THIRD EDITION

ECONOMICS
and

MACROECONO
MICS
Paul Krugman | Robin
Wells

Chapter 1
First Principles

understanding how individuals

make choices

WHAT
YOU
WILL
LEARN
IN THIS
CHAPTER

A set of principles for

understanding how individual
choices interact
A set of principles for
understanding economy-wide
interactions
Because just like
anything, to
understand
economics you
have to start at the
beginning!!!

You

Individual Choice
Individual choice is the decision by an
individual of what to do, which necessarily
involves a decision of what not to do.
Basic principles behind the individual choices:
1. Resources are scarce.
2. The real cost of something is what you
must give up to get it.
3. How much? is a decision at the margin.
4. People usually take advantage of
opportunities to make themselves better
off.

Principle# 1: Scarcity
Choices Are Necessary Because Resources
Are Scarce
A resource is anything that can be used to
produce something else.
Examples: land, labor, capital

Resources are scarce the quantity available

isnt large enough to satisfy all productive uses.
Examples: petroleum, lumber, intelligence
Whats the scarcest resource of all?

TIME

Principle# 1: Scarcity
Choices Are Necessary Because Resources
Are Scarce
Scarcity requires us to make trade-offs (which
is a more nuanced way of saying choices).
In other words, you might be able to get more of
something, but only by giving up something else.

Scarcity is the foundational principle of

economics.
Every other concept in economics follows from
the concept of scarcity.
If resources were unlimited, economics would not
exist as a social science.
Prices would not exist, because everything would
be freely available to everyone.

Principle# 1: Scarcity
Scarcity and the Concept of a Malthusian
Bottleneck
Thomas Malthus: Essays on the Principle of
Population (1798)
Observed that plants and animals produce far
more offspring than can survive given the
available resources.
Humans are also capable of over-producing if left
unchecked.
Our ingenuity and compassion for each other also
seems to have superseded the ability of natural
selection to effectively control our population.
Malthus conclusion: unless population is
regulated, famine and poverty could become
globally epidemic, the human species could self-

Principle# 1: Scarcity
Scarcity and the Concept of a Malthusian
Bottleneck
Ecological economics is a relatively new
branch of economics that seeks to merge the
fundamentals of ecology with those of
economics.
The human economy is part of the natural world.
Given our current technological capabilities, the
Earth is an extremely scarce ecological resource
(its the only place in the universe we can live for
an extended period).

The natural environment provides an essential

service in terms of life support for all known
species, including us.

Principle# 1: Scarcity
Scarcity and the Concept of a Malthusian
Bottleneck
Ecological economists point out that there are
two ways an economy can grow:
Greater resource use
Technological advancement (using resources
more efficiently)

Resource scarcity fundamentally limits the

degree to which economic growth can be
achieved through increased resource use!
Exhaustible resources can/will be depleted
eventually.
Renewable resources can be overharvested to the
point of collapse/extinction.

Principle# 1: Scarcity
Example Question
Scarcity exists when:
a. making choices among two or more alternatives
is not necessary.
b. individuals can have more of any good without
giving up anything.
c. individuals can have more of one good but only
by giving up something else.
d. resources are unlimited.

Principle# 2: Opportunity Cost

The Real Cost of an Item Is Its Opportunity
Cost
The real cost of an item is its opportunity
cost: that is, what you must give up in order to
get it.
Opportunity cost is crucial to understanding
individual choices/trade-offs.
Example: The cost of attending an economics
class is what you must give up to be in the
classroom during the lecture.
What would you be doing if you werent in class
right now?

All costs are ultimately opportunity costs.

Principle# 2: Opportunity Cost

In fact, everybody thinks about opportunity cost.
The bumper stickers that say I would rather be
(fishing, golfing, swimming, etc) are
referring to opportunity cost.
It is all about what you have to forgo to obtain
your choice.

I WOULD RATHER BE SPENDING TIME WITH

MY FAMILY THAN EXPLAINING ECONOMICS
TO
YOU.
But I am willing to forgo some time spent with my family for
a job and the chance to earn income because the
opportunity cost of spending too much time with my family
and not doing my job is that I could lose my job!

Principle# 2: Opportunity Cost

A Womans Work

In 1900, only 6% of married

women in the U.S. worked for pay
outside the home.
By 2005, the number was about
60%.
This change is of course due in
part to changing cultural
attitudes.
But it also had to do with the
growing availability of home
appliances, especially washing
machines.
In pre-appliance days, the
opportunity cost of working
outside the home was very
high: it was something women
typically did only in the face of
dire financial necessity.
With modern appliances, the time

Principle# 2: Opportunity Cost

U.S. President Dwight D. Eisenhower gave us

perhaps the most poignant example of
opportunity cost ever stated:

Principle# 2: Opportunity Cost

Example Question #1
You have $1 to spend on a vending machine
snack. A bag of chips will cost you $1 and a
candy bar will also cost you $1. If you choose
the bag of chips, the opportunity cost of buying
the chips is:
a. $1.
b. the enjoyment you would have received from the
candy bar.
c. $1 plus the enjoyment you would have received
from the candy bar.
d. $2 minus the enjoyment you received from the
bag of chips.

Principle# 2: Opportunity Cost

Example Question #2
Margo spends $10,000 on one year's college
tuition. The opportunity cost of spending one
year in college for Margo is:
a. $10,000.
b. whatever she would have purchased with the
$10,000 instead.
c. whatever she would have earned had she not
been in college.
d. whatever she would have purchased with the
$10,000, plus whatever she would have earned
had she not been in college.

Principle# 2: Opportunity Cost

Class Discussion

Principle# 3: Marginal Decisions

How Much? Is a Decision at the Margin
You make a trade-off when you must give up
something in order to get something else.
In other words, you must compare the costs with
the benefits if you want to make the right
decision.

Making trade-offs at the margin: comparing

the costs and benefits of doing a little bit more
of an activity versus doing a little bit less.
If the marginal benefit exceeds the marginal
cost, you should do it (provided you are a rational
person).
If the marginal cost exceeds the marginal benefit,
you shouldnt.

Principle# 3: Marginal Decisions

So, decisions about whether to do a bit more or
a bit less of an activity are marginal
decisions.
Examples: Hiring one more worker, taking one
more class this semester, studying one more
hour, or eating one more burger
Each has a marginal cost and marginal benefit.

The study of such decisions is known as

marginal analysis.

Principle# 3: Marginal Decisions

CLASS DEMONSTRATION

Principle# 4: Incentives
People Usually Respond to Incentives,
Exploiting Opportunities to Make
Themselves Better Off
An incentive is anything that offers rewards to
people who change their behavior.
Examples:
1. Price of gasoline rises people buy more fuelefficient cars
2. There are more well-paid jobs available for college
graduates with economics degrees more
students major in economics
3. The Attendance Game gives you (both
individually and collectively) more incentive to
show up to class regularly.

Incentives are everywhere. People are generally

Principle# 4: Incentives
Incentives can be positive or negative (typically
called disincentives).
Socio-cultural incentives
Fame/celebrity
General social pressure
Incentives come in all forms:
Criminal punishment
What about letting

Economic incentives

alternative fuel vehicles

drive in HOV lanes?
Free parking at MARTA
stations?
Can you think of other
examples?

Sale prices
Taxes and subsidies
Monetary rewards, fines, or penalties
Cost reduction
Higher profits

Principle# 4: Incentives
Cashing In at School?
In a 20072008 study, Harvard economist
Roland Fryer Jr. found that monetary incentives
cash rewards could improve students
academic performance in schools in
economically disadvantaged areas.

Principle# 4: Incentives
Cashing In at School?
Fryer conducted his research in four different
school districts, employing a different set of
incentives and a different measure of
performance in each.
In New York, students were paid according to
their scores on standardized tests.
In Chicago, they were paid according to their
grades.
In Washington, D.C., they were paid
according to attendance and good behavior,
as well as their grades.
In Dallas, second-graders were paid each
time they read a book.

Principle# 4: Incentives
Cashing In at School?
Fryers experiment revealed some critical insights
about how to motivate behavior with incentives.
How incentives are designed is very
important:
the relationship between effort and outcome,
as well as the speed of reward, matters a lot.
The design of incentives may depend quite a
lot on the characteristics of the people you
are trying to motivate: what motivates a
student from an economically privileged
background may not motivate a student from
an economically disadvantaged one.

Principle# 4: Incentives
Boy or Girl? It Depends on the Cost
In 1978, the government of China introduced
the one-child policy to address the economic
and demographic challenges presented by
Chinas large population.
China was very, very poor in 1978, and its
leaders worried that the country could not afford
to adequately educate and care for its growing
population.
The average Chinese woman in the 1970s was
giving birth to more than five children during
her lifetime.

Principle# 4: Incentives
Boy or Girl? It Depends on the Cost
So the government restricted most couples,
particularly those in urban areas, to one child,
imposing penalties on those who defied the
mandate.
As a result, by 2009 the average number of births for a
woman in China was only 1.8.

The one-child policy had an especially

unfortunate unintended consequence.
Because China is an overwhelmingly rural country and
sons can perform the manual labor of farming, families
had a strong preference for sons over daughters.
In other words, it created a disincentive to have a
daughter.

Principle# 4: Incentives
Boy or Girl? It Depends on the Cost
In addition, tradition dictates that brides
become part of their husbands families and
that sons take care of their elderly parents.
As a result of the one-child policy, China soon
had too many unwanted girls.
Some were given up for adoption abroad, but all too
many simply disappeared during the first year of
life, the victims of neglect and mistreatment.

China has recently begun to relax its one-child

policy.
http://www.cnn.com/2015/10/29/asia/china-one-child-po
licy/

Principle# 4: Incentives
Example Question
Say the U.S. government implemented a carbon
tax on electricity generation. For each unit of
CO2 emitted, electric generators would have to
pay a tax. This would give electric generators an
incentive to:
a. do nothing. The tax would not incentivize any
changes.
b. switch to less carbon-intensive generation
technologies.
c. generate more electricity from fossil fuels.
d. argue that anthropogenic climate change isnt
real, call for the EPA to be abolished, and lament
that America is becoming a socialist country.

Interaction: How Economies Work

Interaction of choicesmy choices affect your
choices, and vice versais a feature of most
economic situations.
Principles that underlie the interaction of
individual choices:
5. There are gains from trade.
6. Markets move toward equilibrium.
7. Resources should be used as efficiently as
possible to achieve societys goals.
8. Markets *usually* lead to efficiency (except
when they dont, which is most of the time).
9. When markets dont achieve efficiency,
government intervention can improve societys
welfare.

Principle# 5: Gains from Trade

There Are Gains From Trade
In a market economy, individuals engage in
trade.
They provide goods and services to others and receive
goods and services in return.
NOTE: Here we have left out the role of money in
facilitating trade in modern market economies, but we
will come back to that later.

There are gains from trade.

People can get more of what they want through trade
than they could if they tried to be self-sufficient.
Think about all the things you consume in a given
day now think about if you had to make all of it
yourself.
Theres no way you could do it.

Principle# 5: Gains from Trade

The New Yorker Collection 1991

Ed Frascino from cartoonbank.com.
All Rights Reserved.

This increase in output is due to specialization:

each person specializes in the task that he or she
is good at performing.

I hunt and she gathers otherwise we couldnt make

ends meet.

The economy, as a whole, can produce more

when each person specializes in a task and trades
with others.

Principle# 5: Gains from Trade

Discussion Question
Were going to talk about this topic a lot more in
the next few weeks, but heres a quick exercise
to help us start thinking about it.

Principle# 6: Equilibrium
Markets Move Toward Equilibrium
An economic situation is in equilibrium when
no individual would be better off doing
something different.
Any time there is a change, the economy will
move to a new equilibrium.
Example: What happens when a new checkout
line opens at a busy supermarket?
Or are you too busy checking out the tabloids to
notice?

Principle# 6: Equilibrium
Choosing Sides
Why do people in America drive on the right side
of the road? Of course, its the law.
Long before it was the law, it was an equilibrium!
Why?

Principle# 6: Equilibrium
Choosing Sides
Why would some places choose the right and
other places choose the left?
Thats not completely clear, although it may have
depended on the dominant form of traffic.
Men riding horses and carrying swords on their left
hip preferred to ride on the left (think about getting
on or off the horse, and youll see why).
On the other hand, right-handed people walking
but leading horses apparently preferred to walk on
the right.

Principle# 6: Equilibrium
Choosing Sides
Once a rule of the road was established, there
were strong incentives for each individual to stay
on the usual side of the road.
Those who didnt would keep colliding with
oncoming traffic.

So, once established, the rule of the road would

be self-enforcingthat is, it would be an
equilibrium.

Principle# 6: Equilibrium
Discussion Question

Principle #7: Efficiency

Resources Should Be Used As Efficiently As
Possible to Achieve Societys Goals
An economy is efficient if all opportunities to
make some people better off without making
other people worse off have been exhausted.
In other words, when all gains from trade have
been exhausted.
By definition, an economic equilibrium is efficient
(provided certain conditions are met well get to
that later).

Think about example (c) from the previous slide.

Why is the initial situation inefficient?
Why is the equilibrium outcome efficient?

Principle #7: Efficiency

Discussion Question

Digression: Efficiency vs. Equity

Should economic policy makers always strive to achieve

economic efficiency?

Equity means that everyone gets his or her fair share.

Equity and efficiency are not always compatiblethat is,
what is equitable is not necessarily efficient, and vice versa.
Moreover, since people can disagree about whats fair, in
economics equity isnt as well-defined a concept as
efficiency.
Many (if not most) political issues can be boiled down to the
conflict between equity and efficiency.

Economics as a whole is generally more concerned with

efficiency than equity, because:
Conceptually, efficiency fits neatly into the mathematical
paradigm we have constructed for ourselves.
Equity invokes a more emotional, altruistic component of
human nature that economists are not typically comfortable
with we would rather brush it aside as irrational behavior.
But is it?

Digression: Efficiency vs. Equity

How far should policy makers go in promoting
efficiency over equity?
Example #1: Handicapped-designated parking
spaces in a busy parking lot
A conflict between:
Equity: making life fairer for handicapped
people, and
Efficiency: ensuring all opportunities to make
people better off have been fully exploited by
never letting parking spaces go unused.

Digression: Efficiency vs. Equity

How far should policy makers go in promoting
efficiency over equity?
Example #2: The Social Security System
A conflict between:
Equity: making life fairer for the elderly who
are unable to work to support themselves, and
Efficiency: not withholding Social Security taxes
from working peoples paychecks and letting
them allocate their income in whatever way they
find most beneficial.

Digression: Efficiency vs. Equity

How far should policy makers go in promoting
efficiency over equity?
Example #2: The Social Security System
But the Social Security System is extremely
effective at lifting the elderly out of poverty.
According to a 1999 study by the Center on Budget
and Policy Priorities, in 1997 the poverty rate among
the elderly was 11.6%.
By contrast, the study concluded, without Social
Security nearly half (47.6%) the U.S. population age 65
or older would have lived below the poverty line in
1997.
You would have to be pretty heartless to prefer the
latter to the former just so working-age people can
keep a few extra dollars per paycheck, despite it being

Principle #8: Markets are

Efficient But

Every individual neither intends to promote the

public interest, nor knows how much he is
promoting it he intends only his own security;
and by directing that industry in such a manner as
its produce may be of the greatest value, he
intends only his own gain, and he is in this, as in
many other cases, led by an invisible hand to
promote an end which was no part of his
intention. Adam Smith, The Wealth of Nations
(1776), Book IV, Chapter II

Principle #8: Markets are

Efficient But

Markets *Usually* Lead to Efficiency

In an economists perfect world, the
incentives built into a market economy
already ensure that resources are put to their
most efficient use.
Opportunities to make people better off are never
wasted.

This is the essence of Adam Smiths famous

theory of the invisible hand and the
foundational principle of modern free-market
capitalism.
Coincidentally, Smith only used the term invisible
hand
twice
in thewhat?
entire book,
that isisthe
phrase
But
guess
Thebut
world
not
that will always and forever be attributed to the idea.

perfect! (duh)

Principle #8: Markets are

Efficient But

According to the First Theorem of Welfare

Economics, markets are efficient if (and only
if):
There is perfect competition.
Property rights are well-defined.
Consumers and producers all display perfectly
rational behavior (that is, they maximize benefits
and minimize costs).
There are no information asymmetries.
There are no transactions costs.
These are the conditions that define the
There arefree-market
no externalities.
economists perfect world.

That is a VERY restrictive set of conditions!

Almost no market actually exists that meets all of
them.
The implication is that in real life markets are not

Principle #8: Markets are

Efficient But

A market failure occurs when one or more of

the conditions listed on the previous slide is not
met.
Result: the equilibrium market outcome is
inefficient.

One type of market failure is that which occurs

due to market power, the most extreme case
being monopoly.
A monopolist reduces production and charges higher
prices compared to the efficient market quantity and
price.
Although the market is in equilibrium, the monopoly
equilibrium is not economically efficient in the sense
that the net benefit to society is not maximized.
A monopolist can prevent mutually beneficial trades
from occurring so as to capture a greater share of

Principle #8: Markets are

Efficient But

A second type of market failure occurs when the

good is public in nature.
For example, the interstate highway system, national
defense, public primary education, or the national
parks system.

As explained in the attendance game, public

goods have two key characteristics.
1. No one can be excluded from benefitting from
them.
2. One person consuming the public good does not
reduce the amount available to others.

These characteristics violate the condition that

property rights must be well-defined.
. No private entity owns the interstate highway system

Principle #8: Markets are

Efficient But

A third type of market failure occurs when

consumers or producers do not behave
rationally.
Humans are not robots with computers for brains.
We make mistakes and miscalculations.
We make choices that run counter to our own selfinterest.
We are generally myopic.*
We act on our emotions.

When people dont behave rationally, market

efficiency is undermined.
A relatively new branch of economics called
behavioral economics is devoted to the study of
irrational behavior and its implications for economic
decision making.

Principle #8: Markets are

Efficient But

A fourth type of market failure occurs when the

parties to a transaction have asymmetric
information.
That means one party knows something about the
good or service that the other party does not know.

Economists have identified two broad categories

of information asymmetry:
Moral hazard when one party cannot perfectly
monitor the others actions (think of a employeremployee relationship, for example).
Adverse selection when one party cannot know the
other partys type, the latter may present false
information about its type (this is the classic Lemons
problem).

A third kind would be outright criminal fraud,

Principle #8: Markets are

Efficient But

The
Lemons Problem

First explained in a seminal 1970 paper by

economist George Akerlof.
Imagine the market for used cars (before
CarFax).
Buyers cannot distinguish between a high quality used
car (a peach) and a low quality one (a lemon).
They are only willing to pay the price , which is the
average of the prices for a peach () and a lemon () that
would occur with complete information.
Thus, we have .

Principle #8: Markets are

Efficient But

The
Lemons Problem

Sellers know the true quality of the car they are

selling.
If the car is a lemon, they will sell it for .
If the car is a peach, they can only get for it, so they
will prefer not to sell it.

Over time, adverse selection drives high-quality

cars out of the market, leaving only lemons.
The market price is
driven down to , further
reducing the incentive to
sell a peach, until only
lemons are left in the
market.

Principle #8: Markets are

Efficient But

Digression: Adverse Selection and Health

Insurance
Consider the market for health insurance.
It is likely to have the highest take up rate
amongst unhealthy people (those who dont
exercise, smoke, etc.) and the elderly
They are the groups most likely to need health
care, therefore, it makes sense for them to
purchase health insurance.
Healthy people (young people, especially)
naturally have a lower willingness to pay for
health insurance, because they have a much
lower probability of needing health care.
The insurance company cannot perfectly observe
the buyers type (healthy vs. unhealthy), which

Principle #8: Markets are

Efficient But

Digression: Adverse Selection and Health

Insurance
If only the people with the highest expected
health care costs purchase insurance (unhealthy
people), this drives up the price of insurance.
This further reduces the incentive for young, healthy
people to purchase insurance.
Its exactly like the lemons problem, only the price
goes in the opposite direction!

Asymmetric information results in a market

failure.
The market fails to provide the correct incentives, and
many mutually beneficial trades do not occur.

Principle #8: Markets are

Efficient But

Digression: Adverse Selection and Health

Insurance
So whats the solution? [The answer is: Pass a
law that requires everyone to purchase health
insurance.]

Principle #8: Markets are

Efficient But

High transactions costs can prevent mutually

beneficial trades from occurring as well.
Transactions costs are basically costs incurred in
making an economic exchange (aside from the actual
cost of the good or service itself).

Transactions costs can be broadly divided into

three main categories:
1. Search and information costs
2. Bargaining and legal costs
3. Enforcement costs

Depending on the good or service, these can

be significant, presenting an impediment to
free trade and market efficiency.

Principle #8: Markets are

Efficient But

Externalities occur when individual actions

result in economic costs or benefits not taken
into account by the market.
Externalities can be bad (example: a
production/consumption process that generates
pollution).
They can also be good (the more people who get
vaccinated, the less likely an unvaccinated person
is to get sick).

Principle #9: Government

Intervention

When Markets Dont Achieve Efficiency,

Government Intervention Can Improve
Societys Welfare
Market failures give rise to an essential role of
government in a market economy.
Government intervention in markets, when properly
applied and correctly administered, can improve
market efficiency when market failures exist.
There is also no question that government
intervention, when unnecessary or poorly
administered, can undermine market efficiency.

Principle #9: Government

Intervention

When Markets Dont Achieve Efficiency,

Government Intervention Can Improve
Societys Welfare
Examples of government interventions to
correct market failures:
Anti-trust laws (to prevent anti-competitive behavior)
& regulation of natural monopolies.
Provision of public goods
Regulations for all sorts of things
Reducing asymmetric information
Reducing transactions costs
Correcting externalities
Government
interventions can
and do improve
societys welfare!

Economy-Wide Interactions
Principles that underlie economy-wide
interactions
(i.e., the primary focus of this class)
Principle# 10: One persons spending is
another persons income.
Principle# 11: Overall spending sometimes
gets out of line with the economys productive
capacity.
Principle# 12: Government policies can change
spending.

SUMMARY
1. All economic analysis is based on a set of
basic principles that apply to three levels of
economic activity. First, we study how
individuals make choices; second, we study
how these choices interact; and, third, we
study how the economy functions overall.
2. Everyone has to make choices about what to
do and what not to do. Individual choice is
the basis of economics.
3. The reason choices must be made is that
resourcesanything that can be used to
produce something elseare scarce.

SUMMARY
4. Because you must choose among limited
alternatives, the true cost of anything is what
you must give up to get it all costs are
opportunity costs.
5. Many economic decisions involve questions not
of whether but of how much? Such
decisions must be taken by performing a
trade-off at the marginby comparing the
costs and benefits of doing a bit more or a bit
less. Decisions of this type are called marginal
decisions, and the study of them, marginal
analysis, plays a central role in economics.

SUMMARY
6. The study of how people should make
decisions is also a good way to understand
actual behavior. Individuals usually respond to
incentives -- exploiting opportunities to make
themselves better off.
7. The next level of economic analysis is the
study of interactionhow my choices depend
on your choices, and vice versa. When
individuals interact, the end result may be
different from what anyone intends.

SUMMARY
8. Individuals interact because there are gains
from trade: by engaging in the trade of
goods and services with one another, the
members of an economy can all be made
better off. Specialization each person
specializing in the task he or she is good at is
the source of gains from trade.
9. Because individuals usually respond to
incentives, markets normally move toward
equilibriuma situation in which no
individual can make himself or herself better
off by taking a different action.

SUMMARY
10.An economy is efficient if all opportunities to
make some people better off without making
other people worse off are taken. Resources
should be used as efficiently as possible to
achieve societys goals. But efficiency is not the
sole way to evaluate an economy: equity, or
fairness, is also desirable, and there is often a
trade-off between equity and efficiency.
11.Markets usually lead to efficiency, with some
well-defined exceptions.

SUMMARY
12.When markets fail and do not achieve
efficiency government intervention can improve
societys welfare.
13.Because people in a market economy earn
income by selling things, including their own
labor, one persons spending is another
persons income. As a result, changes in
spending behavior can spread throughout the
economy.

SUMMARY
14.Overall spending in the economy can get out of
line with the economys productive capacity.
Spending below the economys productive
capacity, leads to a recession; spending in
excess of the economys productive capacity
leads to inflation.
15.Governments have the ability to strongly affect
overall spending, an ability they use in an effort
to steer the economy between recession and
inflation.

KEY TERMS

Individual choice
Resource
Scarce
Opportunity cost
Trade-off
Marginal decisions
Marginal analysis
Incentive
Interaction
Trade
Gains from trade
Specialization
Equilibrium