How People Make Decisions

There is no mystery to what an economy is Whether we are talking about the economy of Los Angeles, the United States, or the whole world, an economy is jusl a group of people dealing with one another as they go about their lives. Because the behavior of on economy reflects the behavior of the individuals who make up I Ik- economy, we begin our study of economics with four principles of individual decision making.

Principle 1: People Face Trade-offs

You may have heard I Ik- old saying, "There ain't no Such thing as a free lunch." Grammar aside, there is much truth to this adage. To gel 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.

Consider a student who must decide how to allocate her most valuable resource—her time. She can spend all her time studying economics, spend all of it studying psychology, or divide it between the I wo fields. For ever)' hour she studies one subject, she gives up an hour she could have used studying the ether. And for every hour she spends studying, she gives up an hour that she could have spent napping, bike riding, watching TV, or working at her part-time job for some extra spending money.

Or consider parents deciding how to spend their family income. They can buy food, clothing, or a family vacation Or they can save some of the family income for retirement or the children's college education. When they choose to spend an extra dollar on one of these goods, they have one less dollar to spend on some other good.

When people are grouped info societies, f hey face different kinds of trade-offs. The classic trade-off b between "guns and butter." The more a society spends on national defense (guns) to protect its shores from foreign aggressors, the less it can spend on consumer goods (butter) to raise the standard of living at home. Also important in modern society b the trade-off between a dean environment and a high level of income. Laws that require firms to reduce pollution raise the frconomi-ci tfi» «tudy of how Mxwry manages its scarce rciources co« 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 ot" these three. Thus, while pollution regulations yield the benefit of a dcaner environment and the improved health th.it comes with it, they have the cost of reducing the incomes of the firms' owners, workers, and customers

Another trade-off society faces is between efficiency and equality. Efficiency mean» that society is getting the maximum benefits from its scarce resources. Cquality means that those benefits are distributed uniformly among society's members. In other words, efficiency refers to the size of the economic pie, and equality refers to how the pie is divided into individual slices.

When government policies are designed, these two goals often conflict. Consider, for instance, policies aimed at equalizing the distribution of economic well-being. Some of these policies, such as the welfare system or unemployment insurance, try to help the members of society who are most in need. Others, such as the individual incontc tax. ask the financially successful to contribute more than others to support the government. While achieving greater equality, these policies reduce efficiency. When Ihe government «.distributes income from the rich to the poor, it reduces the reward for working hard; as a result, people work less and produce fewer goods and services. In other words, when the government tries to ait ll>e economic pie into more equal slices, Ihe pie gets smaller.

Recognizing that people face trade-offs docs not bv itself tell us what decisions they will or should make. A student should not abandon the study of psychology just because doing so would increase the time available for the study of economics. Society should not stop protecting the environment ¡ust because environmental regulations reduce our material standard of living. The poor should not be ignored just because helping them distorts work incentives. Nonetheless, people are likely to make good decisions only if they understand the options they have available. Our study of economics, therefore, starts by acknowledging life's trade-offs.

*ffid#«ey the property of society getting the moil it can from its scarce resources equality the property of distributing economic prosperity uniformly among the mambars of society

Principle 2: Tin-: Cost of Something Is What You Give Up to Get It

Because people face trade-offs, making decisions requires comparing the costs and benefits of alternative counscs of action- In many eases, however, the cost of an action is not as obvious as it might first appear.

Consider the decision to go to college. The main benefits are intellectual enrichment anil a lifetime of better job opportunities. But what are the costs? To answer this question, you might be tempted to add up the money you spend on tuition, books, room, and board. Yet this total does not truly represent what you give up to spend a year in college.

There are two problems with this calculation. First, it includes some things that are not really costs of going to college. Even if you quit school, you need a place to sleep and food to eat. Room and board are costs of going to college only to the extent that they are more expensive at college than elsewhere. Second, this calculation ignores the largest cost of going to college—your time. When you spend a year listening to lectures, reading textbooks, and writing papers, you cannot spend that lime working at a job. For most students, the earnings given up to attend school are the largest single cost of their education.

The opportunity cost of an item is what you give up to get that item. When making any decision, decision makers should be aware of the opportunity costs opportunity cost whatever must be given up to obtain some rtam that accompany each possible action. In fact, they usually are. College athletes who can earn millions if they drop out of school and play professional sports arc-well aware that their opportunity cost of college is very high. It is not surprising that they often decklc that the benefit b not worth the cost.

rational paople peopl* »»ho systematically and purposefully do th* bost thay can to achieve their objectives marginal ch*ng#« small incremental adjust ments to a plan of actio«

Principle 3: Rational People Think at the Margin

Economists normally assume that people are rational. Rational people systematically and purposefully do the best they can to achieve their objectives, given the available opportunities. As you study economics, you will encounter firms that decide how many work«-» to hire and how much of their product to manufacture and sell to maximize profits. You will also encounter individuals who decide how-much time to spend working and what goods and services to buy with the resulting income to achieve the highest possible level of satisfaction.

Rational people know that decisions in life are rarely black and white but usually involve shades of gray. At dinnertime, the decision you face is not between fasting or eating like a pig but whether to take that extra spoonful of mashed potatoes. When exams roll around, your decision is not between blowing them off or studying 24 hours a day but whether to spend an extra hour reviewing your notes instead of watching TV'. Economists use the term marginal changes to describe small Incremental adjustments to an existing plan of action. Keep in mind that margin means "edge," so marginal changes are adjustments around the edges of what you are doing. Rational people often make decisions bv comparing marginal benefits and marginal costs.

For example, consider an airiine deciding how much to charge passengers who fly standby. Suppose that flying a 200-seat plane across the United States costs the a irline $100,000,1n this case", the average cost of each seat is $100,000/200, which is $500. One might be tempted to conclude that the airline should never sell a ticket for less than $500. In fact, a rational airline can often find ways to raise its profits by thinking at the margin. Imagine that a plane is about to take off with ten empty seats, and a standby passenger waiting at the gate will pay $300 for a seat. Should the airline sell the ticket? Of course it should. If the plane Itas empty seats, the cost of adding one more passenger is tiny. Although the nrrni^e cost of flying a passenger b $500, the marginal cost b merely the cost of the bag of peanuts and can of soda that the extra passenger will consume. As long as the standby passenger pays more than the marginal cost, selling the tk'ket is profitable.

Marginal decision making can help explain some otherwise puzzling economic phenomena. Here b a classic question: Why b water so cheap, while diamonds are so expensive? Humans need water to survive, while diamonds are unnecessary; but fur some reason, people are willing to pay much more for a diamond than for a cup of water. The reason is that a person's willingness to pay for any good is based on the marginal benefit that an extra unit of the good would yield The marginal benefit, in turn, depends on how many units a person already has. Water is essential, but the marginal benefit of an extra cup b small because water is plentiful. By contrast, no one needs diamonds to survive, but bccaujc diamonds are so rare, people consider the marginal benefit of an extra diamond lo be large.

A rational decision maker takes an action if and only if the marginal benefit of the action exceeds the marginal cost. Thb principle can explain why airlines are willing to sell a ticket below average cost and why people arc willing to pay more for diamonds than for water. 1« can take some time to gel used to the logic of marginal thinking, but the study of econoaiics will give you ample opportunity to practice.

Principle 4: People Respond to Incentives

An incentive is something that induce» ¿1 person to act, such as the prospect of a punishment or a reward. Because rational people make decisions by comparing costs and benefits, they respond to incentives. You will see that incentives play <1 central rule in the study of economics. One economist went so far as to surest that the entire field cotild be simply summarized: "People respond to incentives. The rest is commentary."

Incentives are crucial to analyzing how markets work. For example, when the price of an apple rises, people decide to eat fewer apples. At the same time, apple orchards decide to hire mure workers and harvest more apple». In other words, a higher price in a market provides an incentive for buyers to consume less and an incentive for sellers to produce more. As we will see, the influence of prices on the behavior of consumers and producers is crucial for how a market economy allocates scarce resources.

Public policymakers should never forget about incentives: Many policies change the costs or benefits that people face and, therefore, aller their behavior. A lax on gasoline, for instance, encourages people to drive smaller, more fuel-efficient cars. That is one reason people drive smaller cars in Europe, where gasoline taxes arc high, than in the United States, where gasoline taxes are low. A gasoline tax also encourages people to carpool, take public transportation, and live closer to where they work. It the tax were larger, more people would be driving hybrid car», and if it were large enough, they would switch to electric cars.

When policymakers fail to consider how their policies affect incentives, they often end up with unintended consequents. For example, consider public policy regarding auto safety. I oday, all cars have seat bells, but this was not true 50 years ago. In the lWOs, Ralph Nader's book Unsafe at Any Speed generated much public concern over auto safety. Congress responded with laws requiring seat belts as standard equipment on new cars.

How does a seat belt law affect auto safety? 1 he direct effect is obvious: When a person wears a seat belt, the probability of surviving an auto accklenl rises. But that's not the end of the story because the law also affects behavior by altering incentives. The relevant behavior here is the speed and care with which drivi-r» operate their cars. Driving slowly and carefully is costly because it uses the driver's time and energy. When deckling how safely to drive, rational people compare, perhaps unconsciously, the marginal benefit from safer driving to the marginal cost. As result, they drive more slowly and carefully when the benefit of increased safety is high. For example, when road conditions arc icy, people drive more attentively and at lower speeds than they do when road conditions arc clear.

Consider how a seat belt law alters a driver's cost-benefit calculation. Seat belts make accidents less costly because they reduce the likelihixnl of injury or death. In other words, seat belts reduce the benefits of slow and careful driving People respond lo seat belts as Ihey would to an improvement in road conditions—by driving faster and !i-»s carefully. The result of a seat belt law, therefore, is a larger number of accidents I he decline in safe driving has a clear, adverse impact on pedestrians, who are more likely to find themselves in an accident hut (unlike the drivers) don't have the benefit of added protection.

At first, this discussion of incentive» and seat belts might Seem like idle speculation Yet in a classic 1W5 study, economist Sam IVIt/man argued that auto-safety laws have had many of these effects According to Peltzman's evidence, these laws produce both fewer deaths per accident and more accidents. He concluded incentive something that induces a poruxi to act

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that the net result ¡5 little change in the number of driver deaths and an increase in the number of pedestrian deaths.

Peltzman's analysis of auto safety is an offbeat example of the general principle that people respond to incentives- When analysing any policy, we must consider not only the direct effects but also the less obvious indirect effects that work through incentive«. If the policy changes incentives, it will cause people to alter their behavior.

QUICK QUIZ Describe an important trade off you recently faced. • Give a*i example of sort%e action that ha* both a monetary and nonmonetary opportunity cost. • Describe an incentive your parents offered to you in an effort to influence your behavior.

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