Skip to main content

The following six concepts are key to evaluate trade-offs and reason economically. Students participating in the essay contest are encouraged to review these concepts and incorporate at least one into their essays.

1. Opportunity Cost: There is No Such Thing as a Free Lunch

People and societies face trade-offs. To obtain something they want, people have to give up something in return, and what they give up is known as the opportunity cost. Individuals face numerous trade-offs, from such mundane choices as whether to attend a ballgame or a movie, to more important choices, such as how much income to spend vs. how much to save. An important trade-off a high school senior faces is whether to go on to college. The opportunity cost of pursuing a college degree is not only the expenses for books and tuition but also the income the student would forego while attending college.

Societies or nations also face important choices. Markets on their own may have undesired outcomes or result in misallocated resources. For example, governments must decide how to redistribute income to alleviate poverty, as well as determine the level and mix of public goods, such as national defense, education, public safety and other programs. Thus, nations must decide the method in which scarce resources are allocated and each method has costs and benefits. The costs and benefits often relate to efficiency (is the nation producing the most given its limited resources) and distributive (is the allocation of resources to individuals "fair").

2. Marginal Analysis: Thinking Incrementally

Recognizing trade-offs does not in itself tell us what choice to make. Assuming (as economists do) that people behave in their own best interests, then incremental thinking—that is, marginal analysis—leads to the right decision. For example, you and two friends pay $10 to attend a movie on Friday evening that the critics gave five stars. Forty-five minutes into the movie you all agree that the film doesn't even rate one star. One friend wants to leave and go to your house and play pool, but other friends argue that you should see the rest of the film because you have paid for it. They turn to you to resolve their dispute, and it's an easy decision—you favor going to play pool.

On the way to your house, you explain to your friends how marginal analysis led to your decision. In this situation, it was how to spend the rest of Friday evening after you had already started watching the movie. Once you started watching the movie, the cost of a ticket was what economists call a sunk cost; that is, it's an outlay that once made cannot be recovered. The trade-off you faced was spending another hour and one-half watching a boring movie or playing pool.

In addition to keeping sunk costs from distorting your decision, you explain that marginal analysis means that decisions are reached by weighing additional costs against additional benefits. In this case, the benefit of playing pool is greater than the benefit of watching the rest of the movie. So, despite the fact that you had spent money and time watching the movie, your best choice was to play pool. If you had let sunk costs (that is, the money and time spent watching the movie) dictate your decision, you would have spent the hour and one-half in a less gratifying activity.

While marginal analysis can be used to salvage an evening on the town, it also guides businesses to maximize profits. A business will continue to expand sales and output to the point that the incremental cost of providing the particular good or service equals the price of that good or service.

Marginal analysis can also be used by societies and nations. The decisions policy makers choose regarding national affairs should also factor in the concepts of sunk costs. So leaders must decide how policies will effect the country at the margin and also think about the opportunity costs. For example, if program A will cost the nation $100 million in taxes but provide the nation with $110 million in societal benefits, the marginal benefit is a positive $10 million. However, if program B costs the same but provides more benefits, the marginal benefit may be greater with program B. Another wrinkle to this analysis is that the cost may be greater than the tax dollars collected, because the taxpayers may have invested those tax dollars in endeavors that would yield an even larger benefit.

3. Markets: Coordinating Consumption and Production

Market-determined prices—that is, prices determined by producers and consumers acting in their own best interest—are the signals that help define the trade-offs we face and that ultimately lead society as a whole to allocate resources efficiently. Understanding how changes in supply and demand affect prices is an important component of economic literacy. When a prospective college student, for example, contemplates majors, she might speculate about where demand for workers is increasing fastest, because wages and job opportunities will probably be greatest in those occupations.

When prices change then trade-offs change, and people's decisions change. Our college student might discover, for example, that the demand for software engineers has increased and, subsequently, that wages for those jobs have also risen. Also, many public policy decisions, such as changes in the tax code, involve changing incentives with the hope of changing behavior.

Many times people are unhappy with the prices that markets produce, but an economically literate person realizes that prices are important signals that reflect underlying changes in supply and demand. Consumers and producers respond to these signals in ways that make society better off. For example, as gasoline prices rose dramatically in the 1970s due to supply disruptions in the Middle East, consumers reacted by driving fewer miles, and U.S. oil producers had an incentive to increase production. Subsequently, oil prices declined over time. When governments interfere with these market adjustments, society is usually worse off. Recall that as gasoline prices first rose in the 1970s, the U.S. government attempted to control prices. So instead of energy conservation and increased production, we got shortages, long lines at gas stations and a more serious disruption in economic activity than otherwise.

Nations not only decide through the rule of law how much free market activity is allowed, they also decide how much to use the market in the provision of government services. Should the government hire and manage government services directly, or should the government decide what services are needed and then use market forces to provide these services.

4. Prices

For prices to play this coordinating role, people must be able to distinguish relative price changes from changes in the overall price level. To examine how a particular price change alters the trade-offs, it must be abstracted from an overall change in prices. Suppose cost of a college education has risen from $5,000 to $10,000 during the last five years. The nominal increase would be 100 percent. But if overall prices had risen 50 percent, the purchasing power of the dollar would have dropped. Thus, inflation accounts for half of the $5,000 increase, and the other half would represent a real increase in the cost of a college education.

Price stability—that is, an economy without inflation or deflation—gives people the ability to distinguish between relative and overall price changes. Price instability hurts economic growth because it is harder for decision makers to distinguish between real and relative price changes. Price stability and instability is generally determined by the money supply. Given that central banks control the money supply, part of a nations economic growth is determined by how governments set up there central banks. Central banks that are given a lot of autonomy and are free from political pressure may have an easier job of providing price stability literacy is understanding how, and to what end, central banks control the money supply.

5. Trade and Specialization

Trade is an engine for economic growth because it enables an economy to take advantage of specialization, and increases and improves the trade-offs confronting society. Along with the "invisible hand," Adam Smith saw how the division of labor, that is, specialization, increases the wealth of nations. He visited a pin factory and found:

One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds at the top for receiving the head; to make the head requires two or three distinct operations; to put it on, is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands ... I have seen a small manufactory of this kind where ten men only were employed, and where ... each person ...(averaged) four thousand eight hundred pins a day. But if they had all wrought separately and independently, and without any of them having been educated to this peculiar business, they certainly could not each them make twenty, perhaps not one pin in a day.

Having established a specialty in the manufacture of pins, a nation would then have to establish a trading relationship with another country that specialized in some other product; without trade, the benefits of specialization cannot be realized. It may be to the advantage of that country to specialize in pins even if other countries can produce pins at a lower cost, if the first country can produce pins more efficiently than it can produce other goods; that is, it has a comparative advantage. Quite simply: "Each producer has a 'comparative advantage' in doing what it does best—and trading for the rest," wrote Leonard Silk, former New York Times business writer.

Specialization allows a person, business or nation to specialize in those endeavors that they do best, instead of striving for self-sufficiency. This benefits us in two ways: First, a greater variety of goods and services are available; and second, they are available at a lower cost. Between 1960 and 1995 world exports rose at a 6.1 percent annual rate and world output advanced 3.8 percent. "This growth of trade has led to wider competition, allowing countries to benefit from their comparative advantage and raising living standards everywhere," according to the 1997 Economic Report of the President.

In addition to specialization, trade also promotes technology transfer, cultural awareness and increases social capital all of which can increase economic growth.

6. Market Failure

Although many decisions in a market economy occur in private markets, government has a role, and being able to evaluate whether or not government should intervene in the economy is another element of economic literacy. For markets to function properly, governments must define property rights and make contracts enforceable.

But it may also be necessary for government to intervene if markets are allocating goods and services inefficiently, in other words, if there is a market failure. In some markets, either the buyer or the seller may have incomplete information that distorts the trade-offs confronting them; for example, the government may require certain labeling disclosures on food products to help consumers make choices. Antitrust laws are intended to keep producers from restricting output and charging higher prices than would be set in perfectly competitive markets.

Left alone, markets may produce too few or too many particular goods. The justification for many of the goods and services that government provides is that provisions would be inadequate if left to the markets alone. That's why the government provides public goods and services ranging from provision of national defense and police protection to roads, education and health care. In other instances, markets may fail to consider the cost imposed on third parties; for example, market prices may not reflect the costs imposed by air pollution (when the affected parties cannot easily negotiate an agreement), and it may be necessary for the government to intervene.

Besides correcting market failures, governments have a role in guaranteeing a socially acceptable distribution of income. Markets compensate people according to their ability to produce goods and service that others will purchase. They do not secure for everyone adequate food, clothing, shelter, health care and so on, thus the justification for a progressive income tax and government assistance programs.

Moreover, because of government's large relative share of economic activity, it has a big impact on overall economic performance. Therefore, another aspect of economic literacy is to understand government's role in dealing with economic fluctuations and growth.

To acknowledge that government in some instances can improve market outcomes does not necessarily imply that government always does improve them. Public policy is often far from perfect—as noted in the above example regarding 1970s gasoline prices. Sometimes policy is made with incomplete knowledge or to reward the politically influential. Thus, an aim of economic literacy is to teach people how to ascertain when a government policy will improve market outcomes. That doesn't mean that economically literate people will necessarily agree on outcomes or policy, but at least they will understand the choices and trade-offs they are making.

Underlying these six concepts are the 20 Voluntary National Content Standards in Economics that were prepared under the leadership of the Council for Economic Education.

Adapted from The Region
"Why Johnny Can't Choose"
And what Johnny (and Jane) needs to know to understand the economy
by: David S. Dahl