doctors might well have had the potential to become excellent pilots, and vice versa; but it is very unlikely that anyone who decided to pursue both careers would be as good a pilot or as good a doctor as someone who decided at the beginning to specialize in that field. So it is to everyone’s advantage that individuals specialize in their career choices.

Markets are what allow a doctor and a pilot to specialize in their own fields. Because markets for commercial flights and for doctors’ services exist, a doctor is assured that she can find a flight and a pilot is assured that he can find a doctor. As long as individuals know that they can find the goods and services they want in the market, they are willing to forgo self-sufficiency and to specialize. But what assures people that markets will deliver what they want? The answer to that question leads us to our second principle of how individual choices interact.

It’s a busy afternoon at the supermarket; there are long lines at the checkout counters. Then one of the previously closed cash registers opens. What happens? The first thing, of course, is a rush to that register. After a couple of minutes, however, things will have settled down; shoppers will have rearranged themselves so that the line at the newly opened register is about the same length as the lines at all the other registers.

How do we know that? We know from our fourth principle that people will exploit opportunities to make themselves better off. This means that people will rush to the newly opened register in order to save time standing in line. And things will settle down when shoppers can no longer improve their position by switching lines—that is, when the opportunities to make themselves better off have all been exploited.

A story about supermarket checkout lines may seem to have little to do with how individual choices interact, but in fact it illustrates an important principle. A situation in which individuals cannot make themselves better off by doing something different—the situation in which all the checkout lines are the same length—is what economists call an equilibrium. An economic situation is in equilibrium when no individual would be better off doing something different.

Recall the story about the mythical Jiffy Lube, where it was supposedly cheaper to leave your car for an oil change than to pay for parking. If the opportunity had really existed and people were still paying $30 to park in garages, the situation would not have been an equilibrium. And that should have been a giveaway that the story couldn’t be true. In reality, people would have seized an opportunity to park cheaply, just as they seize opportunities to save time at the checkout line. And in so doing they would have eliminated the opportunity! Either it would have become very hard to get an appointment for an oil change or the price of a lube job would have increased to the point that it was no longer an attractive option (unless you really needed a lube job). This brings us to our sixth principle:

Because people respond to incentives, markets move toward equilibrium.

As we will see, markets usually reach equilibrium via changes in prices, which rise or fall until no opportunities for individuals to make themselves better off remain.

The concept of equilibrium is extremely helpful in understanding economic interactions because it provides a way of cutting through the sometimes complex details of those interactions. To understand what happens when a new line is opened at a supermarket, you don’t need to worry about exactly how shoppers rearrange themselves, who moves ahead of whom, which register just opened, and so on. What you need to know is that any time there is a change, the situation will move to an equilibrium.

The fact that markets move toward equilibrium is why we can depend on them to work in a predictable way. In fact, we can trust markets to supply us with the essentials of life. For example, people who live in big cities can be sure that the supermarket shelves will always be fully stocked. Why? Because if some merchants who distribute food didn’t make deliveries, a big profit opportunity would be created for any merchant who did—and there would be a rush to supply food, just like the rush to a newly opened cash register.

So the market ensures that food will always be available for city dwellers. And, returning to our fifth principle, this allows city dwellers to be city dwellers—to specialize in doing city jobs rather than living on farms and growing their own food.

A market economy, as we have seen, allows people to achieve gains from trade. But how do we know how well such an economy is doing? The next principle gives us a standard to use in evaluating an economy’s performance.

Suppose you are taking a course in which the classroom is too small for the number of students—many people are forced to stand or sit on the floor—despite the fact that large, empty classrooms are available nearby. You would say, correctly, that this is no way to run a college. Economists would call this an inefficient use of resources. But if an inefficient use of resources is undesirable, just what does it mean to use resources efficiently?

You might imagine that the efficient use of resources has something to do with money, maybe that it is measured in dollars-and-cents terms. But in economics, as in life, money is only a means to other ends. The measure that economists really care about is not money but people’s happiness or welfare. Economists say that an economy’s resources are used efficiently when they are used in a way that has fully exploited all opportunities to make everyone better off. To put it another way, an economy is efficient if it takes all opportunities to make some people better off without making other people worse off.

In our classroom example, there clearly was a way to make everyone better off—moving the class to a larger room would make people in the class better off without hurting anyone else in the college. Assigning the course to the smaller classroom was an inefficient use of the college’s resources, whereas assigning the course to the larger classroom would have been an efficient use of the college’s resources.

When an economy is efficient, it is producing the maximum gains from trade possible given the resources available. Why? Because there is no way to rearrange how resources are used in a way that can make everyone better off. When an economy is efficient, one person can be made better off by rearranging how resources are used only by making someone else worse off.

In our classroom example, if all larger classrooms were already occupied, the college would have been run in an efficient way: your class could be made better off by moving to a larger classroom only by making people in the larger classroom worse off by making them move to a smaller classroom.

We can now state our seventh principle:

Resources should be used as efficiently as possible to achieve society’s goals.

Should economic policy makers always strive to achieve economic efficiency? Well, not quite, because efficiency is only a means to achieving society’s goals. Sometimes efficiency may conflict with a goal that society has deemed worthwhile to achieve. For example, in most societies, people also care about issues of fairness, or equity. And there is typically a trade-off between equity and efficiency: policies that promote equity often come at a cost of decreased efficiency in the economy, and vice versa.

To see this, consider the case of disabled-designated parking spaces in public parking lots. Many people have difficulty walking due to age or disability, so it seems only fair to assign closer parking spaces specifically for their use. You may have noticed, however, that a certain amount of inefficiency is involved. To make sure that there is always a parking space available should a disabled person want one, there are typically more such spaces available than there are disabled people who want one. As a result, desirable parking spaces are unused. (And the temptation for nondisabled people to use them is so great that we must be dissuaded by fear of getting a ticket.)

So, short of hiring parking valets to allocate spaces, there is a conflict between equity, making life “fairer” for disabled people, and efficiency, making sure that all opportunities to make people better off have been fully exploited by never letting close-in parking spaces go unused.

Exactly how far policy makers should go in promoting equity over efficiency is a difficult question that goes to the heart of the political process. As such, it is not a question that economists can answer. What is important for economists, however, is always to seek to use the economy’s resources as efficiently as possible in the pursuit of society’s goals, whatever those goals may be.

No branch of the U.S. government is entrusted with ensuring the general economic efficiency of our market economy—we don’t have agents who go around making sure that brain surgeons aren’t plowing fields or that Minnesota farmers aren’t trying to grow oranges. The government doesn’t need to enforce the efficient use of resources, because in most cases the invisible hand does the job.

The incentives built into a market economy ensure that resources are usually put to good use and that opportunities to make people better off are not wasted. If a college were known for its habit of crowding students into small classrooms while large classrooms went unused, it would soon find its enrollment dropping, putting the jobs of its administrators at risk. The “market” for college students would respond in a way that induced administrators to run the college efficiently.

A detailed explanation of why markets are usually very good at making sure that resources are used well will have to wait until we have studied how markets actually work. But the most basic reason is that in a market economy, in which individuals are free to choose what to consume and what to produce, people normally take opportunities for mutual gain—that is, gains from trade.

If there is a way in which some people can be made better off, people will usually be able to take advantage of that opportunity. And that is exactly what defines efficiency: all the opportunities to make some people better off without making other people worse off have been exploited. This gives rise to our eighth principle:

Because people usually exploit gains from trade, markets usually lead to efficiency.

However, there are exceptions to this principle that markets are generally efficient. In cases of market failure, the individual pursuit of self-interest found in markets makes society worse off—that is, the market outcome is inefficient. And, as we will see in examining the next principle, when markets fail, government intervention can help. But short of instances of market failure, the general rule is that markets are a remarkably good way of organizing an economy.

Let’s recall from the Introduction the nature of the market failure caused by traffic congestion—a commuter driving to work has no incentive to take into account the cost that his or her action inflicts on other drivers in the form of increased traffic congestion.

There are several possible remedies to this situation; examples include charging road tolls, subsidizing the cost of public transportation, and taxing sales of gasoline to individual drivers. All these remedies work by changing the incentives of would-be drivers, motivating them to drive less and use alternative transportation. But they also share another feature: each relies on government intervention in the market. This brings us to our ninth principle:

When markets don’t achieve efficiency, government intervention can improve society’s welfare.

That is, when markets go wrong, an appropriately designed government policy can sometimes move society closer to an efficient outcome by changing how society’s resources are used.

An important branch of economics is devoted to studying why markets fail and what policies should be adopted to improve social welfare. We will study these problems and their remedies in depth in later chapters, but, briefly, there are three principal ways in which they fail:

An important part of your education in economics is learning to identify not just when markets work but also when they don’t work, and to judge what government policies are appropriate in each situation.