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Five high-level ideas—or concept clusters, if you like—come up so frequently in economics that they’re worth getting acquainted with up front: payoff maximizing, trade-offs, marginal thinking, multi-party effects, and institutions.
Payoff maximizing
Economists assume that when people or firms make choices, each option the chooser faces offers a payoff. The payoff may be measured in dollars or in a quantity of some tangible good. A rational chooser will select an option that maximizes the payoff—so, often, an option that carries the greatest possible dollar value.
In the chapter on Preference and Choice, we’ll think about payoffs not in terms of money or goods but in terms of utility, the satisfaction of preferences. The basic idea, however, will remain the same: a rational person seeks to maximize their utility. That is, a rational person tries to end up with an outcome that is at least as satisfactory as any other possible outcome.
“People try to maximize their payoff” may sound like just a different way of saying, “People want to be as happy as possible.” How insightful is that, after all? But when we think in terms of maximizing payoffs, we have the beginnings of a mathematical model of how choice works. It’s a powerful model, as you’ll see.
Trade-offs
There’s a cost to almost everything you decide to do. Often, at least part of the cost is monetary. But beyond the money you’re spending, there’s the fact that when you choose to do one thing, you’re choosing not to do something else. A vacation trip will cost you money for tickets, food and lodging, and so on. But the trip also means giving up a chance to stay home and catch up on sleep. If your time off is unpaid, you’ll also be giving up a chance to earn more money working. The things you could do but choose not to, in order to do something else, are called opportunity costs, because they represent opportunities you’re passing up. Any time you weigh different options, you should take into account not only the dollar cost of each but also its opportunity cost.
We express the fact that you don’t normally get something for nothing by saying that life is full of trade-offs. Whenever you work through a difficult decision by writing down pros and cons on a sheet of paper, you’re listing trade-offs. When analysts working for a firm or a governmental body prepare a report on the benefits and costs (including opportunity costs) of a proposed policy or course of action, the report is called a cost-benefit analysis. This is just trade-offs under a different name. The point of the exercise, whatever we call it, is to maximize the net payoff of the decision—total benefit minus total cost.
Marginal thinking
Many of the choices economists are interested in involve a whole range of options that differ only slightly from one option to the next. For example, you could decide to stay at an amusement park for 3 hours, or 3 hours and 1 minute, or 3 hours and 2 minutes, and so on. A baker could decide to make 12 loaves of bread, or 13, or 14, etc. In cases like this, maximizing one’s payoff requires starting someplace and creeping up on the best option through a series of small changes while monitoring the marginal cost, which is the cost of a small change, and the marginal benefit, which the benefit of a small change. When the marginal benefit exceeds the marginal cost, the change was a good idea, so keep going! When the marginal cost exceeds the marginal benefit, the change was a bad idea, so back up! When the marginal benefit and the marginal cost are equal, the point of maximum payoff has been reached. Stop! The point of maximum payoff, where you stop changing your mind because you’ve settled on the best option, is the point of equilibrium.
Multi-party effects
Often, while you’re making your choices, other people are making choices, too, in a shared environment. Now, equilibrium will be reached when everyone, not just you, settles on their preferred option. It’s natural to picture this kind of situation as an “I win, you lose” competition. Frequently, however, two parties can both gain by specialization and engaging in trade, in a shared environment called a market. For example, someone who bakes bread and also grows vegetables may be better off specializing in bread and exchanging some of that bread for produce from a person who specializes in gardening. The gardener, in turn, benefits from sticking to gardening and obtaining bread through trade with the baker. (The next chapter will go more detail about this.)
Gains from trade are the most important multi-party effect, but there are other, more complicated ones. One example: industrial production creates pollution that harms people who receive no compensating benefit. This is called a negative externality. Another example: some goods and services become more valuable as more people use them. (Think of a piece of communication technology or a social media platform). This is called a network externality. Both of these are discussed in the chapter on Externalities.
Institutions
Societies manage multi-party effects through institutions. Very broadly, an institution is any cultural practice, or formal or informal organization, that determines the conditions under which people interact. Economically important institutions include laws and social norms concerning private property, laws concerning debt, government agencies that regulate the behavior of private firms, and government entities that try to moderate the ups and downs of a country’s economy. The difference between healthy and unhealthy institutions can mean, for a nation, the difference between economic growth and prosperity on the one hand and stagnation and poverty on the other.
An incentive is a cost or benefit created by an institution to influence the choices people and firms make. Many incentives are deliberate. Copyrights and patent laws, for example, give artists and inventors exclusive rights to sell the new content and technologies they create. This creates a socially desirable incentive for people to innovate. Bankruptcy laws limit the extent to which a business failure can ruin a person’s life. This creates a desirable incentive for people with ideas and drive to invest their personal resources in doing things that create jobs for others.
On the other hand, some incentives are unintended consequences. For example, someone who has good health insurance may engage in risky behaviors (extreme sports, anyone?) that they would avoid if they weren’t insured. The insurance company would prefer not to encourage such behaviors, but it’s in the very nature of insurance that it makes risky behaviors less costly.
