Economic principles are time-tested understandings about how the economy functions. Economic principles represent understandings that are broader than economic laws. Like economic laws, however, these principles are generalizations that tend to be true in most cases. In essence, economic principles are statements that have a high probability of accurately explaining an economic situation, or predicting a response or reaction to certain stimuli. The five basic economic principles that follow provide a set of understandings that apply to numerous situations in the microeconomy and the macroeconomy.

Economic Choices Involve Costs

Economic choice is a conscious decision to use scarce resources in one manner rather than another. Scarcity forces people to make trade-offs because they simply cannot have everything they may want. Scarcity takes many forms. Scarce financial resources limit a consumer's ability to purchase products. Scarce natural resources limit a producer's ability to supply products. Scarce human or capital resources limit a nation's progress toward economic development. Students often experience a scarcity of time—for homework, athletics, jobs, and recreation. Because people live in a world of unlimited wants and finite resources, they must choose wisely among competing wants or needs. The study of economics helps people determine how to use their scarce resources.

The most basic understanding about economic choice is that all choices have a cost. Ordinarily, people equate the cost of a good with its price. That is, if the price of a cup of coffee is $1.50, most people express the “cost” of that cup of coffee in monetary terms—one dollar and fifty cents. Economists, however, tend to measure the true cost of the choices people make through a different lens. Economists see the real cost, or opportunity cost, of any choice in terms of what is foregone, or given up, if resources are used one way rather than another. To put it another way, the opportunity cost of a choice represents the second best use of scarce resources—the item the consumer did not buy, the good the business did not produce, or the program the government did not fund. Once again, consider the purchase of a $1.50 cup of coffee. If the buyer was both thirsty and hungry but had just $1.50 to spend, the opportunity cost of buying the coffee may well have been the lost opportunity to consume a $1.50 pastry.

Another key understanding about economic choice is that many of our decisions are made “at the margin.” In the study of economics, the term “margin” refers to the next or additional unit. Marginalism is a type of analysis that weighs the additional costs of any decision against the additional benefits that might be derived. People are involved in many types of marginal decisions. Consumers, for example, consider the marginal utility, or additional satisfaction that they might receive from the purchase of a second or third cup of coffee before buying additional coffees. People tend to reject most “all or nothing” decisions, preferring the rationality of making decisions at the margin.

Incentives Influence People's Decisions

Incentives are factors that motivate people to pursue certain actions and discourage others. Incentives affect many types of decisions. For instance, there are fines for many types of traffic infractions. Hefty fines provide an incentive for drivers to follow established rules of the road. In a similar way, incentives influence people's economic decisions and actions.

Incentives signal to consumers, businesses, workers, savers and investors, and other marketplace participants how they should use their scare resources. Consumers, for example, respond to price incentives. When the price of a product falls, consumers tend to buy a greater quantity of the product. Conversely, when a product's price rises, consumers buy a lesser quantity. This predictable consumer response to a change in price is the foundation of the most famous law in economics—the law of demand. Similarly, businesses respond to profit incentives. Profit is the difference between the price of an item and the cost of producing the item. The lure of profit encourages businesses to seek the lowest cost inputs when producing a product. This desire for profit also motivates businesses to devote more resources to the production of goods for which there is a high demand. Conversely, the fear of business losses discourages the production of certain goods when input costs rise or the demand for these goods falls. Workers, savers, investors, and other marketplace participants also respond to a variety of invisible price signals to guide their decisions.

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