Eight basic principles of economics

Hera are the eight basic principles of economics which we ran through in our first two classes (Fri 25/09 and Wed 29/09).

1. Individuals behave based on internal self interest
2. People respond to external incentives
3. People face trade-offs (TINSTAAFL)
4. Decisions are made at the margin
5. Trade and competition works
6. Relative prices guide decisions
7. Markets can fail
8. Government intervention may improve outcomes

If you have taken an economics class before you should be familiar with these concepts.  These are just eight that I choose.  There are others that could be included and other lists have been produced (see here, here, and of course Greg Mankiw’s list here).

For the reading material provided on Blackboard in Section 1B start with the short Douglas Clement piece, Thinking Like an Economist.  You should then read PJ O’Rourke’s take on the principles of economics with Chapter Six of his 1998 book Eat the Rich.  The chapter is called from Beatnik to Business Major.

James Gwartney offers his choice of Ten Key Elements of Economics in a six-page magazine piece.  Diane Coyle produces her list at the end of her article on How to Think Like an Economist.  The relevant piece is from pages 17 to 21.  There are also some short piece in Section 1C that may be useful.  In particular give a look to Why Johnny Can’t Choose by David Dahl and David Beer’s What Every Debater Should Know About Economics.  All of these readings can be printed from Blackboard.

A short extract from John McMillan’s excellent book on markets, Reinventing the Bazaar, provides a useful insight into the fifth concept above – trade and competition works.  The extract from the chapter To The Best Bidder is reproduced below while the full chapter is available on Blackboard.

Let us compare bargaining and competition in a little more detail. The value of fish fluctuates from day to day, depending on the vagaries of consumer demand and the size of the catch. With no objective basis for establishing value, negotiating a price could be frustrating. Imagine a buyer and a seller bargaining over the price of a tuna. The buyer has calculated that the most he should pay (that is, what he will earn reselling it in pieces) is $8,000. The seller has calculated that the least she should accept (her cost of supplying it plus a return on her effort) is $6,000. A trade would create a net gain of $2,000. The seller does not know the maximum the buyer will pay, and the buyer does not know the seller’s minimum.

Suppose first that the buyer and seller are locked in together. They deal with each other or not at all. The price could be as low as the seller’s cutoff of $6,000 or as high as the buyer’s cutoff of $8,000. With any price in this range, both the buyer and the seller are better off than if they had no deal. There is no unique price the bargaining will necessarily reach. This indeterminacy leads each to try for a larger share of the pie.

The price that emerges from the haggling reflects their relative bargaining power. Threats, feints, and bluffs are sources of bargaining advantage. The buyer pretends he does not have much need for the tuna, and the seller acts as if her “rock-bottom price” is high. Each takes a calculated risk, for such intransigence could cause the negotiations to break down; they might bluff their way into positions from which they cannot retreat. Even if agreement is reached, it might be only after long drawn-out negotiations, with each testing the other’s patience by holding out for a better deal. Both lose if there is a delay or impasse, but that can happen as an unintended consequence of hard bargaining.

Now let us change the story by supposing our buyer can buy from either of two sellers. One’s cost of supplying the tuna is $6,000; the other’s is $6,500. (To keep the story simple, assume the buyer wants a single tuna, and the sellers’ tuna are identical.) Eschewing bargaining tricks, the buyer merely accepts offers from the two sellers, playing each off against the other. If one offers $7,500, he invites the other to undercut it. This seller willingly complies, offering, say, $7,400. The mutual undercutting continues until the offered price falls to $6,500, at which point the seller with the higher cost drops out of the competition.

There is no indeterminacy over the price with competition; it is equal to the higher of the two sellers’ costs. Both buyer and seller are satisfied; the buyer’s net return (value minus price) is $1,500 and the seller’s net return (price minus cost) is $500, When competition exists, the tactics of bargaining yield little payoff. If one of the sellers fries to bargain hard, the buyer can turn to the other. The buyer, on the other hand, need not go to the trouble of haggling, since the competitive process is at work in his favor.

Competition is still more advantageous to the buyer when there are more sellers. If there are three, and the additional one’s cost is the price is driven down to $6,000. In general, the price under competition is the second-lowest cost, for that is where the competition stops. As the number of competitors increases, the gap between the lowest and second-lowest cost shrinks, so the price approaches the cost of the most efficient seller. More competition brings lower prices.