CHAPTER

1
The Principles and Practice of
Economics
Is Facebook free? Facebook doesn’t charge you a penny for membership, so it’s natural to say, Learning Objectives
“Yes.”
Think of economics as the
study of people’s choices
But here’s another way to think about it. What do you give up when you use Facebook? That’s a
different kind of question. Facebook doesn’t take your money, it’s true, but it does take your Understand what
time. If you spend an hour each day on Facebook, you are giving up whatever else you could distinguishes economics
obtain with that same amount of time. For example, a U.S. college student employed just seven from the other social
sciences
hours per week will earn about $4,000 dollars in a year. That means if you are using Facebook
seven hours a week, you are giving up time that is worth nearly $4,000 in potential wages. For Understand the first key
$4,000, you could pay the annual lease on a second-hand Porsche. That is the indirect cost of principle of economics –
using Facebook. People try to choose the
best available option (the
principle of optimization)

Apply the concept of

opportunity cost

Understand the second key

principle – economic
systems tend toward
equilibrium, a state in which
nobody would benefit by
changing his or her own
behavior (the principle of
equilibrium)

Use economic reasoning to

make better decisions
The economic cost of surfing Facebook an hour a day is the best alternative thing that you
could have done with that time – for instance, working a part-time job and earning enough
money to lease a used Porsche.

THE SCOPE OF ECONOMICS

Most people are surprised to learn how much ground economists cover. Economists study all
human behavior, from a young person’s decision to lease a new sports car, to the speed the new
driver chooses as she rounds a hairpin corner, to her decision not to wear a seat belt. These are
all choices, and they are all fair game to economists. And contrary to what you may have
assumed, they are not all directly related to money.
The concept of choice is key to understanding economics, because economists think of
almost all human behavior as the outcome of choices. For instance, imagine that Dad tells his
teenage daughter that she must wash the family car. Though it may not be obvious, the young
woman in fact has several options: she can wash it, she can negotiate for an easier chore, she
can refuse to wash it and suffer the consequences, or she can move out (admittedly a drastic
response, but still a choice). Obeying one’s parents is a choice, though it may not feel like one.
Economists see almost all human behavior as the result of choices.

Economic Agents and Economic Resources

Saying that economics is all about choices is an easy way to remember what economics is.
However, it is also useful to provide a more precise definition. The definition introduces two
important concepts: agents and resource allocation.
An economic agent is an individual or an organization that makes choices. For example, a
consumer chooses to eat bacon cheeseburgers or tofu burgers. A parent chooses to enroll her
children in public school or private school. A student chooses to attend his classes or to skip
them. A citizen chooses whether or not to vote, and if so, which candidate to support. A
worker chooses to do her job or pretend to work while texting. A criminal chooses to hotwire
cars or mug little old ladies. A business leader chooses to open a new factory in Cincinnati or
Shanghai. A senator chooses to vote for or against a bill. Of course, you are also an economic
agent since you make an enormous number of choices every day.
 However, not all economic agents are individuals. Economic agents can also be
organizations like countries, armies, companies, universities, political parties, labor unions,
sports teams, and street gangs. These organizations also make choices.
The second important concept to understand is that economics studies the allocation of
scarce resources. Scarce resources are things that people want, like Bordeaux wine, gold
wedding bands, Shiatsu massages, Coach hand bags, California peaches, iPhones, triple-
chocolate-fudge ice cream, a room with a view. These things are scarce, because people’s
appetite for them exceeds their availability.
Consider sports cars. If sports cars were given away for free, there would not be enough of
them to go around. Instead, sports cars are sold to the consumers who are willing to pay the
most to buy them. The existence of a marketplace for sports cars gives economic agents a
choice. Return to our opening example. You can sacrifice some of your scarce time to take a
job and use the extra earnings to lease a car. Or you can use your time for some other activity—
surfing Facebook, exercising at the gym, or cramming for an exam. Decisions like these are
referred to as allocations. In this example, you are allocating your time. Will you use your time
to earn money to lease a car? Or will you use your time to surf Facebook so you know what
your friends did last night? Since your time is limited, you should allocate your time -- a scare
resource -- to obtain whatever you value the most.
Economists don’t have a preconception of whether a part-time job or Facebook is the best
way to use your time. Either activity might be best for you. We are interested in teaching you to
use economic logic so that you can compare the costs and benefits of the relevant alternatives.

Definition of Economics

We are now ready to formally define economics. Economics is the study of how agents
choose to allocate scarce resources and how those choices affect society. As expected, this
formal definition emphasizes choices.

Margin Definition: Economics is the study of how agents choose to allocate scarce resources
and how those choices affect society.

The definition also takes into account how these choices affect society. For example, the
sale of a new sports car doesn’t just affect the person driving out of the showroom. The sale
generates sales tax, which is collected by the government, which in turn funds projects like
highways and hospitals. The purchase of the new car also generates some congestion – that’s
one more car in rush-hour gridlock or taking up space on your street. If the new owner drives
recklessly, the car may also generate risks to other drivers. The car will also be a new source of
pollution. Economists study the original choice and its multiple consequences for other people
in society.

Positive, Prescriptive and Normative Economics

So we now have an idea of what economics is about: people’s choices. But what is the reason
for studying choices? Part of the answer is that economists are just plain curious, but that’s only
a small part of the picture. Understanding people’s choices is practically useful for three
separate reasons. Economic analysis:

1. Describes what people actually do or predicts what they will do in the future
2. Recommends or prescribes what individual people ought to do
3. Recommends or prescribes what society (for instance, the government) ought to do.
 Notice that the first application is different from the other two in that it is descriptive; the
other two are advisory. Description and prescription are conceptually distinct. Descriptions of
what people actually do are objective and value-free. Such descriptions are simply matters of
fact or matters that can be eventually checked with data. For instance, it is a fact that in 2006,
16% of U.S. families earn less than $15,000 per year after paying their taxes.i Factual
statements can be verified with data.
Recommendations, by contrast, are subjective. Recommendations depend on value
judgments. For instance, one must make a value judgment to say that our society should raise
taxes on the rich (presumably making them worse off) to pay for new social programs that will
support families with low incomes. Saying that we should (or should not) take resources from
Peter so we can give resources to Paul is a value judgment.

Positive analysis: Describing what people actually do

We now want to explain the first item in the list above. Describing what has happened or
predicting what will happen is referred to as positive economics or positive analysis. For
instance, imagine that government policymakers need to predict the consequences of a new
policy that doubles the tax on cigarettes. A positive economic analysis generates the following
predictions based on historical evidence relating cigarettes sales and cigarette taxes.
As a consequence of a doubling in the cigarette tax:

• The number of cigarettes sold is predicted to drop by 20%.

• The number of lung cancer deaths is predicted to fall by 10%.
• The tax revenue from cigarette sales is predicted to rise by 60%.

These factual predictions are estimates of what will happen as a result of a doubling of the
cigarette tax. These estimates – based on the historical relationship between cigarette taxes and
cigarette smoking – do not rely on any value judgments. None of these bullets judge the
desirability of these consequences. Finally, these estimates can be checked with data after the
tax has been changed.

Margin Definition of Positive economics: value-free descriptions or predictions about the world
that can be verified with data.

Prescriptive analysis: Prescribing what an individual should do

Prescriptive economics is the part of economics that advises people on their decisions.
Prescriptive economics is almost always value-dependent, though economists try very hard not
to inject their own values into prescriptive analysis. So whose value judgments do we try to
use? Economists tend to believe that the person being advised should take the lead role – many
economists would say the only role – in determining the value judgments or preferences to be
used.
Honoring and respecting the consumer’s preferences is referred to as the concept of
consumer sovereignty. In other words, economists make the consumer “all-powerful” in
determining what preferences/values to use. “How much do you like smoking?” “How painful
would it be for you to quit?” “How much do you care about adverse health consequences that
may occur decades in the future?” Then economists put all of the consumer’s preferences into
the economic calculations.
A typical economist might therefore give prescriptive advice like this to a smoker:

The indirect cost associated with the reduction in your lifespan is quite large. The life-
shortening effect of smoking just one pack of cigarettes is equivalent in value to $222,
though this depends on how you weigh the cost of dying earlier than you otherwise
 might. Does your pleasure from smoking a pack of cigarettes offset the indirect cost of
$222 per pack?

Notice that the economist does not tell the smoker what preferences to have. Instead, the
economist encourages the consumer to use her own preferences to weigh the tradeoffs. It is
legitimate in the mind of an economist for the consumer to answer: “Yes, smoking a pack is
worth it to me, even though I am paying an indirect cost of $222.” Another legitimate answer
might be, “I don’t care about illnesses that will affect me decades from now, so the estimated
cost of $222 does not apply to me.”
Now that’s an eye-popping cost: $222 per pack. By the end of this course, you will
understand how economists make calculations like this. Such calculations combine both positive
analysis –for instance, using data to measure the long-run health effect of smoking – and some
value judgments about how to weigh illnesses that happen in the distant future. In Chapter 11
we’ll look at this calculation in more detail and show you exactly what the value judgments are.
You can then decide whether you agree with them. We’ll also show you how to make your own
value judgments to implement these kinds of calculations. You do not need to accept
economists’ value judgments in order to use economic reasoning to generate prescriptive
advice. Indeed, economists strongly encourage you to use your own value judgments when
making prescriptive calculations for yourself.

Margin definition of prescriptive economics: analysis that prescribes what an individual

should do, in which the analysis relies on the consumer’s own preferences and values.

Normative analysis: Prescribing what society should do

Consider the following economic statements:

Positive statement: If the tax on cigarettes is doubled, the number of lung cancer deaths will
fall by 10%.

Normative statement: The government should raise the tax on cigarettes.

The first statement is positive because it is based on data (actual facts) – in this case, similar tax
changes in the past. The second statement is normative because it is based on both positive
economic analysis and some additional value judgments.
For instance, here’s one value judgment that could be used to justify taxes on cigarettes:
“The government should tax smokers if this will lead to a substantial reduction in the second-
hand smoke inhaled by nonsmokers.” Arguing that smokers should be taxed to benefit non-
smokers is a value judgment, an expression of preference. It is a statement of what should
occur.
Whenever a value judgment is required in a decision that affects society, economists describe
the analysis as normative. Normative economics is value-dependent analysis that prescribes
what society should do.

Margin definition of normative economics: value-dependent analysis that prescribes what

society should do.

An economist must make value judgments whenever she evaluates policies that make one
group worse off so another group can be made better off. Value judgments are therefore
unavoidable when economists think about government policies, since there are very few policies
that make everyone better off. For instance, one person’s migratory bird sanctuary is another
person’s mosquito-infested swamp. Protecting a wetland with environmental regulations
benefits some people –bird watchers -- and harms others. Most government policies have
winners and losers. Deciding whether the costs experienced by the losers are justified by the
benefits experienced by the winners is a value judgment. Is it ethical to create regulations that
prevent a landowner from draining a swamp so he can build a parking lot? What if those
environmental regulations will protect migratory birds that people like to watch? Are there
other solutions to this seemingly intractable problem? Should the government perhaps try to
buy the land from the landowner? And if this is the government’s policy, how should we fairly
determine the price that the government will pay?
When economists give advice about what society should do, they can no longer rely
exclusively on the concept of consumer sovereignty. Think a bit more about the wetland
example. One sovereign consumer – the landowner -- wants to pave the wetland over and sell it
for a very high price. Other sovereign consumers –bird watchers – want to keep the
environment unchanged or buy the property at a low price from the landowner. Whose desires
should prevail? In cases like this, the principle of consumer sovereignty alone does not yield an
answer. We need additional value judgments to decide.
Sovereign consumers have divergent views on the future of this lake. The owner of the
property wants to build a parking lot. The environmentalist wants to preserve the wetland to
protect the whooping crane, an endangered species. Who should decide?

When an economist makes a policy recommendation, ask yourself what value judgment lies
behind the economic analysis and whether you agree with the value judgment. Nobody has a
monopoly on ethical judgments, and you are under no obligation to adopt economists’ value
judgments. You should draw a distinction, though, between subjective value judgments and
objective economic calculations that use those value judgments to derive a policy
recommendation.
 If you want to know, “Should people prevent other species from going extinct?” then you
may need more than an economics course. However, if you want to know how to design
government policies that efficiently stop extinctions, then economics is for you. Once you give
economists a value judgment – “it’s important to prevent whooping cranes from going extinct”
– then economists can get to work. We can design the economic policy that most efficiently
achieves that goal.
Determining what a society should value is the job of an informed citizenry – the voters.
Economists can contribute to the analysis of values, but economists do not have and should not
have the final word. Translating society’s value judgments into cost-effective public policies is
where economists take the leading role. Throughout this book, we will keep reminding you
when we are making economic recommendations that rely on value judgments. We will try to
acknowledge those value judgments and point out when they are controversial.

Microeconomics and Macroeconomics

There is one other distinction that you need to know in order to understand the scope of
economics. Economics can be divided into two broad fields of study, though many economists
do a bit of both. Microeconomics is the study of how individuals, households, firms, and
governments make choices, and how those choices affect prices, the allocation of resources, and
the well-being of other agents. For example, microeconomists study how Google prices its
services. Specifically, Google gives away searches for free but earns money by selling
advertisements. Google’s business model affects other firms. If any other firm decided to
charge for searches, it would not be able to attract many customers because Google’s free
searches are a better deal.
Macroeconomics is the study of economic aggregates and the economy as a whole.
Economic aggregates are economy-wide phenomena, like the growth rate of a country’s
economic output, or the percentage increase in prices (the inflation rate), or the fraction of the
labor force that is looking for work but cannot find a job (the unemployment rate).
Macroeconomists design government policies that improve aggregate economic performance.
For example, macroeconomists try to identify the best policies for stimulating an economy that
is experiencing slow growth (an economy in recession). However, macroeconomists are also
interested in the effects of bad policies, since they recognize that governments will sometimes
pick the wrong course of action. Macroeconomists want to be able to forecast what will happen
in the economy, taking into account both good and bad government policies.

Margin Definition: Microeconomics is the study of how individuals, households, firms, and
governments make choices, and how those choices affect prices, the allocation of resources, and
the well-being of other agents.

Margin Definition: Macroeconomics is the study of economic aggregates and the economy as a
whole.

THREE PRINCIPLES OF ECONOMICS

You now have a sense of what economics is about. But you might be wondering what
distinguishes it from the other social sciences: anthropology, political science, psychology, and
sociology. All of the social sciences study human behavior, so what sets economics apart?
 Economists emphasize three key concepts. We introduce them now, and examine the first
two in some detail for the remainder of this chapter. We will then study the third principle in
Chapter 2.

1. Optimization: We have explained economics as the study of people’s choices. The study of
all human choices may initially seem like an impossibly huge topic. And at first glance,
choosing a double-bacon cheeseburger at McDonalds does not appear to have much in common
with the decision to build a $500 million laptop factory in China. Economists have identified
some powerful concepts that unify the enormous range of human choices. One such insight is
that all choices are tied together by optimization: people decide what to do by consciously or
unconsciously weighing the pros and cons of the different available options. In other words,
people make choices that are motivated by calculations of benefits and costs. Economists do not
believe that people blindly follow the herd (or the advice of their parents or friends).
Optimization is the first principle of economics. Economists believe that optimization
explains all of our choices, including minor decisions like accepting an invitation to see a
movie, and major decisions like deciding to marry or to drop out of college.
2. Equilibrium: The second principle of economics holds that economic systems tend
toward equilibrium, a state in which no agent would benefit by changing his or her own
behavior. The economic system is in equilibrium when each agent feels that he or she cannot do
any better by picking another course of action.
3. Empiricism and Causality: Economists test their ideas with empirical analysis – in
other words, economists use data to test their theories. Economists are particularly interested in
understanding what is causing things to happen in the world. We can illustrate what causation
is and is not via a trivial example. Hot days and crowded beaches tend to occur at the same time
of the year. What is the cause and what is the effect here? It is, of course, that hot days cause
people to go swimming. It is not that swimming causes the outside air temperature to rise. We’ll
come back to the concept of causality in much more detail in Chapter 2. Sometimes causes are
easy to determine but sometimes identifying the causal mechanism requires great ingenuity.

THE FIRST PRINCIPLE OF ECONOMICS: OPTIMIZATION

Let’s now consider our first principle in more detail. Economics is the study of choices, and
economists have a theory about how choices are made. Economists believe that people (and
other economic agents) optimize, meaning that agents always try to choose the best feasible
option. Feasible options are those that are available and affordable to an economic agent. If
you have $10 in your wallet (and no credit/debit/ATM cards), then a $5 Big Mac is a feasible
lunch option, while a $50 filet mignon is not.
The concept of feasibility goes beyond the financial budget of the agent. There are many
different constraints that determine what is feasible. For instance, it is not feasible to work more
than 24 hours in a day. It is not feasible to attend meetings (in-person) in New York and Beijing
at the same time.
We have devoted much of this book to the analysis of optimization. We will explain how to
optimize, and we will make clear why economists believe that a great deal of human behavior
looks like optimization. We will also discuss the important cases where behavior deviates from
optimization. In the cases where agents fail to optimize, prescriptive economic analysis can
help them realize their mistake and make better choices in the future.

Margin Definition of Optimization: trying to choose the best feasible option.

Optimization Toolbox: Tradeoffs and Budget Constraints

To understand optimization, you need to understand tradeoffs. Tradeoffs arise whenever

resources are scarce so that some benefits must be given up in order to gain others. In other
words, a tradeoff occurs when you give one thing up to get something else. Using a scarce
resource for one purpose makes the resource unavailable for other purposes. Think about
Facebook. If you spend an hour on Facebook, then you cannot spend that hour doing other
things. For example, you cannot work at most part-time jobs at the same time you are editing
your Facebook profile.

Margin Definition of Tradeoff: An economic agent faces a tradeoff when resources are scarce
and the agent needs to give up one thing to get something else.

Margin Definition of Budget Constraint: an equation representing the goods or activities that a
consumer can choose given her limited budget of resources.

Economists summarize tradeoffs with budget constraints. A budget constraint is pretty

much what it sounds like; it is the set of things that a person can choose to do (or buy) without
breaking her budget. Here’s an illustrative example.

Suppose that you can do only one of two activities with your free time: work at a part-time job
or surf the Web. Suppose that you have five free hours in a day (once we take away necessities
like sleeping, eating, bathing, attending college classes, doing problem sets, studying for exams,
etc…). Think of these five free hours as your budget of free time. Then your budget constraint
will be:

5 hours = hours surfing the web + hours working at part-time job

To make this look more like an equation and less like a sentence, let’s adopt the following
mathematical shorthand, which economists call mathematical notation. Let

hsurf = hours surging the web

hwork = hours working at part-time job

So, the budget constraint can be written like this:

5 hours = hsurf + h work (1.1)

Equation 1.1 implies that the person faces a tradeoff. For each extra hour that they spend surfing
the web, they need to spend one less hour working at their part-time job, and vice versa. More
of one activity implies less of the other.
Budget constraints are useful economic tools because they quantitatively clarify the relevant
tradeoffs that an economic agent faces. When economists talk about the choice that an economic
agent faces, the economist first specifies the budget constraint. In almost all of the cases that we
study in this course, the budget constraint will look a lot like Equation 1.1. We will put the total
resources on the left-hand-side of the equation. We will divide the resources across two or more
activities on the right-hand-side of the equation.
You have just learned an important economic tool: the budget constraint. Throughout this
book, every time we teach you a new tool that is helpful for optimization we will highlight that
tool by putting the words “Optimization Toolbox” in the title of the subsection. You can think
of this growing lineup of concepts as a collection of workable tools that will help you solve all
kinds of economic problems.
Optimization Toolbox: Opportunity Cost
We are now ready to introduce another critical tool in the optimization toolbox: opportunity
cost. Our surfing example provides a perfect illustration of the concept. The time that we spend
on the Web is time that we could have spent in some other way: playing tennis, jogging,
daydreaming, sleeping, calling a friend on the phone, catching up on email, working on a
problem set, working at a part-time job, etc. You implicitly sacrifice time on these alternative
activities when you spend time surfing the Web. Try generating your own list of alternative
activities that are squeezed out when you surf the Web. Think about the best alternative to
surfing, and put that at the top; then work down from there. Your list illustrates the concept of
opportunity cost; you can either spend the time surfing the Web or on some other activity. You
can’t have both.
Evaluating trade-offs like this can be difficult because so many options are under
consideration. However, only one activity really matters to an optimizer: the best alternative
activity. Economists refer to this best alternative activity as the opportunity cost. This is what
an optimizer is effectively giving up when she surfs the web.

Margin definition: opportunity cost is the best alternative use of a resource

The importance of opportunity cost is clear once we remember that resources like time are
limited. Whenever we do one thing, something else gets squeezed out. When you surf the web
for an hour, some other activity is reduced by an hour even if you don’t realize it. You can’t be
executing a volley on the tennis court and posting your latest pics on Facebook at the same time.
Even if you postpone your tennis game to surf the Web, you still need to reschedule it at some
time. Something’s gotta give! (Studying for the economics final?) Optimization requires that
you take account of the opportunity cost of whatever you are doing. In essence, an optimizer
never neglects to consider how else she could be using her limited resources, including her time.
Reading this description, you might object with an argument like this: “I only surf the Web
from midnight to 2 AM, and during that time there aren’t many other options.” However, there
are some options. You could answer email or work on problem sets during that time, thereby
freeing up time earlier in the day to devote to things like tennis and a part-time job. So when we
calculate opportunity cost, we take into account this kind of juggling.
Economists often try to put a monetary value on opportunity cost. Translating benefits and
costs into monetary units, like dollars, makes everything easier to analyze. One way to calculate
the money value of an hour is to analyze the consequences of taking a part-time job, or working
additional hours at the part-time job you already have.

Margin definition: The median is the midpoint in a group—in other words, half the group
members are less than the median and half are greater than the median.

Economists would then conclude that the opportunity cost of the time of a typical college
student is at least $10 per hour. Here’s why. A part-time job is in the list of alternatives to
surfing the Web. If the part-time job is at the top of the list, then it’s the best alternative, and the
wage from the part-time job is your opportunity cost of surfing the Web. The wage is what you
give up for each hour that you surf.
What if the part-time job is not at the top of the list, so it’s not the best alternative? Then the
best alternative is even more valuable than the part-time job, so the best alternative is worth
more than the wage you would get from the part-time job. In this case, your opportunity cost
exceeds the $10 part-time wage.
 Drawing the last two paragraphs together, you can see that your opportunity cost is either $10
per hour –the part-time wage—or a value that is even greater than that. So your opportunity
cost of time is at least $10 per hour. In general, the opportunity cost of your time is at least the
hourly wage that you can find in your local job market. In other words, every time you dedicate
an hour of your time to something, you are giving up something else that is worth at least the
wage you can get in the job market. We’ll consider the interesting and useful consequences of
this point later in the chapter.

What You Want versus What You Can Afford: Cost-Benefit Analysis

We are now ready to see how economists actually solve simple optimization problems. Such
calculations depend on the quantitative evaluation of different feasible alternatives. Economists
call this process cost-benefit analysis. Cost-benefit analysis is a calculation that adds up costs
and benefits using a common unit of measurement, like dollar values. It is used to identify the
alternative that has the greatest net benefit: benefits minus costs.

Margin definition: Cost-benefit analysis is a calculation that adds up costs and benefits using a
common unit of measurement, like dollar value.

To see these ideas in action, suppose that you and a friend are going to Miami Beach from
Boston for spring break. The only question is whether you should drive or fly. Your friend
argues that you should drive since splitting the cost of a rental car and gas “will only cost $200
each.” He tries to seal the deal by pointing out “that’s much better than a $300 plane ticket.”
To analyze this problem using cost-benefit analysis, you need to list all of the costs and
benefits of driving relative to the alternative of flying. You then need to translate those costs
and benefits into a common unit of measurement.
From a benefit perspective, driving saves you $100 -- the difference between $200 of driving
costs and $300 for a plane ticket. From a cost perspective, driving costs you an extra 40 hours
of time -- the difference between 50 hours of round-trip driving time and about 10 hours of
round-trip airport/flying time. Spending 40 extra hours traveling is a cost of driving.
But we still don’t know whether driving is a good idea or a bad idea, since we haven’t yet
expressed everything in common units. Suppose the opportunity cost of your time is $10 per
hour. This is the value of your time. Then the net benefit of driving relative to flying is

($100 cost saving) – (40 hours of additional travel time)!($10/hour) = $100 - $400 = -$300.

Hence, the net benefit of driving is overwhelmingly negative. An optimizer would choose to
fly.
Your decision about travel to Miami is a simple example of cost-benefit analysis. This book
will train you in making such calculations. We’ll use cost-benefit analysis to optimize in many
different situations – for instance, to explore questions like “Is it better to install solar panels on
your roof or to buy your electricity from the local power company?” Cost-benefit analysis is a
great tool for collapsing all sorts of things down to a net dollar benefit. If you are making
choices as to which house to buy, which job to take, or whether Medicare should pay for heart
transplants, cost-benefit analysis can help. Economists are not popular for making some of these
“cold-hearted” calculations, but it’s nonetheless useful to be able to quantitatively analyze
difficult decisions.
To an economist, cost-benefit analysis and optimization are the same thing. When you pick
the option with the greatest net benefits – benefits minus costs -- you are optimizing. So cost-
benefit analysis is useful for prescriptive and normative economic analysis. It enables an
economist to determine what an individual or a society should do. Cost-benefit analysis will
also yield many useful positive economic insights. In many cases, cost-benefit analysis will
correctly predict the choices that real consumers will make.
EVIDENCE-BASED ECONOMICS: THE OPPORTUNITY
COST OF WEB SURFING
Question: What is the opportunity cost of using Facebook?
Answer: $365 billion dollars per year.
Data: Wages from U.S. Census, and Facebook usage statistics from Facebook.
Method: Multiply total hours on Facebook by average opportunity cost of an hour.
Caveat: We can only crudely estimate the average opportunity cost of an hour for Facebook’s
300 million worldwide users.

We can now turn to the question we posed at the beginning of the chapter where we asked if
Facebook was really free. By now you know that the answer is “no” because there is an
opportunity cost involved. But how do you determine if using Facebook is worth it? To answer
that question, you need data. Whenever you see a section entitled “Evidence-Based
Economics” in this textbook, you’ll know that we are using real data to analyze an economic
question. !
When we discussed opportunity cost, we estimated the dollar value of your time. We have
pointed out that every hour of your time comes with an opportunity cost of at least $10. In other
words, an hour of one activity crowds out other activities that are estimated to be worth at least
$10. Using this information, we can estimate the total opportunity cost of time on Facebook.
In 2009, Web users worldwide spent 100 million hours on Facebook each day. On a per
person basis, each of the 300 million Facebook users allocates an average of 20 minutes to the
site per day. College students use Facebook more intensively. The average college student
spends an hour per day on Facebook.
Let’s assume that all of the time spent on Facebook has an opportunity cost of $10 per hour.
This is a rough estimate of the average opportunity cost of the worldwide users of Facebook. It
follows that the total opportunity cost of time spent on Facebook is

! 100 million hours " ! $10 " ! $1 billion "

# $# $=# $.
% day & % hour & % day &

That adds up to $365 billion per year. In other words, if people substituted their time on
Facebook for work paying $10 per hour, the world economy would have produced about $365
billion more output in 2009. To put that in perspective, the production of the entire economy of
Argentina is $330 billion per year.
We can also study the opportunity cost of an individual college student. Since each student
spends an average of one hour per day on Facebook, the average opportunity cost is $3,650 per
year. As before, this assumes a $10 opportunity cost of time.
So far, we have gone through a purely positive analysis, describing the frequency of
Facebook usage and the tradeoffs that this usage implies. None of this analysis, however,
answers the key question: Are Facebook and other social networking sites like MySpace worth
it? We’ve seen that the time spent on sites like these is costly since it has valuable alternative
uses. But perhaps we are also deriving substantial benefits that justify this significant allocation
of time. For example, social networking sites keep us up-to-date on the activities of our friends
and family. They facilitate the formation of new friendships and new connections. And, put
simply, the sites are entertaining. Although these benefits are hard to quantify, they are
certainly real and substantial in magnitude.
Because we cannot easily quantify these benefits, economists leave this to the sovereign
consumer to decide for herself. Economists won’t tell you what to do, but they will help you
highlight the tradeoffs that you are making in your decision. Here is how an economist might
prescriptively analyze social networking sites:
 Given a $10 per hour opportunity cost, the total opportunity cost of using social
networking websites for an hour a day adds up to about $3,650 per year. That much
money can buy you a lot of useful things. For instance, a flight from New York to Paris
costs less than $1,000. A flight from New York to Honolulu costs less than $500. A
half-carat diamond engagement ring costs about $3,000. Given the $3,650 opportunity
cost of using Facebook, MySpace, Twitter, Tagged, and LiveJournal, do you feel that
you are receiving benefits that exceed this implicit cost?

Economists don’t want to impose their tastes on other people. In the view of an economist,
people who get big benefits from intensive use of Facebook should stick with Facebook, despite
the opportunity cost. Economists only want people to recognize the implicit tradeoffs that are
being made, and are interested in helping people make the best use of their scarce resources like
money and time. In most circumstances, people are already putting their resources to best use.
Occasionally, however, economic reasoning can help people better appreciate the tradeoffs that
are being made.

THE SECOND PRINCIPLE OF ECONOMICS:

EQUILIBRIUM
In most economic situations, you aren’t the only one trying to optimize. Other people’s
behavior will influence what you decide to do. Economists think of the world as a group of
economic agents who are interacting and influencing one another’s efforts at optimization.
Equilibrium is the special situation in which everyone is optimizing, so nobody would benefit
by changing his or her own behavior.

Margin Definition: Equilibrium is a situation in which nobody would benefit by changing his or
her own behavior.

An important clarification needs to accompany the definition of equilibrium. When we say

that nobody would benefit by changing his or her own behavior, we mean that nobody believes
they would benefit from such a change. In equilibrium, all economic agents are making their
best feasible choices taking into account all of the information they have, including their beliefs
about the behavior of others. We could rewrite the definition by saying that in equilibrium,
nobody perceives a benefit from changing his or her own behavior.

To build intuition for the concept of equilibrium, consider the length of the checkout lines at
your local supermarket (ignoring the express lines). If any line has a shorter wait than the
others, optimizers will choose that line. If any line has a longer wait than the others, optimizers
will avoid that line. So the short lines will attract shoppers, and the long lines will drive them
away. As a result, all lines will end up having roughly the same wait time. Economists say that
“in equilibrium,” all of the check-out lines will have roughly the same length. When the lines
are the same, no shopper has an incentive to switch lines.

In this book, we’ll often study how groups of economic agents behave. A group could
be two chess players, or 30 participants in an eBay auction, or millions of investors buying and
selling shares on the New York Stock Exchange, or billions of consumers buying oil to heat
their homes and drive their cars. In all these cases, we will study the equilibrium of the market
or game (more about games shortly). In other words, we’ll study these environments using the
assumption that everyone is simultaneously optimizing. Economists believe that this
equilibrium analysis provides a very good description of what actually happens when groups of
people interact.
How Would You Decide? The Difficulty of Achieving Cooperation

To understand various economic concepts, it helps to study a structured environment, or game,

in which multiple economic agents are involved. Economists use the word “game” to
emphasize that two or more economic agents are participating in a structured environment and
that their individual decisions affect the payoffs of the other participants. In situations like this,
the participating economic agents are called “players.”

Margin definition: In a game, two or more economic agents are participating and their
individual decisions affect the payoffs of the other participants.

To understand the concept of equilibrium, let’s consider a famous game – often called the
Public Goods Game -- that illustrates how difficult it is to achieve cooperation. In one version
of the game, there are six players. Each player is initially given $3. Economists call this seed
money the endowment of each player.

Margin definition: The endowments in an economic game are the resources that each player is
given at the start of the game.

Rules of the Game

Each player has one of two options. She can either contribute her $3 endowment to a
common pool of resources – we’ll call this the commons -- or she can keep her $3 endowment
for herself. Whatever money is contributed to the commons is doubled, and then shared evenly
with all six players. The commons serves the public good, but players are not required to
contribute to it.
We can express each player’s payoff as an equation. If the player gives up her $3
endowment by contributing to the commons, her payoff is:

2 ! ( total contributions to commons) 2 ! ($3 + other's contributions to commons)

=
6 6

In this scenario, her payoff is 1/6th of the (doubled) amount in the commons. She gets 1/6th since
there are six players in the game and each player gets an equal share of the doubled amount in
the commons, whether or not they contributed to it.
If the player instead holds onto her endowment, then her contribution to the commons is $0,
and her total payoff is:

2 ! ( total contributions to commons) 2 ! ($0 + other's contributions to commons)

$3 + = $3 +
6 6

In this scenario, her payoff is $3 -- since she held onto her endowment -- plus 1/6th of the
doubled amount contributed to the commons (by the other players). She gets 1/6th of the doubled
amount in the commons even though she did not contribute to it.
In the exercises at the end of this chapter, we ask you to use algebra to show that the player
always makes more money if she does not contribute to the commons.

Two Illustrative Scenarios

 Let’s consider two scenarios to illustrate the depressing logic of this game.

1. Suppose that all six players give their $3 endowment to the commons. Then the
contributions to the commons are 6 ! $3 = $18, which doubles to $36. When this is shared
with everyone, each of the six players receives $6, double the starting endowment of $3.

2. Consider a second scenario. Suppose that the other five players give their $3 endowment to
the common pool, but you don’t. Then the contributions to the commons are 5 ! $3 = $15,
which doubles to $30. When this is shared with everyone, each of the players, including
you, receives $5 from the commons. But you also get to keep your original endowment of
$3, since you did not put this in the commons. So your total payoff is $5 + $3 = $8.

"#$%&%'!()*+!,-.!%//01'23'%45!165732%.1!8.2!'$5!90&/%6!:..;1!:3<5!

!! ,-.!165732%.1! =3>.88!'.!>.0! =3>.88!'.!'$5!.'$52!8%45!9/3>521!

"#!!!!
$%&'()*&!+)*,'-./,&0!,)!,1&!2/.3-+!4))5! 67!! 67!! 67!! 67!! 67!! 67!!
8#!!!
$%&'()*&!./,!()/!+)*,'-./,&0!,)!,1&!2/.3-+!4))5! 69!! 6:!! 6:!! 6:!! 6:!! 6:!!

The first scenario in Exhibit 1.2 generates the best possible payoff for the group of six
players: $6 for every player. But scenario two shows that you will raise your own payoff if you
do not contribute to the public good. With that in mind, would you contribute to the commons
if you were actually playing this game? Think about this for a moment before continuing. What
would you do? What would you expect the other players to do?

Actual Results

What happens when games like this are actually played by real experimental subjects? Do
players hold on to their endowment? Or do they give it to the commons? The answer is a little
bit of both.
The first time the game is played, most players contribute to the commons. But as the game
is repeatedly played and the players learn what other players are likely to do, cooperation fades.
Almost all players eventually stop cooperating. Universal non-cooperation turns out to be the
only situation in which no player can benefit by changing his or her behavior – the equilibrium.
Specifically, Exhibit 1.3 shows that if no one is contributing to the commons, then changing
your behavior by contributing would (i) reduce your own financial payoff, and (ii) raise the
financial payoff of the other players who aren’t contributing themselves! So if nobody else is
contributing, you don’t want to contribute either.

"#$%&%'!()?+!@.25!%//01'23'%45!165732%.1!8.2!'$5!90&/%6!:..;1!:3<5!

!! ,-.!<.25!165732%.1! =3>.88!'.!>.0! =3>.88!'.!'$5!.'$52!8%45!9/3>521!

;#!!<).)5(!+)*,'-./,&0!,)!,1&!2/.3-+!4))5! 6;!! 6;!! 6;!! 6;!! 6;!! 6;!!
 =#!!>*3(!()/!+)*,'-./,&!,)!,1&!2/.3-+!4))5! 6"!! 6=!! 6=!! 6=!! 6=!! 6=!!

All of this is bad news for society. We just said that in equilibrium everyone ends up
contributing nothing, so each group member walks off with only $3. If the group had instead
behaved cooperatively, everyone would have earned $6. The failure to cooperate illustrates the
general fact that personal optimization does not always lead to the social good. This societal
problem is referred to as the “tragedy of the commons.” Social scientists use this name to refer
to any situation in which agents pursuing their private benefits reach an equilibrium that is bad
for society in general. It is a “tragedy” in the sense that in pursuing their own ends, individuals
hurt the group as a whole and ultimately themselves.

The Free Rider Problem

Let’s use the public goods game to analyze an economic environment that may be of some
personal interest: your dorm room. To highlight the parallels, assume that six roommates live in
a dorm apartment. Suppose that each of these roommates has an endowment of free time. The
roommates can spend some of their free time contributing to the public good by throwing away
used pizza boxes and soda cans, and otherwise cleaning the apartment. Or they can spend all
their free time on activities that only benefit themselves – for instance, watching YouTube
videos or listening to Pandora.
The roommates face their own “tragedy of the commons.” It would be beneficial to the
group if they all chipped in and did a little cleaning. But each roommate has an incentive to
leave that to others. An individual roommate enjoys the full benefits from watching a YouTube
video or listening to customized music from Pandora, but only one-sixth of the benefit from
cleaning the apartment. Because of these incentives, the roommates may contribute too little to
the public good. In other words, dormitory apartments with lots of roommates are often a mess.
The situation gets more interesting if one of the roommates starts cleaning things up.
Unfortunately, these efforts might not have much effect on the other roommates. As the
apartment starts looking better, the other roommates might be encouraged to do even less
cleaning than before. After all, the need for their individual cleaning efforts has gone down.
Lazy roommates are an example of the free rider problem. Most people want to let someone
else do the dirty work. We would all like to be the free riders who don’t contribute but still
benefit from the investments that others make.
Sometimes free riders get away with it. When there are very few free riders and lots of
contributors, the free riders might be overlooked. For example, a small number of people sneak
onto public transportation without paying. These turnstile jumpers are such a small group that
they don’t jeopardize the subway system. But if everyone started jumping turnstiles, the
subway would soon run out of cash.
In the subway system, free riding is discouraged by police patrols. In rooming groups, free
riding is discouraged by social pressure. Even with these “punishment” techniques, free riding
is frequently a problem because it’s not easy to catch the free rider in the act. It’s easy to slip
over a turnstile in a quiet subway station. It’s easy to leave cookie crumbs on the couch when
nobody is watching.
People’s private benefits are often out of sync with the public interest. Jumping the subway
turnstile is cheaper than paying for a subway ticket. Watching YouTube is more fun than
sweeping up the remains of last night’s party. Equilibrium analysis helps us predict the
behavior of groups of people and understand why free-riding occurs.
Equilibrium analysis also helps us design special institutions – like financial contracts -- that
eliminate free-riding, making the commons less tragic. For example, what would happen in the
six-person rooming group if everyone agreed to pay $5 per week so the roommates could hire a
cleaning service? It would be easier to enforce $5 weekly payments than to monitor compliance
with the rule “clean up after yourself, even when nobody is here to watch you.” Empty bottles
don’t have name tags. In chapter 9, we’ll discuss contracts and other institutions that enable
groups to resolve the problem of free riding.

A free rider in the New York subway system. Are you paying for him to ride the
subway?

IS ECONOMICS GOOD FOR YOU?

Is taking this course good for you? Let’s start by thinking about the costs. Though
opportunity costs are often hidden, they are usually important. The key opportunity cost of this
course is another course that you won’t be able to take during the time spent as a student. What
other course did economics crowd out? Japanese history? Biochemistry? Russian poetry? If
you are taking the two-semester version of this course, then you need to think of two other
courses that economics is crowding out.
Now consider the benefits of an economics education. The benefits come in a few different
forms, but the biggest benefit is the ability to apply economic reasoning in your daily life.
Whether you are deciding how much to spend on a date, where to go on vacation, or how to
keep an apartment with six roommates clean, economic reasoning will improve the quality of
your decisions. These benefits will continue throughout your life as you make more complex
decisions such as where to invest your retirement savings and how to secure the best mortgage.
Most good business decisions are guided by the logic of economic costs and benefits. We want
you to use economic principles to make all of your choices optimal. This is prescriptive
economics. Learning how to make good choices is the biggest benefit you’ll realize from
learning economics. That’s why we have built our book around the concept of decision-making.
We also think that economics is a lot of fun. Understanding people’s motivations is a blast,
particularly since there are many surprising insights along the way. Economic logic is a pair of
X-Ray glasses that enables you to see everything in a different, very interesting light.
To realize these payoffs, you’ll need to connect the ideas in this course to the economic
activities around you. To make those connections, keep a few tips in mind:

• You can apply economic tools such as tradeoffs and cost-benefit analysis to any economic
decision. Learn to use them in your own daily decisions. This will help you master the
tools and also appreciate their limitations.

• Even if you are not in the midst of making a decision, you will learn a lot of economics by
keeping your eyes open when you walk through any environment in which people are using
or exchanging resources. Think like an economist the next time you find yourself in a
supermarket, a used car dealership, a soccer match, or a poker game.

• The easiest way to encounter economic ideas is to keep up with what’s happening in the
world. Go online and read a national newspaper like The New York Times or The Wall
Street Journal. Newsmagazines will also do the job. There’s even a newsmagazine called
The Economist, which is required reading for prime ministers and presidents. Almost
every page of any newspaper or magazine describes events driven by economic factors.
Identifying and understanding these forces will be a challenge. But over time, you’ll find
that it gets very easy to find and interpret the economic story behind every headline.

Once you realize that you are constantly making economic choices, you’ll understand that
this course is only a first step. You’ll discover the most important applications outside class and
after the final exam. The tools of economics will improve your performance in all kinds of
situations -- making you a better businessperson, a better consumer, and a better citizen. Keep
your eyes open and remember that every choice is economics in action.