Ten Key Concepts

1. Incentives Matter
• People respond rationally to incentives
o The Bathroom Mirror story
• What may look irrational to you might be rational to the market
actors – The Potato story
• Change the incentives: Change the behavior
• Supply and Demand are incentive stories where price is the signal
o As price rises suppliers bring more to market
o As price rises demanders buy less and search for alternatives
or substitutes
o Price increases that bring profits also set in motion
entrepreneurship. Existing and potential suppliers are
attracted by the profit opportunities.

2. T.A.N.S.T.A.A.F.L.
• All actions have a cost. Is the lunch provided by this FTE program
free?
o Not if scarce resources (and all resources are scare) were
used to produce the lunch.
o You give up one of the most valuable assets you have – your
time.
o Books outside my office door – What sign should I post?
“Free books” or “Zero-Price books”?
• What does college cost? Largest component cost never shows up
in the accounting. Sure we have books, tuition, housing, and other
direct expenses. But what about foregone wages? $7 x 2000 hours
x 4 years = $56,000
• Politicians in particular abuse this truth. Every constituent wants
“something for nothing” and promising free (zero-price) delivery is
a common political promise. This does not mean that the good or
service provided is free – someone else may pay for it but it is
definitely not free.
• What the government gives away it must first take away.
• Example: The US Federal Government alone spent
$552,964,000,000 (over ½ a billion dollars) on Health and
Medicare programs in 2005.

Source: Common Sense Economics: What Everyone Should Know About Wealth and 1
Prosperity by James Gwartney, Richard L. Stroup, and Dwight R. Lee
 o Free lunch program
o Free health care
o Free education
o Free housing

3. Decisions are made “at the margin.”

• Marginal = Additional
• Economists use the terms marginal cost (MC) and marginal benefit
(MB)
• Avoid binomial thinking – 0,1; All,None; Black/White
• Think “somewhere between 0 & 1”; some; grey
• People respond to changes to their current situation
o I need to get the car washed. I notice that the usual price for
the carwash is $8 but if I buy 10 gallons of gas I get the car
wash for $5. I look at my fuel gauge and I am on 1/8 of a
tank. I fill-her-up with gas and the MC of the carwash drops
from $8 to $5.
• Suppose you are sent out to the orange grove to pick a bag of fruit.
What fruit do you pick first? The low-lying…
• Should we completely eliminate all pollution? Of course not! It is
likely that the most efficient solution to the pollution problem is
world-mass suicide. (At the margin, your decomposition is going
to happen anyway and if you stop living you will stop polluting. )
Again – it is almost never an all-or-nothing deal! We can reduce a
good bit of pollution but should keep in the equation the MC and
MB.

4. Exchange/Trade promotes economic progress.

• Trade must be of free will and non-coercive
• When I buy a slurpee…
• Markets produce “gains from trade” in the form of consumer
surplus and producer surplus. Explain consumer and producer
surplus.

Source: Common Sense Economics: What Everyone Should Know About Wealth and 2
Prosperity by James Gwartney, Richard L. Stroup, and Dwight R. Lee
 • Trade moves goods and services from people who value them less
to those who value them more. Value differs among people. :
“One man’s trash is another man’s treasure.”
• Specialization is the handmaiden of trade. Specialization allows us
to become more efficient and to pursue activities that others value.
Without trade we could not specialize. How much does your
household get through trade? Nearly everything!
• Trade allows mass production techniques that increase efficiency
and increase learning on the part of suppliers. The supplier’s goal
is to decrease costs to become more efficient and to therefore be
more competitive.
• Trade allows innovation and entrepreneurship to flourish.

5. Transaction costs reduce exchange activity.

• Transaction costs are the costs of negotiating, consummating and
monitoring a trade.
• Transaction Costs come in many forms
o Geographical distance – mountains, rivers and oceans
o Informational obstacles - internet
o Political (taxes, licensing, price controls, tariffs, etc.)
• Middlemen
o Often maligned but still exist – Why?
o They are essentially brokers of information and reduce
transaction costs
o Grocery – how many products are available in a grocery
store?
ƒ Who coordinates the numerous suppliers to bring
groceries to a central bazaar for us? Your grocer is a
middleman who coordinate many suppliers, brings the
product to a central location, maintains inventories
and provides information through advertising and
pricing.

6. Profits (and losses) send important signals.

Source: Common Sense Economics: What Everyone Should Know About Wealth and 3
Prosperity by James Gwartney, Richard L. Stroup, and Dwight R. Lee
 • Firms combine resources and should add value. If they do add value
then they can make a profit this is a signal to them that they are doing
something right. They are combining resources in such a way as to
increase the value to consumers.
• If they reduce the value of the resources they use they will make
losses. Very common! About 85% of all small businesses go out of
business in the first 5 years. How many Fortune 500 companies are
left from the 1940 list? 17
• Losses and bankruptcy are “good” from a systematic perspective.
They halt those activities that destroy value.

7. The way to make profits is to help others. People want certain things
and if I can provide them it helps both them and me.
• Acquiring the skills and talents to help others pay dividends.
Sometimes the skills are “natural” but even these natural talents can
be honed, developed and extended. Tiger Woods practices golf a lot!
• We increase our earnings by making our activities more valuable to
others and by increasing our efficiency in doing it.

8. Economic Progress is very important and it comes through trade,

investment, better ways of doing things (productivity) and sound
economic institutions.
• The growth in economic well-being is stunning
o Overheads: Braudel, Economist GDP from Millennium
Edition
• Keys are investment – capital is plant and equipment. Capital is a
compliment for labor – better and more capital increase the
productivity of labor.
• Human capital – investments in skill, training, learning
• Goal is to increase productivity because productivity is the major
determinant of standard-of-living for a society. Dallas Fed
overhead.
• Institutions matter! The base for a commercial society is property
rights that are
o Defined
o Defensible
o Divestible
o Hernando de Soto and The Mystery of Capital
ƒ Barking dogs

Source: Common Sense Economics: What Everyone Should Know About Wealth and 4
Prosperity by James Gwartney, Richard L. Stroup, and Dwight R. Lee
 9. Market prices provide direction to both buyers (demanders) and
sellers (suppliers.)
• Adam Smith’s Invisible Hand
• Problem for 17th century political philosophy was should we form
a society driven by passions or interests?
• A number of philosophers set the stage to organize society around
interests because they believed that they were less volatile, more
cooperative and less likely to lead to conflict
• Passions had led to deep division in Europe and many wars
• Smith’s Invisible Hand quote
• The marvel of prices – F.A. von Hayek.
a. The tin story – what do users of tin need to know?
b. Price as a summary statistic capturing a tremendous amount
of underlying information
c. Prices as Embodied Knowledge
d. Prices coordinate the actions of thousands, millions even
billions

10. Remember the Secondary Effects!

a. Any action affects other things and we often forget this
b. Brazilian Arm Chop overhead
c. Time frame problems
d. If we design incentives for people to behave in certain ways we
had better think long and hard about how they might react!
e. Dilbert Cartoon (Make overhead)
f. Particular problem in politics – promise short-term benefits and
pass along the long-term consequences and costs
g. We will cover the short and long term effects of rent controls
later
h. ST and LT effects of tariffs
i. “Protect the steel industry” and “steel workers”
ii. Creates trade tensions and retaliatory tariffs
iii. Price of steel rises domestically
iv. All companies and end consumers who use steel pay
higher prices

Source: Common Sense Economics: What Everyone Should Know About Wealth and 5
Prosperity by James Gwartney, Richard L. Stroup, and Dwight R. Lee