How People Make Decisions

Title : How People Make Decisions Course : Microeconomic Principles There is no mystery to what an economy is. Whether we are talking about the economy of Los Angeles, the United States, or the whole world, an economy is just a group of people dealing 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, we begin our study of economics with four principles about individual decision making. Principle 1: People Face Trade-offs You may have heard the old saying, “There ain’t no such thing as a free lunch.” Grammar aside, there is much truth to this adage. To get something that we like, we usually have to give up something else that we also like. Making decisions requires trading off one goal against another. Consider a student who must decide how to allocate her most valuable resource—her time. She can spend all of her time studying economics, spend all of it studying psychology, or divide it between the two fields. For every hour she studies one subject, she gives up an hour she could have used studying the other. And for every hour she spends studying, she gives up an hour she could have spent napping, bike riding, watching TV, or working at her part-time job for some extra spending money. Consider parents deciding how to spend their family income. They can buy food, clothing, or a family vacation. Or they can save some of the family income for retirement or the children’s college education. When they choose to spend an extra dollar on one of these goods, they have one less dollar to spend on some other good. When people are grouped into societies, they face different kinds of trade-offs. One classic trade-off is between “guns and butter.” The more a society spends on national defense (guns) to protect its shores from foreign aggressors, the less it can spend on consumer goods (butter) to raise the standard of living at home. Also important in modern society is the trade-off between a clean environment and a high level of income. Laws that require firms to reduce pollution raise the cost of producing goods and services. Because of these higher costs, the firms end up earning smaller profits, paying lower wages, charging higher prices, or some combination of these three. Thus, while pollution regulations yield the benefit of a cleaner environment and the improved health that comes with it, they come at the cost of reducing the incomes of the regulated firms’ owners, workers, and customers. Another trade-off society faces is between efficiency and equality. Efficiency means that society is getting the maximum benefits from its scarce resources. Equality means that those benefits are distributed uniformly among society’s members. In other words, efficiency refers to the size of the economic pie, and equality refers to how the pie is divided into individual slices. Principle 2: The Cost of Something Is What You Give Up to Get It Because people face trade-offs, making decisions requires comparing the costs and benefits of alternative courses of action. In many cases, however, the cost of an action is not as obvious as it might first appear. Consider the decision to go to college. The main benefits are intellectual enrichment and a lifetime of better job opportunities. But what are the costs? To answer this question, you might be tempted to add up the money you spend on tuition, books, room, and board. Yet this total does not truly represent what you give up to spend a year in college. Principle 3: Rational People Think at the Margin Economists normally assume that people are rational. Rational people systematically and purposefully do the best they can to achieve their objectives, given the available opportunities. As you study economics, you will encounter firms that decide how many workers to hire and how much of their product to manufacture and sell to maximize profits. You will also encounter individuals who decide how much time to spend working and what goods and services to buy with the resulting income to achieve the highest possible level of satisfaction. Rational people know that decisions in life are rarely black and white but usually involve shades of gray. At dinnertime, the question you face is not “Should I fast or eat like a pig?” More likely, you will be asking yourself “Should I take that extra spoonful of mashed potatoes?” When exams roll around, your decision is not between blowing them off and studying 24 hours a day but whether to spend an extra hour reviewing your notes instead of watching TV. Economists use the term marginal change to describe a small incremental adjustment 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. Rational people often make decisions by comparing marginal benefits and marginal costs. Principle 4: People Respond to Incentives An incentive is something (such as the prospect of a punishment or reward) that induces a person to act. Because rational people make decisions by comparing costs and benefits, they respond to incentives. You will see that incentives play a central role in the study of economics. One economist went so far as to suggest that the entire field could be summarized as simply “People respond to incentives. The rest is commentary”. Incentives are key to analyzing how markets work. For example, when the price of an apple rises, people decide to eat fewer apples. At the same time, apple orchards decide to hire more workers and harvest more apples. In other words, a higher price in a market provides an incentive for buyers to consume less and an incentive for sellers to produce more. As we will see, the influence of prices on the behavior of consumers and producers is crucial to how a market economy allocates scarce resources. Principle 5: Trade Can Make Everyone Better Off You may have heard on the news that the Chinese are our competitors in the world economy. In some ways, this is true because American and Chinese firms produce many of the same goods. Companies in the United States and China compete for the same customers in the markets for clothing, toys, solar panels, automobile tires, and many other items. Principle 6: Markets Are Usually a Good Way to Organize Economic Activity The collapse of communism in the Soviet Union and Eastern Europe in the late 1980s and early 1990s was one of the last century’s most transformative events. Communist countries operated on the premise that government officials were in the best position to allocate the economy’s scarce resources. These central planners decided what goods and services were produced, how much was produced, and who produced and consumed these goods and services. The theory behind central planning was that only the government could organize economic activity in a way that promoted economic well-being for the country as a whole. Principle 7: Governments Can Sometimes Improve Market Outcomes One reason we need government is that the invisible hand can work its magic only if the government enforces the rules and maintains the institutions that are key to a market economy. Most important, market economies need institutions to enforce property rights so individuals can own and control scarce resources. Principle 8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services The differences in living standards around the world are staggering. In 2014, the average American had an income of about $55,000. In the same year, the average Mexican earned about $17,000, the average Chinese about $13,000, and the average Nigerian only $6,000. Not surprisingly, this large variation in average income is reflected in various measures of quality of life. Citizens of high-income countries have more TV sets, more cars, better nutrition, better healthcare, and a longer life expectancy than citizens of low-income countries. Principle 9: Prices Rise When the Government Prints Too Much Money Although the United States has never experienced inflation even close to that of Germany in the 1920s, inflation has at times been an economic problem. During the 1970s, for instance, when the overall level of prices more than doubled, President Gerald Ford called inflation “public enemy number one.” By contrast, inflation in the first decade of the 21st century ran about 2½ percent per year; at this rate, it would take almost 30 years for prices to double. Because high inflation imposes various costs on society, keeping Principle 10: Society Faces a Short-Run Trade-off between Inflation and Unemployment Although a higher level of prices is, in the long run, the primary effect of increasing the quantity of money, the short-run story is more complex and controversial. Most economists describe the short-run effects of monetary injections as follows: • Increasing the amount of money in the economy stimulates the overall level of spending and thus the demand for goods and services. • Higher demand may over time cause firms to raise their prices, but in the meantime, it also encourages them to hire more workers and produce a larger quantity of goods and services. • More hiring means lower unemployment.