Tradeoffs: Each of us is constantly making choices—students decide to study at the library rather than in

the dorm, to have pizza rather than sushi, to go to college rather than work full-time. Societies, too,
make choices—to preserve open spaces rather than provide more housing, to produce computers and
import televisions rather than produce televisions and import computers, In some cases, individuals or
governments explicitly make these choices. In other cases, however, the choices were the result of the
uncoordinated actions of millions of individuals. Neither the government nor any one individual decided
that the United States would import cars from Japan and export wheat to India. But in each case, choice
involves trade-offs—to get more of one thing involves having less of something else. We are forced to
make trade-offs because of scarcity

Scarcity: Scarcity figures prominently in economics; choices matter because resources are scarce. For
most of us, our limited income forces us to make choices. We cannot afford everything we might want.
Spending more on rent leaves less available for clothes and entertainment. Getting a sunroof on a new
car may mean forgoing leather seats to stay within a fixed budget. Limited income is not the only reason
we are forced to make trade-offs. Time is also a scarce resource, and even the wealthiest individual
must decide what expensive toy to play with each day. When we take time into account, we realize
scarcity is a fact of life for everyone.

INCENTIVES It is one thing to say we all face trade-offs in the choices we make. It is quite another to
understand how individuals and firms make choices and how those choices might change as economic
circumstances change. If new technologies are developed, will firms decide to increase or decrease the
amount of labor they employ? If the price of gasoline rises, will individuals decide to buy different types
of automobiles? When faced with a choice, people evaluate the pros and cons of the different options.
For example, a retail chain deciding on the location for a new store must weigh the relative advantages
of different locations. One location might have more foot traffic but also higher rent. Another location
might be less desirable but have lower rent. If a firm starts selling more of its goods through the
Internet, it will rely less on foot traffic into its retail store. This shift reduces its incentive to pay a high
rent for a good location. Economists analyze choices by focusing on incentives. In an economic context,
incentives are benefits (including reduced costs) that motivate a decision maker in favor of a choice.
Many things can affect incentives, but among the most important are prices. If the price of gasoline
rises, people have a greater incentive to drive less. If the price of MP3 players falls, people have a
greater incentive to buy one. When economists study the behavior of people or firms, they look at the
incentives being faced. Sometimes these incentives are straightforward. Increasing the number of
courses required to major in biology reduces the incentive to pick that major. In other circumstances,
they may not be so obvious. For example, building safer cars may create incentives to drive faster.
Identifying the incentives, and disincentives, to take different actions is one of the first things
economists do when they want to understand the choices individuals or firms make. Decision makers
respond to incentives; for understanding choices, incentives matter.
EXCHANGE Somehow, decisions that are made—by individuals, households, firms, and government as
they face trade-offs and respond to incentives—together determine how the economy’s limited
resources, including its land, labor, machines, oil, and other natural resources, are used. The key to
understanding how this happens lies in the role of voluntary exchange in markets. Long before the rise
of modern industrial societies, the benefits of exchange were well understood. Coastal societies with
access to fishing resources, for example, would trade some of their fish to inland societies in return for
meat and furs. The coastal group sought meat and furs that were worth more to them than the fish they
gave up; the inland group likewise exchanged meat and furs for fish. Both groups benefited from
voluntary exchange. An important insight in economics is the recognition that both parties in a voluntary
exchange gain. Whether it takes place between two individuals, between an individual and a firm, or
between residents of two different countries, exchange can improve the well-being of both parties.

Economists describe any situation in which exchange takes place as a market, Most goods, from cameras
to clothes, are not sold directly from producers to consumers. Instead they are sold from producers to
distributors, from distributors to retailers, and from retailers to consumers. All of these transactions are
embraced by the concept of markets and a market economy. In a market economy like that of the
United States, most exchanges take place through markets, and these exchanges are guided by the
prices of the goods and services involved. The goods and services that are scarcer, or require more
resources for their production, come at a higher price. Exchange in markets is a key to understanding
how resources are allocated, what is produced, and who earns what.

INFORMATION Making informed choices requires information. After all, it is hard to weigh the costs and
benefits of alternative choices if you do not know what they are! Information

is, in many ways, like other goods and services. Firms and individuals are willing to

purchase information, and specialized institutions develop to sell it. In many areas,

separate organizations are designed solely to provide information to consumers. Consumer Reports is a
prime example. The Internet also now serves as a major source

of independent information for buyers. But there are some fundamental ways

in which information differs from other goods. information can be freely shared. When I tell you
something, it does not subtract

from what I know (though it may subtract from the profits I might earn from that

information). In some key areas of the economy, the role of information is so critical that

it affects the nature of the market. In the used-car market, buyers and sellers negotiating

over the price of a vehicle may have quite different information about its

quality. The seller may have better information about the quality of the car but also

has an incentive to misrepresent its condition, since better-quality cars command

higher prices. As a result, the buyer will be reluctant to trust claims that the car is

in perfect shape.

When consumers lack adequate information to make informed choices, governments

frequently intervene to require that firms provide information. Even in the absence of regulation, firms
have incentives to signal to buyers that

their products are of high quality. One way they do this is to offer guarantees that a

producer of low-quality goods could not afford to offer.

Imperfect information also can interfere with incentives. Employers want to

create incentives for employees to work hard. Information, or its absence, plays a key role in determining the
shape of markets
and the ability of private markets to ensure that the economy’s scarce resources are used
efficiently.

DISTRIBUTION

The market economy determines not only what goods are produced and how they
are produced but also for whom they are produced. economists also believe that certain interventions by
government
are desirable. Like the appropriate balance between public and private sectors,
the appropriate balance between concerns about equality (often referred to
as equity concerns) and efficiency is a central issue of modern economies. As
elsewhere, trade-offs must be made.
Wrap-

The Three Major Markets

The market economy revolves around exchange between indi
viduals
(or households) who buy goods and services from firms, and
firms, which take inputs, the various materials of production, and
produce outputs, the goods and services that they sell. In thinking
about a market economy, economists focus their attention on three
broad categories of markets in which individuals and firms interact.
The markets in which firms sell their outputs to households are
referred to collectively as the product market. Many firms also
sell goods to other firms; the output of the first firm becomes the
input of the second. These transactions too are said to occur in the
product market.
On the input side, firms need (besides the materials they buy in
the product market) some combination of labor and machinery to
produce their output. They purchase the services of workers in the
labor market. They raise funds to buy inputs in the capital market.
Traditionally, economists also have highlighted the importance of
a third input, land, but in modern industrial economies land is of
secondary importance. For most purposes, it suffices to focus
attention on the three major markets—product, labor, and capital—
and this text will follow that pattern.

As Figure 1.1 shows, individuals participate in all three markets. When individuals
buy goods and services, they act as consumers in the product market. When people
act as workers, economists say they “sell their labor services” in the labor market.
When people buy shares of stock in a firm, deposit money in a savings account, or
lend money to a business, they are participating in the capital market as investors.

THE THREE MAJOR MARKETS

1. The product market: the markets in which firms sell the goods they produce.

2. The labor market: the market in which households sell labor services and firms

buy labor services.

3. The capital market: the market in which funds are borrowed and lent.

CAUSATION AND CORRELATION

Economists want to accomplish more than just asserting that different variables

are indeed correlated. They would like to conclude that changes in one variable cause

the changes in another variable. This distinction between correlation and causation

is important. If one variable “causes” the other, then changing the first variable

necessarily will change the other. If the relationship is just a correlation, this

may not be true.

During the 1970s, imports of Japanese cars into the United States increased

while sales of U.S.-produced cars decreased. The two variables were negatively

correlated. But did increased Japanese car sales cause the decrease in sales of

American-made cars? Perhaps both were responding to a common factor that was

the true cause of both the rise in Japanese car sales and the decline in sales of

American cars. In fact, that is what was happening—the huge increase in oil prices

after 1973 caused consumers to shift their purchases away from gas-guzzling

American cars and toward more fuel-efficient Japanese cars.

Economics is a social science. It studies the social problem of choice from a scientific

viewpoint, which means that it is built on a systematic exploration of the problem of

choice. This systematic exploration involves both the formulation of theories and

the examination of data.

A theory consists of a set of assumptions (or hypotheses) and conclusions derived

from those assumptions. Theories are logical exercises: if the assumptions are

correct, then the results follow. If all college graduates have a better chance of get

ting

jobs and Ellen is a college graduate, then Ellen has a better chance of getting a

job than a nongraduate. Economists make predictions with their theories. They

might use their theory to predict what would happen if a tax is increased or if imports

of foreign cars are limited. The predictions of a theory are of the form “If a tax is

increased and if the market is competitive, then output will decrease and prices

will increase.”

In developing their theories, economists use models. To understand how models

are used in economics, consider a modern car manufacturer trying to design a new

automobile. It is extremely expensive to construct a new car. Rather than creating

a separate, fully developed car for every conception of what engineers or designers

would like the new car to be, the company uses models. The designers might use a

plastic model to study the general shape of the vehicle and to assess reactions to the

car’s aesthetics. The engineers might use a computer model to study air resistance,

from which they can calculate fuel consumption. Just as engineers construct different models to study
particular features of a

car, economists construct different models of the economy—in words or equations—

to depict particular features of the economy. An economic model might describe a

general relationship (“When incomes rise, the number of cars purchased increases”),

describe a quantitative relationship (“When incomes rise by 10 percent, the number

of cars purchased rises, on average, by 12 percent”), or make a general prediction

(“An increase in the tax on gasoline will decrease the demand for cars”)

8. Why are economists interested more in causation than correlation?

A variable is any item that can be measured and that changes. Prices, wages, interest

rates, and quantities bought and sold are variables. What interests economists

is the connection between variables. When economists see what appears to be a

systematic relationship among variables, they ask, Could it have arisen by chance

or is there indeed a relationship? This is the question of correlation.

Economists use statistical tests to measure and test correlations. Consider

the problem of deciding whether a coin is biased. If you flip the coin 10 times and

get 6 heads and 4 tails, is the coin a fair one? Or is it weighted toward heads?

Statistical tests will show that the result of 6 heads and 4 tails easily could have hap

pened
by chance, so the evidence does not prove that the coin is weighted. It also