There is no mystery to what an “economy” is. Whether we are talking about the economy of the municipality Kratovo or Los Angeles, about the GNP of small countries or big nation, about Ghana or Australia, or of the whole world, an economy is just a group of people interacting with one another as they go about their lives. Because the behavior of an economy reflects the behavior of the individuals who make up the economy, we start our study of economics with four principles of individual decisionmaking.
The first lesson about making decisions is summarized in the adage: “There is no such thing as a free lunch.” To get one thing that we like, we usually have to give up another thing that we like.
Making decisions requires trading off one goal against another.
Think for a moment about your own life – your daily activities, the possessions you enjoy, the surroundings in which you live. Is there anything you don’t have right now that you’d like to have? Anything that you already have but that you would like more of? If your answer is “no,” congratulations! Either you are well advanced on the path of Zen self-denial, or else you are a close relative of Bill Gates. The rest of us, however, feel the pinch of limits to our material standard of living. This simple truth is at the very core of economics. It can be restated this way: We all face the problem of scarcity – it means that society has limited resources and therefore cannot produce all the goods and services people wish to have. Just as a household cannot give every member everything he or she wants, a society cannot give every individual the highest standard of living to which he or she might aspire.
Economics is the study of how society manages its scarce resources. In most societies, resources are allocated not by a single central planner but through the combined actions of millions of households and firms. Economists therefore study how people make decisions: how much they work, what they buy, how much they save, and how they invest their savings. Economists also study how people interact with one another. When people are grouped into societies, they face different kinds of tradeoffs. The classic tradeoff is between “guns and butter.” The more we spend on national defense to protect our shores from foreign aggressors (guns), the less we can spend on consumer goods to raise our standard of living at home (butter). Also important in modern society is the tradeoff between a clean environment and a high level of income. Laws that require firms to reduce pollution raise the cost of producing goods and services. Because of the higher costs, these firms end up earning smaller profits, paying lower wages, charging higher prices, or some combination of these three. Thus, while pollution regulations give us the benefit of a cleaner environment and the improved health that comes with it, they have the cost of reducing the incomes of the firms’ owners, workers, and customers.