Ten Key Elements of Economics

1. Incentives Matter.

All of economics rests on one simple principle: that incentives matter. Altering incentives, the costs and benefits of making specific decisions, alters people’s behavior.

Understanding incentives is an extremely powerful tool for understanding why people do the things they do because the impact of incentives can be seen on almost every level, from simple family decision making to securities markets and international trade.

In fact, markets themselves work because both buyers and sellers change their behavior when incentives change. If buyers want to purchase more of something than sellers are able or willing to provide, its price will start to rise. As the price increases, however, sellers will be more willing to provide the good or service. Eventually, the higher price will bring the amount demanded and the amount supplied into balance.

2. There Is No Such Thing as a Free Lunch.

The reality of life on our planet is that productive resources are limited, while the human desire for goods and services is virtually unlimited. Would you like to have some new clothes, a luxury boat, or a vacation in the Swiss Alps? Most of us would like to have all of these things and many others! However, we are constrained by the scarcity of resources, including a limited availability of time.

Because we cannot have as much of everything as we would like, we are forced to choose among alternatives. But using resources—time, talent, and objects, both man-made and natural—to accomplish one thing reduces their availability for others. One of the favorite sayings of economists is, “There is no such thing as a free lunch.”

Of course, a good can be provided free to an individual or group if others foot the bill. But this merely shifts the costs; it does not reduce them. Politicians often speak of “free education,” “free medical care,” or “free housing.” This terminology is deceptive. These things are not free. Scarce resources are required to produce each of them. Governments may be able to shift costs, but they cannot avoid them.

3. Decisions Are Made at the Margins.

If we want to get the most out of our resources, we should undertake actions that generate more benefits than costs and refrain from actions that are more costly than they are worth. For example, a family that wants to purchase a home will save for a down payment by working long hours to earn money and by spending less on entertainment and eating out. High school students who want to go to college will spend more time studying and devote less time to video games than they would if they didn’t care about college. This weighing of costs and benefits is essential for individuals, businesses, and for society as a whole.

Nearly all decisions are made at the margin. That means that they almost always involve additions to, or subtractions from, current conditions, rather than an “all-or-nothing” decisions. The word “additional” is a substitute for “marginal.” We might ask, “what is the marginal (or additional) cost of producing or purchasing one more unit?” Marginal decisions may involve large or small changes. The “one more unit” could be a new shirt, a new house, a new factory, or even an expenditure of time, as in the case of a high school student choosing among various activities. All these decisions are marginal because they involve additional costs and additional benefits.

4. Trade Promotes Economic Progress.

The foundation of trade is mutual gain. People agree to an exchange because they expect it to improve their well-being. The motivation for trade is summed up in the statement: “If you do something good for me, I will do something good for you.” Trade is productive because it permits each of the trading partners to get more of what he or she wants. There are three major sources of gains from trade.

First, trade moves goods from people who value them less to people who value them more. Second, trade makes larger outputs and consumption levels possible because it allows each of us to specialize more fully in the things that we do best. Third, voluntary exchange makes it possible for firms to achieve lower per-unit costs by adopting mass production methods.

It is difficult to exaggerate the importance of trade in our modern world. Trade makes it possible for most of us to consume a bundle of goods far beyond what we would be able to produce for ourselves. Can you imagine the difficulty involved in producing your own housing, clothing, and food, to say nothing of radios, television sets, dishwashers, automobiles, and telephones?

5. Transaction Costs Are an Obstacle to Trade.

Voluntary exchange promotes cooperation and helps us get more of what we want. However, trade itself is costly. It takes time, effort, and other resources to search out potential trading partners, negotiate trades, and close the sale. Resources spent in this way are called transaction costs, and they are an obstacle to the creation of wealth. They limit both our productive capacity and the realization of gains from mutually advantageous trades.

Transaction costs are sometimes high because of physical obstacles, such as oceans, rivers, and mountains, which make it difficult to get products to customers. In other instances, transaction costs are high because of the lack of information. Frequently transaction costs are high because of political obstacles, such as taxes, licensing requirements, government regulations, price controls, tariffs, or quotas.

People who help others arrange trades and make better choices reduce transaction costs and promote economic progress. Such specialists, sometimes called middlemen, include campus bookstores, real estate agents, stockbrokers, automobile dealers, publishers of classified ads, and a wide variety of merchants.

6. Profits Direct Businesses Toward Activities that Increase Wealth.

The people of a nation will be better off if their resources—their land, their buildings, their people—produce valuable goods and services. At any given time, a virtually unlimited number of potential investment projects are under consideration. Some of these investments will increase the value of resources by transforming them into goods and services that increase the satisfaction of consumers. These will promote economic progress. Other investments will reduce the value of resources and reduce economic progress. If we are going to get the most out of the available resources, projects that increase value must be encouraged, while those that use resources less productively must be discouraged.

This is precisely what profits and losses do. Business firms purchase resources (raw materials, intermediate goods, engineering, and secretarial services, etc.) and use them to produce goods or services that are sold to consumers. If the sales of the products exceed the costs of all the resources required to produce them, then these firms will make a profit. This means that profits result only if firms produce goods and services that consumers value more than the cost of the resources required for their production.

The value of a product to the consumer is measured by the price the consumer is willing to pay. If the consumer pays more than the production costs, then the decision by the producer to bid the resources away from their alternative uses was a profitable one. Profit is a reward for transforming resources into something of greater value.

In contrast, losses are a penalty imposed on businesses that use up resources without converting them into something more valuable. The losses indicate that the resources would have been better used producing other things.

7. People Earn Income by Helping Others.

People differ in many ways—in their productive abilities, their preferences, their opportunities, their specialized skills, their willingness to take risks, and their luck. These differences influence people’s incomes because they affect the value of the good and services that individuals are able or willing to provide to others.

People who earn large incomes do so because they provide others with lots of things that they value. If these individuals did not provide valuable goods or services, consumers would not pay them so generously. There is a moral here: if you want to earn a large income, you had better figure out how to help others a great deal. The opposite is also true. If you are unable or unwilling to help others, your income will be small.

8. Economic Progress Comes Primarily Through Trade, Investment, Betters Ways of Doing Things, and Sound Economic Institutions.

First, investments in productive assets (tools and machines, for example) and in the skills of workers (investment in “human capital”) enhance our ability to produce goods and services. Second, improvements in technology (the use of brain power to discover new products and less costly methods of production) spur economic progress. Third, improvements in economic organization can promote growth.

Investment and improvements in technology do not just happen. They reflect the actions of entrepreneurs, people who take risks in the hope of profit. No one knows what the next innovative breakthrough will be or just which production techniques will reduce costs. Furthermore, entrepreneurial genius is found in unexpected places. Thus, economic progress depends on a system that allows a very diverse set of people to try their ideas to see if they will pass the market test but also discourages them from squandering resources on unproductive projects.

9. The “Invisible Hand” of Market Prices Directs Buyers and Sellers Toward Activities that Promote the General Welfare.

As Adam Smith noted, the remarkable thing about an economy based on private property is that self-interest will further the general prosperity of a community or nation. The individual “intends only his own gain” but he is directed by the “invisible hand” of market prices to promote the goals of others, leading to greater prosperity.

The principle of the “invisible hand” is difficult for many people to grasp. There is a natural tendency to associate order in a society with centralized planning. Yet Adam Smith contends that pursuing one’s own advantage creates an orderly society in which demands are routinely satisfied without a central plan.

This order occurs because market prices coordinate the actions of self-interested individuals when private property and freedom of exchange are present. One statistic—the market price of a particular good or service—provides buyers and sellers with what they need to know to bring their actions into harmony with the actions and preferences of others. Market prices register the choices of millions of consumers, producers, and resource suppliers. They reflect information about consumer preferences, costs, and matters related to timing, location and circumstances that are well beyond the comprehension of any individual or central-planning authority.

The invisible hand works so quietly and automatically that the order, cooperation, and vast array of goods available to modern consumers are taken for granted.

10. Too Often, Long-Term Consequences, or the Secondary Effects, of an Action Are Ignored.

Especially in politics there is a tendency to stress the short-term benefits of a policy while completely ignoring its longer-term consequences. In politics we hear an endless pleading for proposals to help specific industries, regions, or groups without consideration given to the impact on the broader community, including taxpayers and consumers.

Much of this is deliberate. When seeking political favors, interest groups and their hired representatives, lobbyists, have an incentive to put the best spin on their case. They will exaggerate the benefits (most of which they will capture if the policy is enacted) and minimize the costs (most of which will be borne by others). Such interest groups are most effective if the benefits are immediate and easily visible to the voter, but the costs are less visible and mostly in the future. Under these conditions, interest groups can often mislead voters.

Consider the case of rent controls imposed on apartments, usually in response to claims that rent controls will keep rents from rising and make housing more affordable for the poor.

Yes, this is true in the short run, but there will be secondary effects. First, the market for apartments will stagnate. Existing apartments will not be transferred to those who want them most. It will be expensive for someone to give up a rent-controlled apartment, even if another apartment is closer to work, and it will be hard to find a closer one because others are holding onto theirs at the below-market rent.

This article is excerpted from Common Sense Economics: What Everyone Should Know About Wealth and Prosperity, by James Gwartney, Richard L. Stroup, and Dwight R. Lee. Copyright ©2005 by the authors. Reprinted with permission from St. Martin’s Press, LLC.