The principles of economics

Why principles. Every economic problem looks different, but the choices that households, firms and governments make can be traced back to a short list of broad ideas, the principles of economics. They all start from one fact: wants are unlimited while the resources to meet them are scarce and have alternative uses, so people must choose. The principles fall into three groups: how individuals decide, how people interact, and how the economy as a whole works.

How individuals decide.

1. People face trade-offs. Getting more of one thing means accepting less of something else. A student with a week before her exams must divide the same hours between revision, a part-time job and rest; a country must decide what to produce. Governments face trade-offs as well: taxing the rich to help the poor reduces inequality but also weakens the reward for working hard, so it lowers efficiency.
2. A choice costs whatever is sacrificed for it. The true cost of a choice is its opportunity cost: the benefit of the next-best option forgone. A graduate in Patna who spends a year preparing for the civil services gives up the salary of the job she could have taken, on top of coaching fees.
3. Rational people think at the margin. Decisions are rarely all-or-nothing; they are about small, incremental changes, made by comparing the extra benefit with the extra cost. A wheat farmer in Haryana deciding whether to irrigate his field one more time compares the extra grain that watering will bring with the extra cost of diesel and labour for it, not with the average cost of all the waterings so far; costs already fixed do not change with the decision.
4. People respond to incentives. The prospect of a reward or a penalty changes behaviour, so policy-makers must allow for the response or face consequences they did not intend. When the government subsidises electric two-wheelers, more buyers choose them over petrol scooters.

How people interact.

5. Trade can make everyone better off. One side's gain need not be the other's loss. Trade lets each country produce what it does best and gives consumers more choice at lower prices. India exports software services and imports crude oil, and both sides gain.
6. Markets are usually a good way to organise economic activity. In a market economy, millions of households and firms decide for themselves, guided by self-interest and prices; this decentralised system has been found to promote the well-being of all, as if by an invisible hand. Government control of prices tends to weaken that guidance.
7. Governments can sometimes improve market outcomes. A market cannot work well unless the state enforces rules and keeps law and order, so that sellers are sure of being paid; and the government is needed to pursue both efficiency and equality. But the word sometimes matters: the government is not always able to improve on what the market does.

The economy-wide principles. Three more principles concern the economy as a whole: how well people live in a country depends on how much it can produce; prices rise when the government creates too much money; and in the short run society faces a trade-off between inflation and unemployment. The SOL treats these as outside the scope of this paper.

Conclusion. The principles of economics explain how people choose under scarcity (trade-offs, opportunity cost, marginal thinking and incentives) and how their choices fit together (trade, markets and a limited role for government). Together they give a way to analyse economic problems that were never seen before.