Some Principles of Economics

Various principles are used in economics. We will use these principles throughout the semester. Related to microeconomics, we can group them into two categories:

• how people and firms make decisions, and
• how people and firms interact.

How People and Firms Make Decisions

Trade-Offs

It should always be remembered that economic actors, including households, consumers, and firms, face trade-offs. If we want to get something that we enjoy, we need to give up something else. For example, because companies have scarce resources to cover the costs of production, they need to carefully decide what factors of production they will use. Consumers also have limited resources. They need to allocate their income among various goods and services. While investigating any economic decision, such as production and consumption, the trade-offs associated with such decisions must be considered.

Benefits and Costs

While analyzing any economic decisions, we need to analyze the costs and benefits of these economic decisions. The costs of economic decisions are associated with what you need to give up to accomplish your goal. The benefits of economic decisions will be measured by the returns from these economic decisions. For example, entrepreneurs contribute their time and funds to establish a firm. Because both time and funds are limited, they are considered in the cost of production. The benefit from this business will be the revenue that they will gain.

In addition to the actual cost of our economic activities, we need to consider the opportunity costs of actions. Opportunity cost is defined as whatever we need to give up to obtain some other items. For example, when entrepreneurs invest their time and funds to start a new business, they give up other possible business opportunities. Entrepreneurs could have used their time and funds for other possible business or investment opportunities. Therefore, whatever they give up starting a new business will be the opportunity cost of this business.

Thinking at the Margin

In the models, we assume that firms and households are rational. That means that they do their best to achieve their aims. For example, given the prices of goods and services and their income, consumers buy the goods and services that give them the greatest satisfaction. Similarly, firms want to maximize their profit, and they set their production levels accordingly.

Economic decisions may involve focusing on marginal (incremental) decisions. For example, firms should decide on such questions as these: Should I produce one more unit of output? Should I hire one more worker? Should I purchase one more machine?

We can give the following example to understand how marginal decisions are made:

Therefore, a rational decision-maker will take action if and only if the marginal cost of their action is lower than the marginal benefit of the same action.

Importance of Incentives

Economic incentives are defined as anything that makes people act. Our economic decisions change with our incentives as conditions change. For example, when a good is more expensive, consumers purchase less of this good because of its higher cost. On the other hand, rising prices will be good for producers, and they will produce more when the price of their products gets more expensive. Therefore, incentives may change from one group to the other.

How People and Firms Interact

Importance of Trade

Trade can make all participants better off. We continuously trade with each other. For example, firms sell their products to consumers for revenue; households sell their labor to firms for income. Not only individuals but countries can benefit from trading with each other. The most important benefit of trade is that trade lets us specialize in production that households, firms, and countries can do best.

Specialization at the individual level or the country level benefits us. The global links can be seen in many economic activities. Economic activities depend on many individuals that we don’t know. Earning income (wages, profits, and other incomes) gives individuals the incentive to accomplish their tasks. Firms depend on consumers. Consumers depend on firms.

For example, smartphones in the global economy involve a significant amount of trade. Such questions may explain the importance of trade:

• Where did your smartphones come from?
• Who worked and produced these phones?
• Which other inputs are used in production?

Importance of Markets

Markets are the locations (physical or digital) where we organize economic activities. Market economies have many advantages when compared to centrally planned economies. In market economies, resources, goods, and services are allocated through the decentralized economic decisions of many participants (firms and households) as they interact with each other in markets. These collective interactions determine market prices of goods and services, and they reflect both the value of them to consumers and the cost of producing them to producers. In this course, we will learn about the market economy (i.e., capitalist economy). In such economies, when economic participants do what is best for themselves, mostly this will do the best for society. Such market forces are called an "invisible hand," following Adam Smith (the founder of the science of economics). In his 1776 book, he states that an invisible hand (market forces) guides individuals’ self-interest into increasing the whole society’s well-being.

When governments try to control markets, prices cannot adjust as expected from free markets. This leads to distortions in the economic decisions of households and firms. Because of this, it is important to minimize government interventions in markets, unless it is necessary for social welfare, such as health, climate issues, or other externalities.

Role of Government in Free Market Economies

Still, we need governments, even in free market economies. We need the help of governments to

• protect property rights and
• improve the functioning of markets in case of market failures.

Importance of Property Rights

The invisible hand of free market economies can work if and only if we have property rights enforced and guaranteed by governments. Property rights are defined as the ability to own and control our resources.

Role of Government in Case of Market Failure

Governments are sometimes expected to interfere with markets to promote equality and efficiency in economies. Efficiency is obtained when society gets the most it can from its limited resources. Equality is related to the distribution of economic prosperity across the members of society. As we will investigate in the future, markets sometimes may fail due to the actions of large dominant firms or externalities. In such cases, government interventions can increase efficiency and improve market outcomes.