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Source link: http://archive.mises.org/13693/nine-principles-of-economics/

Nine Principles of Economics

August 25, 2010 by

A small set of ideas does most of the heavy lifting in economics. “Ten Principles of Economics” or “Ten Big Ideas” or “Ten Key Elements of Economics” are pretty standard in most introductory economics books. Here’s my version, based on Chapter 1 of The Economic Way of Thinking.

1. People Act. People choose goals (ends), and they choose ways to achieve those goals (means). One of your goals, presumably, is to obtain a well-rounded liberal education. Taking econ 100 is one of the means you have chosen to that end. This also implies subsidiary means-ends relationships. Suppose one of your goals is “pass econ 100.” Reading the textbook, doing the assignments, coming to class, visiting office hours, and visiting the peer tutor are means to that end.

2. Every Action Has a Cost. When you do one thing, you give up the opportunity to do another. For example, you have an almost limitless range of options right now. You could be eating, sleeping, working, or chatting with your friends, but you have chosen instead to read this assignment. Your next best alternative is the cost you have incurred in order to read the assignment. If preparing for the first class takes five hours and your next best alternative is working for $8 per hour, then preparing for class has cost you the opportunity to earn $40 (we will shorten this periodically and say that “preparing for class” cost you $40). You will also hear people say “there is no such thing as a free lunch,” and indeed, free stuff isn’t free. If you spend thirty minutes in line waiting for a slice of free pizza and your next best alternative would be working for $8 per hour, then that slice of pizza has cost you the opportunity to earn $4.

3. People Respond to Incentives. Incentives motivate people to action. People will do more of something as the cost falls, and they will do less of it as the cost rises (the law of demand). Similarly, they will try to supply more of something that gets more remunerative and less of something that gets less remunerative (the law of supply). Prices are some of the most important incentives in economics. The price is the number of dollars that have to be traded for something ($2 for a cup of coffee, for example). Market prices emerge from the interactions of buyers and sellers.

4. People make decisions at the margin. People make trade-offs. Economic analysis is incremental: when people make decisions, they compare the costs and benefits of a little bit more or a little bit less of something. You don’t usually make sweeping categorical decisions about what is good or what is bad. You generally won’t decide that studying economics is Always Good (otherwise, you would study economics 24 hours a day) or Always Bad (otherwise, you would not study economics at all). You will compare, for example, the cost of an additional evening spent studying physics to the benefit of and additional evening studying economics. Generally, people will do everything for which the marginal benefit exceeds the marginal cost and nothing for which the marginal cost exceeds the marginal benefit. The decisions you should make ultimately depend on your goals and values. Economics as such cannot tell you whether you should spend the next minute, the next hour, or the next day studying economics, studying physics, updating your Facebook page, or sleeping, but it can tell you that you’re making a trade-off.

5. Trade makes people better off. Trade is a kind of voluntary cooperation, and it makes us wealthier. This happens in two ways. First, we know that since people act, they will only do things if they expect it to make them better off. If you trade $100 for a ticket to see the Jonas Brothers and Hannah Montana, we infer that it is because you expect to prefer the concert to anything else you could have done with the $100. This is not to say that people won’t make mistakes from time to time—we have all rented a terrible movie or ordered something at a restaurant that we didn’t like—but in general, trade will make us better off. The second way trade makes us better off is by increasing our productivity. According to the law of comparative advantage, when people specialize and trade, they can produce more output with the same inputs. Similarly, they can produce the same outputs with fewer inputs. In either case, people have more resources with which to attain their goals. This has an important implication that echoes a thought originally expressed by Adam Smith: people are more likely to help you achieve your goals if you help them achieve theirs.

6. People are Rational. This is a lot more controversial than it should be. When we say that people are rational, we mean that they will tend to do things that they expect to provide them with net benefits. We don’t mean that they will always make the right decision, that they have complete information, or that they will never make mistakes. We mean that they have goals, they tend to choose the means that they believe are appropriate to achieve them, they respond to incentives, and they learn from mistakes.

7. Using markets is costly, but using government can be costlier still. Transaction costs are the costs of measuring the valuable attributes of goods and services as well as the costs of specifying and enforcing contracts. Since trade is costly, there may be situations in which people do not make trades that would have made them better off. In principle, governments can correct these “market failures.” However, people working for the government respond to incentives, as well. Government policies like price controls, taxes, and subsidies also prevent people from making trades. Because of the incentives they face, government actors often have incentives to make things worse whether they intend to do so or not.

8. Profits tell businesses that they are helping others, while losses tell businesses that they are wasting resources. When private property rights are secure, profits and losses are the market’s feedback mechanism. You earn profits by providing people with goods and services they want at prices they find attractive. You earn losses when you provide people with goods and services they don’t want at prices they find unattractive. The invisible hand of the marketplace will tend to weed out businesses that make people worse off: it tells these businesses that the resources they are using could be better used in another enterprise. Resources will tend to flow of out of enterprises that are unprofitable and toward enterprises that are profitable.

9. We shouldn’t ignore the long-term and unintended consequences of policies and actions. Careful economic analysis is, in part, the process of asking “and then what?” about any policy or action. In his book Applied Economics, Thomas Sowell calls this “thinking past stage one,” and in his classic Economics in One Lesson, Henry Hazlitt defined “the art of economics” as tracing the effects of actions and policies and seeing how they affect everyone rather than just particular groups. The Economic Way of Thinking defines economics as “a theory of choice and its unintended consequences,” and indeed, most applied economic analysis consists of isolating and exploring the unintended consequences—whether they are good or bad—of actions and policies.

{ 47 comments }

Phinn August 25, 2010 at 9:57 am

I love it. I might suggest that it would help to list Items 1, 3 and 6 closer together, maybe arranged as 1, 2 and 3, or maybe even put Rationality first, Acting by Incentives second, and “People Act” third.

A lot of people have trouble understanding “People Act.” It seems so simple. But it’s really several concepts mashed into one. It includes: (a) a perception of various options for future action (perceived through signals), (b) a rational evaluation of each option’s relative potential for gain or loss, (c) a decision to achieve some result (i.e., setting a “goal”), and (d) behavior directed toward changing one’s present reality into a preferred reality.

Mises explains this elegantly, of course, but it’s really a compound concept, and is probably a good idea to separate it into several line items, taking the phrase apart and looking at it bit by bit.

For example, the part where a person perceives various economic options and evaluates their relative potential for profit and loss is critically important to eventually understanding the ABCT. To understand how price manipulations deceive people into engaging in uneconomical behavior, you must first understand that they BELIEVE they are acting profitably.

Also, Item 5 (Trade makes life better) would probably be more “Austrian” if it said something about how “A voluntary trade only occurs when both parties intend to be better off as a result (and they usually are).”

Dave Narby August 25, 2010 at 4:47 pm

I sincerely hope the anti-IP crowd reads this. Then re-reads this. Then re-re-re… Etc.

G. Franklin August 26, 2010 at 3:04 pm

Intellectual property? I don’t see how this article addresses IP… Explain please.

Dave Narby August 26, 2010 at 5:14 pm

First, consider that the purpose of IP is to protect the efforts of innovators.

Then consider how IP (or rather the abolishing of said) relates to points 1, 2, 3, 6 and 9.

Les August 26, 2010 at 5:45 pm

I had an econ prof 45 years ago explain an economy this way: If one party, due to resources and skills can produce 1000 widgets or, alternatively, 500 doodads, and another party the opposite, each left to their own means, splitting their time to get an equal number of each product, would produce 666+ units total, 333 of each. If each party spent all their time on their most productive activity (1000 units) and traded equally, they each would end up with 500 units of each, or 1000 units total. This represents an incentive of 333+additional units, a 50% incentive. All other activity, such as tariffs, transportation costs, protection (fire, police, army, OSHA, FDA), oversight (management, government regulation,etc), taxes of all kinds, etc, shrinks this outcome incrementally. An economy is this process carried out in an elaborate matrix of billions of individual decisions, but is as simple as the example above. The more weighty the drain of all the other activity, the lower the incentive to produce and trade. so be careful of burdening the process. :-)

G. Franklin August 26, 2010 at 6:51 pm

Dave, it would be helpful if you presented some kind of argument here.

How does IP relate to “#1 – People act” or “2 – Every Action Has a Cost”? I don’t really see a direct relation to #6 or #9 either…

I can see a connection to #3 but it could go either pro-IP or anti-IP….

Best Retail Stores September 15, 2011 at 11:39 am

I agree with your though. Thank you for your sharing.

Ryan August 25, 2010 at 1:47 pm

I’m not so sure about “people are rational”. People act to relieve some perceived anxiety. The action that brings relief and the subjective calculus that led to the action may not be at all rational in a way that can be described so objectively.

Seattle August 26, 2010 at 2:58 am

“If a man aims a rifle and misses his target he is not irrational: He is simply a poor marksman.”

DixieFlatline August 26, 2010 at 10:42 am

Ryan, you’re not understanding “people are rational” in a praxeological sense.

Giovanni P August 25, 2010 at 2:33 pm

This is awful. It says nothing to normal people. Just neoclassical economists understand these “principles”. It’s totally non-Austrian. The nominalization of everything is terrible, “trade-offs”, “margin” and these fucking neoclassical concepts aren’t good for being principles of economics. That “People make decisions at the margin” could be easily changed for something about the subjective value of things. And that 7th principle, about the government, is not a principle, it’s a conclusion. It is, I believe, the final conclusion of all the austrian economic thinking ever made — and if you put it as a principle, everything is lost (and no one will believe it).

Dave Narby August 25, 2010 at 4:48 pm

Why not write a version for “normals”, then?

G. Franklin August 26, 2010 at 3:16 pm

Excellent point about conclusions vs principles… Listing “#6 People are rational” next to “#7 governments are ineffective at best” is a big jump…

Dave Narby August 26, 2010 at 5:16 pm

Perhaps he meant “people” as in “individual people” are rational. Crowds… They are sometimes a different story.

He also gave quite a bit of qualification to “rational”.

Ben Southwood August 25, 2010 at 3:48 pm

I liked them, principally because they communicate well to those schooled in other schools of economics.

weak stream August 25, 2010 at 7:02 pm

I like all of this but I think that in addition to “human action” sorts of reasoning we must add that there are moral consequences to not adhering to a strict code of right financial behavior. Many people have weighed the various choices during the r/e and consumer credit bubble and concluded that gaming the system got them ahead. Then they wonder what went wrong. Without a proper discussion about proper financial behavior we may end up chasing our tails on the other end of the line because nobody chose to discuss issues from a moral perspective.

DixieFlatline August 26, 2010 at 10:41 am

Economics is value free. Injecting morals is not necessary for seeing the universe as it is. This must be done first, then and only then can we apply our moral standard to a consistent understanding of reality.

Daniel August 26, 2010 at 4:40 pm

The “moral” issue that caused the boom in the first place was fraud perpetrated by the Fed, not the lenders who were reacting to perceived demand.

weak stream August 26, 2010 at 8:42 pm

That’s right and, no, economics is not moral free. That is why we have the rule of law. Reality is that I’m stronger and faster that all of my clients but that doesn’t mean that I’d be right in mugging them. Morals is what this is all about. Libertarians will get nowhere by proposing anarchy and this isn’t what Mises, Hayek and Rothbard aspired to. Mises was run out of Vienna by Nazis and then moved to the US later to escape the murder and moral irrationality of Europe.

Robert August 25, 2010 at 8:51 pm

I’d strongly suggest changing the title of #6. The statement, “People are rational” is not true. Some people are and some people aren’t. Praxeology can exist just fine without having to use a false qualifier that people are rational.

You can simply say something to the effect that people have goals and act to reach them or something similar to that.

DixieFlatline August 26, 2010 at 10:39 am

You can simply say something to the effect that people have goals and act to reach them or something similar to that.

Which is the same thing as saying they are rational.

G. Franklin August 26, 2010 at 3:10 pm

What if the goals are against their self-interest? (eg. Is it rational for minorities to vote republican? haha…)

Daniel August 26, 2010 at 4:43 pm

Their goals aren’t against their self-interest, but rather towards what they expect or believe to be their best interest, even if it goes completely against their self-interest.

Government is the perfect example of this.

G. Franklin August 26, 2010 at 6:58 pm

Daniel, thanks. That obviously makes sense… I like your example too. haha….

Inquisitor August 26, 2010 at 12:43 am

“In principle, governments can correct these “market failures.” ”

Only by arbitrarily deciding to lower transaction costs, which in itself is a distortion of the market, and hardly optimal. So rather than correct the “failure” they compound it by making an unprofitable trade “profitable” without it really being so. Forget incentives. They simply, by decree, try to reduce these costs to 0. This will distort rational economic activity.

Seattle August 26, 2010 at 3:03 am

It is impossible for the market to reach the conditions of the evenly rotating economy: No matter how efficient the market’s distribution is, there is always room for improvement. Thus, it is logically possible, though highly unlikely, for a central planner to randomly distribute resources in such a way that happens to be superior to the market’s distribution.

This is what is meant by “in principle.” In principle it’s also possible to make a machine that turns water into electricity and ice cubes, if you know the thermodynamic state of every last molecule involved in the reaction.

Inquisitor August 26, 2010 at 1:33 pm

How would a central planner even begin to acquire the information need for it, and how would they eliminate transaction costs (efficiently) when the market treats them as data to cope with?

Daniel August 26, 2010 at 4:47 pm

A central planner in Serendip maybe :P

jaw crusher August 26, 2010 at 1:23 am

support you

Peter Eek August 26, 2010 at 1:57 am

Perhaps you should change “rational” to “egotistical”. I still think it is the same thing and just implys that people take decisions because they want to. In my eyes that is both rational and egotistical.

DixieFlatline August 26, 2010 at 10:37 am

That is completely not the point of calling it rational. Re-read that section.

Bob August 26, 2010 at 8:29 am

Such secular principles, I feel, too often become dogma much like religious articles-of-faith. For me, the best recent reminder of this fact is a video of former US Federal Reserve Chairman Alan Greenspan, acknowledging that his view of how the world works was wrong. Consider how revered was Greenspan’s opinion by many who took his word as “gospel,” and question who is widely revered today as a subject expert whose ideology will be found wrong tomorrow (see http://bit.ly/byPhpK).

DixieFlatline August 26, 2010 at 10:37 am

Principles and ideology are not the same thing.

Xavier August 26, 2010 at 9:36 am

Are these principles proven? For example I feel that most of my economic decisions are based on negative goals; I don’t want to mow the lawn myself, so I check if I can afford to l hire someone. I don’t have time to bake my own bread, so which baker can sell me the cheapest? As I baker I don’t want to get stuck with old bread; so what’s the highest price I can charge to sell them all.

Secondly, the invisible hand doesn’t create ‘the best of possible worlds’; it brings the WORST of possible worlds (just optimized enough to make it work). There’s plenty of room for societies acting upon conscious decisions (government?) improving market efficiencies.

Inquisitor August 26, 2010 at 1:35 pm

“There’s plenty of room for societies acting upon conscious decisions (government?) improving market efficiencies.”

How? Especially without a) bringing about inefficiencies of its own b) creating more.

mpolzkill August 26, 2010 at 1:49 pm

I’m just shaking my head at this “negative goals” statement. I can’t think of any goal, desire or need that can’t be put in negative terms. “I don’t want girls to run from me in horror, so I brush my teeth.” “For the same reason, I don’t want to stink *and* I don’t want to develop nasty sores, so I wipe my…[sorry]” Here’s one especially for you, Xavier: “I don’t want to be mocked in public, so I try to avoid making really dumb comments in public.”

Scott D August 26, 2010 at 11:39 am

Xavier,

“I don’t want to mow the lawn myself, so I check if I can afford to l hire someone.”
“2. Every Action Has a Cost.”

Mowing the lawn takes up your time and requires physical labor. If that time and labor is more valuable to you than the money you would spend on hiring a service to mow for you, you will hire someone. You should note that I am simplifying the situation for the sake of clarity. There might be many more costs/benefits involved. For example, you might derive a psychic benefit of doing a job yourself which causes you to mow the lawn even if all other considerations make it an unprofitable activity.

“Secondly, the invisible hand doesn’t create ‘the best of possible worlds’; it brings the WORST of possible worlds (just optimized enough to make it work). There’s plenty of room for societies acting upon conscious decisions (government?) improving market efficiencies.”

I’m not going to push the matter too firmly on this just yet, because I think that your comment betrays a serious lack of perspective and context. The worst possible world, in my considered opinion, would be places like the Soviet Union, parts of Africa and South America, North Korea and (until recently) most of southeast Asia. The worst of possible worlds occurs when the market is enormously hampered by barriers to trade, theft, and corruption. I think that you would have to admit that a market ruled by the invisible hand is, at least, a better alternative to these regimes, yes?

billwald August 26, 2010 at 2:59 pm

#10 “No one ever lost money by under estimating the intelligence of the American public.”

Les August 26, 2010 at 5:58 pm

How did we become the most productive country in history, then? Remember it is the “American public” that has created and produced these services and goods. Hard to conclude that we don’t collectively have the intellect you so casually demean. Trite comment above, me thinks.

DixieFlatline August 26, 2010 at 6:20 pm

There is no such thing as collective intellect unless you are referring to the knowledge effect in a free market. In that regard, Americans were the beneficiary of such a system during the 19th century.

However, Americans themselves are not significantly better than anyone else when it comes to intellect, and as we can see from the manner of government they have chosen, definitely not superior in collective judgment either.

Ohhh Henry August 26, 2010 at 5:29 pm

Because of the incentives they face, government actors often have incentives to make things worse whether they intend to do so or not.

Not “often” – the word should be “always”.Incentives are the only things that motivate people – remember rule “1. People Act” ?

Because their unique position in society is that of a monopoly maintained by force, the strongest incentive faced by those in government is the one which says that monopolies can only grow in power and money if they are run inefficiently and ineffectively. If a monopoly was run efficiently and effectively, people would not have to spend as much on getting services from the monopoly, and the monopoly-holders would suffer financially. But by doing their jobs in an ineffective and inefficient way, it increases the costs of their services and therefore it maximizes the revenues and compensation available to those working in the monopoly.

The question of the intentions of those in government is meaningless. They act out of self interest the same as everyone else in every occupation. Mother Theresa’s are as rare in government service as they are in Target stores.

Les August 26, 2010 at 5:47 pm

I think I posted this in the wrong spot above, so here it is again.:-)

I had an econ prof 45 years ago explain an economy this way: If one party, due to resources and skills can produce 1000 widgets or, alternatively, 500 doodads, and another party the opposite, each left to their own means, splitting their time to get an equal number of each product, would produce 666+ units total, 333 of each. If each party spent all their time on their most productive activity (1000 units) and traded equally, they each would end up with 500 units of each, or 1000 units total. This represents an incentive of 333+additional units, a 50% incentive. All other activity, such as tariffs, transportation costs, protection (fire, police, army, OSHA, FDA), oversight (management, government regulation,etc), taxes of all kinds, etc, shrinks this outcome incrementally. An economy is this process carried out in an elaborate matrix of billions of individual decisions, but is as simple as the example above. The more weighty the drain of all the other activity, the lower the incentive to produce and trade. so be careful of burdening the process. :-)

Less Antman December 18, 2010 at 4:10 am

If your prof had been kinder, he would have used numbers divisible by 3. Abe would have been able to make 6 widgets or 3 doodads and Bea the reverse. For Abe to have an equal number of each, 1/3 of his time would have to go to widgets and 2/3 to doodads, ending up with 2 of each. Bea, able to make 3 widgets or 6 doodads, would spend 2/3 of her time on widgets and 1/3 on doodads, again ending up with 2 of each. But if Abe stuck to widgets and Bea to doodads, each would produce 6, and an even swap would get them 3 widgets and 3 doodads each instead of the 2 and 2 by not trading, for a 50% mutual gain from trade and the resulting specialization. And this doesn’t even account for gains from economies of scale. Add 6 billion people, thousands of goods and services, stir, and the gains from trade are so overwhelming that we have prosperity throughout the world. Unless the protectionists show up, stop goods from crossing borders, and send soldiers across instead.

Fred Barney October 10, 2010 at 8:34 am

Econmics Economics provides you with a framework that allows you to become instantly unpopular: So see this point action try asking an environmentalist why is smart money not investing in Canadian property?

Fashion Designer Shoes Online March 26, 2011 at 3:24 am

Just thought I would comment and say great theme, did you design it on your own? Really looks awesome!

Espresso machines best March 30, 2011 at 3:04 am

This statement: „People will do more of something as the cost falls, and they will do less of it as the cost rises…” confused me. At the beginning I want to disagree, but when I started to think about my actions in everyday life I realized that it is absolutely true. However it would be cleverer if it would be opposite. That is human nature.

jocuri November 8, 2011 at 4:58 pm

As someone said above, nothing!

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