Economics is a social science. What exactly does that term mean? "Social" means that is about examining the way the people organize their interactions with each other in societies. "Science" means that the "scientific method" is used as a way of thinking about and studying social organization. We have some other social sciences, such as sociology, anthropology, education, history, and law. These disciplines all look at different aspects of societies or examine them from a certain perspective. Economics is the social science that concerns itself with how people make consumption and production choices in a world of endless wants and limited means.

Economics is not an ideology or a set of political beliefs; it is merely one of the ways in which people try to understand the society we live in, and how it works. It is a way of looking at the world, what we call the "economic way of thinking." This has proven to be a useful tool for understanding and explaining a great deal of human behavior. It explains how people do many of the things they do, and why, and it allows us to predict, with a reasonable degree of confidence, what the effects of some action taken by a government or a group of individuals will be.

Note that I said, "reasonable degree of confidence." That could be taken as a set of meaningless weasel words, with terms like "reasonable" and "confidence" not being clearly defined. However, what I am trying to do when I make this statement is to avoid being too sure about our knowledge of the outcomes. While it is true that people behave in a way that is "generally" predictable, you must always remember that when we study societies, we are talking about people, and people do not uniformly behave in a predictable manner. In mathematical terms, there are too many variables, and we cannot isolate and correct them all. So, what I am saying here is the "soft-sell" on economics: it is a helpful and pretty reliable way of understanding the world, just not a perfect or strictly deterministic way. Note that the "economic way of thinking" has been applied to many other social science disciplines, most famously law and sociology, and it has done a great deal to explain behavior in these areas. If you are interested, you may want to read more about the works of people like Richard Posner in law and economics, and Gary Becker in sociology. Economics also has strong ties to the field of psychology. Several of the recent Nobel Prizes in economics have been awarded to scholars or teams studying economic behavior from a psychological perspective. This should be unsurprising: both disciplines have the goal of trying to figure out how and why people make the decisions and choices that they make.

A great many economics textbooks have been written, and they all strive to start at the same place, laying out what the "fundamental principles" are. One of the best attempts is by Gregory Mankiw, a professor at Harvard University and former chair of the President's Council of Economic Advisors. He has laid out a list of ten "principles of economics" that is broadly accepted as a good summary of the main points that I will try to make here.

Actually, it's more like "7 Principles," because the last three pertain to macroeconomic issues, which is an area of study that will not be addressed in this course. Instead, we will examine microeconomics, which is the study of individual economic actors: people, and firms, and their interactions in markets. Included as an agent in this study will be governments, which play a large role in the economic lives of every individual and every firm.

A good understanding of these seven points will provide you with a very solid grounding for how to think about economic problems throughout this course and throughout the rest of your lives. I will list them below, with some explication. Before I list them, I want to add three "axiomatic" statements that have to be considered before we move on. An axiom is an assumed statement, sort of a "first principle" that is not, or need not be proved. It is a basic understanding of how things happen.

Axiom 1: Things that we want to consume more of are called economic goods or, usually, just "goods". The opposite of a good is a "bad," which is something that we want less of. However, there are very few things that are universally bad - almost every economic bad is somebody else's good. For example, we might think of pollution from burning coal as bad, and it certainly has a detrimental effect on many people, especially those who live near power plants. But the more pollution a plant operator can put into the air, the more electricity he sells, and the more money he makes.

Axiom 2: All goods are scarce. It is important to understand what "scarce" means in this context. There are quite a few words that have one meaning when used in general conversation, and a narrower, more specific definition when used in economic analysis. In general usage, "scarce" usually refers to something that is in short supply, or is running out, or is hard to find. In economics, scarce simply means that something is not limitless. Another way of thinking about it is this: a good is considered scarce if we have to give something up to consume it. When viewed in this light, the phrase "all goods are scarce" makes a bit more sense. Bottles of orange juice or episodes of TV shows are not scarce in the general sense, but they certainly are in the economic sense.

Axiom 3: Wants are unlimited. This is perhaps a polite way of saying "people are greedy" in the sense that people almost always prefer to consume more goods than less. If they reach a limit to how much of some good they want to consume, it is not hard to find another good they would like to consume more of. It is important to consider that things like leisure, rest, and peace of mind can be seen as goods.

Now, moving on to Mankiw's list:

Principle 1: People face tradeoffs.

This means that we have to make choices in a world of unlimited wants and scarce resources. If you want something, you will have to give something else up. You have to make a choice. Perhaps, in a perfect world, we would not have to make choices – we could have all that we want without having to give up anything else, but this is not the world we live in. From the desert island example, we had a simple trade-off: if you wanted more coconuts, you had to give up fish, and vice versa. If you wanted more leisure time, you had to give up some food to get it.

Principle 2: The cost of something is what you give up to get it.

In everyday life, we think of costs generally in terms of money, or perhaps time or effort. However, whenever you make an economic choice, what you give up are all of the choices that you didn’t make. This is what we call an “opportunity cost.” Ask the average man on the street what the cost of a bag of Doritos is, and he will say “99 cents.” Ask an economist, and he will tell you “every other thing that I could have spent 99 cents on." Or maybe, “the most valuable thing I could have spent 99 cents on, but did not because I spent it on Doritos.” Needless to say, this causes a lot of people to avoid having conversations with economists at parties but, nonetheless, thinking about costs in this way helps us better understand economic decision making. This contains a secondary point: money is only a tool, a store of value or a method of accounting. Money is only basically good for one thing: exchanging for goods that we consume. So, the cost of one consumption choice is the most valuable consumption choice we could have had, but chose not to make. Likewise, the opportunity cost of an investment, of either time or money, is the best other investment we could have made with that time and/or money. For example, the opportunity cost of going to an 8 am class is probably an hour of sleep for most people. Once again, think back to the desert island economy: it took you an hour to catch a fish, or half an hour to get a coconut. So what was the cost of a fish? Well, you can look at it two ways: first, you could say that it cost you an hour. This is true, but, really, an hour was only good for one of two things: catching fish or harvesting coconuts. So, if you spent an hour catching a fish, you were giving up two coconuts. We say that the opportunity cost of the fish is two coconuts - 2 coconuts is what you have to give up to gain an extra fish.

Opportunity cost is all the other things you give up to get something else. For example, let’s say you buy a car for 25 thousand dollars. If you don't spend your money on buying the car, you could invest your money (for example: deposit it into a savings account and receive interest or buy stocks, ...). When you buy the car, you give up all the other things that you could have done with the 25 thousand dollars. In economics, you should consider all of those. For example, if investing the money would give you interest, then, the opportunity cost of buying the car would be 25 thousand dollars plus lost interest of given up investment.

Another example: When you are a full-time student, the opportunity cost would be: the tuition that you pay plus money that you could have made if you were working and not spending your time at school.

Another example: Let's assume you are living in Pittsburgh and you want to buy a TV. There is a store in Pittsburgh that sells the TV for 500 dollars. However, you find a store in New York that has a TV on sale for 300 dollars. But there is no shipping service. So, you need to go there and pick it up there. What would you do? The true cost of buying the TV from the store in New York is $300 plus all the other costs that you don't need to pay if buy the TV from the Pittsburgh store. If you decide to buy the TV from New York:

• You need to rent a car (if you use your own car, you should consider the wear and tear costs of driving to New York and back).
• You need to pay for gas.
• If you work, you need to take a day off and lose the money that you could have earned.

Next is a short video with more explanation.

Video: What is Opportunity Cost? (2:45)

Principle 3: Rational people think at the margin.

“Thinking at the margin” means that we think about the next decision we need to make, and the incremental effects of that decision. Put another way, people have to be forward-looking, because the past is in the past, and nothing can be done to change it.

Principle 4: People respond to incentives.

I will talk about this in more depth in the next section when we address rationality and utility maximization. This principle is intuitively very obvious: every child understands the notion of the carrot and the stick: positive and negative incentives designed to modify behavior. A further examination of this topic leads us to discover that people usually act in their own best interest, so when governments design policies, they have to be sure that they are incentivizing the “right” behavior. An interesting topic has arisen recently: the Estate Tax, which is applied to inheritances, is set to be reinstated at the beginning of 2011 after having lapsed at the end of 2009. This means that a wealthy person dying a few minutes after the coming New Year will leave his or her heirs with a significantly larger tax bill than if he died a few minutes before midnight. Thus, the heirs perhaps have an incentive to see to it that a terminally ill parent dies a little bit earlier. This is what is called a “perverse incentive,” because our society generally frowns upon people trying to cause others to die earlier than they otherwise might. Whenever you participate in an economic transaction, it always helps to think about what incentives the other person in the transaction faces.

Principle 5: Trade can make everyone better off.

I might be inclined to make a stronger statement: that trade MUST make everybody better off, but we can go with Mankiw’s weaker statement for now. The fundamental notion behind voluntary trade is that each party is giving up something in exchange for something that they place a higher value upon. If this were not the case, the person would choose to not make the trade. For example, when I buy a bag of Doritos, the shopkeeper will voluntarily make the trade because I am paying him more money than he paid for the chips, so he’s better off, and I will voluntarily make the trade because I get more happiness from consuming the chips than anything else I could spend that 99 cents on. We’re both made better off by the transaction. We will look at applications of this notion in much more depth later on.

Principle 6: Markets are usually a good way to organize economic activity.

This is another statement that could be made a little more forcefully, but we can let it be. Markets refer to institutions (not just places) that allow people to voluntarily and willingly participate in trades to improve their lives. People sell their labor and brain power to firms, which use it to help them make profits for the owners of those firms. People use the money they earn to purchase goods and services to help them live their lives in a way that best makes them happy. In a truly free-market system, we have millions of individual, voluntary economic transactions taking place every day. In reality, sometimes (or, perhaps, always) markets do not work in this idealized manner, which leads to the next principle.

Principle 7: Governments can sometimes improve market outcomes.

When markets do not work well, we speak of “market failure” (there will be much more on this later in the course). Sometimes a government can intervene in a market, by setting rules or restrictions that enable a better outcome for society than would be obtained through an unfettered free market. Many people believe, for example, that product safety laws or workplace safety rules are unambiguous improvements upon unregulated outcomes. However, the government cannot fix every problem, and sometimes government intervention in a market can end up making things worse for society. This is what is called “government failure,” and we will also look at this in much more depth later on in the course.

The last three principles, which I will simply list below, pertain to macroeconomic issues that will not be addressed in this course.

• Principle 8: A country’s standard of living depends on its ability to produce goods and services.
• Principle 9: Prices rise when the government prints too much money.
• Principle 10: Society faces a short-run tradeoff between inflation and unemployment.

As outlined in the previous section, we are trying to study why people make the economic decisions that they make. To try to understand this question, we assume that people do things that make them happy. This is not a difficult concept to understand: any time we are faced with a choice, there is an outcome that will make us happier than another outcome. Some choices are not very enjoyable, such as doing our laundry or paying our taxes, but we do so because the alternative will leave us with less happiness: most of us prefer clean clothes to dirty, and most of us prefer to not be hounded into court by the taxman.

Economists don't use the word "happiness," but instead have coined another term: "utility." You might think of a utility as the company that provides your electricity or drinking water, and these have the same root meaning derived from the word "use." In the economic context, think of utility as the use, the value of the use or the happiness derived from the use of some good. Basically, "utility" is the economic catch-all term for whatever benefit we get from the consumption of some economic good, or in a broader sense, the benefit we derive from the outcome of an economic decision.

So, if somebody gets utility from making a decision, and more utility (happiness) is unambiguously better than less, then we make the claim that people are "rational utility maximizers." That is, in every decision that we make, we think rationally about the outcomes and make the choice that gives us the most utility. This is a simple and elegant statement, and it lies at the foundation of modern western economic thought, but it is not completely uncontroversial or even all that uncomplicated. For example, many decisions are not simple yes/no or A/B choices. Sometimes there are many possible choices - indeed, there are usually many possible choices, and we don't always know which of those choices will make us happier for the simple reason that we cannot see the future with perfect foresight. People make uninformed decisions, hurried decisions, unlucky decisions, and just plain wrong decisions every day. We are not perfectly rational, and we usually do not have either the time or knowledge, or foresight to always make the correct decision. This is an area of intense study at the boundaries of contemporary economic thought - several of the recent Nobel prizes in economics have gone to people researching what is called "behavioralism," a field of study that spans economics, psychology, and neurology. In other words, it gets really complicated. So, we make the assumption that people are rational utility maximizers. It may not be perfectly true, but it is reasonably defensible (most of us try to make the best decisions most of the time, and we don't deliberately do things that will hurt ourselves). Most importantly, it gives us a firm foundation to build upon. It is what we call a "simplifying assumption": we can assume it to be true, and doing so will allow us to answer a broad swath of questions about economic decision-making and outcomes. And after we have reasonably answered all of those questions, we can start relaxing our assumptions one at a time to see how the outcome changes. It turns out that, even if you relax the assumption of perfect rationality, most of the answers to the questions do not change in a meaningful or substantive manner.

Money and Utility

It is important to state at this point that money and utility are not the same things. People are not money-maximizers; for example, most of us would rather have the weekends off instead of working a second job. I could take a second job working in a restaurant at night, but I get more happiness spending my evenings at home or out with my family.

However, in this course, and in almost any other study of economics, you will find utility defined in terms of money. This action is defined as "monetization." This is not because we believe that money is everything. It is because we are lazy and want to explain things in simple terms. So, what we are using is using money as a common unit of measure and accounting. For example, for my winter vacation choice, I could go skiing or go to a beach resort in Mexico. In order to measure the happiness obtained from these two choices, we need a common unit of measure, and since money is a universally accepted proxy as a measure of value, that is what we use. So, economists talk about everything in terms of money because doing so makes our lives (and those of students) easier.

In the first lesson, we spoke of the concept of marginal analysis. That is, we look at how something changes if we change some other thing a little bit. For example, what will be the effect on sales of raising price a little bit? Or what will be the effect on price of adding some new regulations to a market? We also spoke in Lesson One about the concept of "utility," which is the economist's catch-all term to describe happiness, wealth, value-from-use, and so on. Utility is basically the benefits that derive to a person from using or consuming a product or service, or, more generally, the amount of extra happiness a person gets from making a certain decision and executing that choice. One of the axioms we spoke of is that people are utility maximizers, and every choice that is made is made with the goal of increasing utility.

When we speak of demand in a market, we have to consider just how much utility does a person get from consuming a certain good, at the margin. So, we are considering a process of gradual change: how much utility does a person get from consuming one more unit of a good, and how does this change with further consumption? A great deal of research has been performed on this issue, and it generally backs up what we all know intuitively: the more we have consumed of something, the less value the next unit of consumption holds for us. This is defined as the concept of Declining Marginal Utility. This sounds like a complicated piece of jargon, but it helps to think of what each word means, and the concept becomes easy to grasp.

• "Declining" means "decreasing," or "getting smaller."
• "Marginal," as described above, refers to the effect of enacting some small change, i.e., "at the margin."
• "Utility" refers to the happiness we get from doing something.

String these three definitions together, and what we are saying is that the amount of happiness we get from consuming some good goes down as we consume more of it.

So, what does this mean in the context of a market? Well, to consume a good, we have to give up something to get it. Put simply, we have to buy it. So we give away some money, which can be thought of as a measure of potential utility, for a good that gives us actual utility. Since we want to maximize utility, we will willingly trade money for a good as long as we get more utility from consuming a good than we are giving away to get it. I will restate this, as it is perhaps the key underlying principle of a market economy: if someone gets $5 of happiness from consuming something, they will be happy to pay up to $5 for that good. If the price of the good is $6, then a rational utility maximizer will not buy the good: he is giving away $6 worth of utility to get $5 worth of utility. Nobody will do this willingly - if he has full knowledge of the values of the good and the money.

The concept of declining marginal utility is the foundation of demand-curve modeling, which is one side of our market model. This will be described in more depth in the next section.