All economic analysis is based on a set of basic principles that apply to three levels of economic activity. First, we study how individuals make choices; second, we study how these choices interact; and third, we study how the economy functions overall.
Everyone has to make choices about what to do and what not to do. Individual choice is the basis of economics—
The reason choices must be made is that resources—anything that can be used to produce something else—
Because you must choose among limited alternatives, the true cost of anything is what you must give up to get it—
Many economic decisions involve questions not of “whether” but of “how much”—how much to spend on some good, how much to produce, and so on. Such decisions must be made by performing a trade-
The study of how people should make decisions is also a good way to understand actual behavior. Individuals usually respond to incentives—exploiting opportunities to make themselves better off.
The next level of economic analysis is the study of interaction—how my choices depend on your choices, and vice versa. When individuals interact, the end result may be different from what anyone intends.
Individuals interact because there are gains from trade: by engaging in the trade of goods and services with one another, the members of an economy can all be made better off. Specialization—each person specializes in the task he or she is good at—
Because individuals usually respond to incentives, markets normally move toward equilibrium—a situation in which no individual can make himself or herself better off by taking a different action.
An economy is efficient if all opportunities to make some people better off without making other people worse off are taken. Resources should be used as efficiently as possible to achieve society’s goals. But efficiency is not the sole way to evaluate an economy: equity, or fairness, is also desirable, and there is often a trade-
Markets usually lead to efficiency, with some well-
When markets fail and do not achieve efficiency, government intervention can improve society’s welfare.
Because people in a market economy earn income by selling things, including their own labor, one person’s spending is another person’s income. As a result, changes in spending behavior can spread throughout the economy.
Overall spending in the economy can get out of line with the economy’s productive capacity. Spending below the economy’s productive capacity leads to a recession; spending in excess of the economy’s productive capacity leads to inflation.
Governments have the ability to strongly affect overall spending, an ability they use in an effort to steer the economy between recession and inflation.