Key Concepts in Economics and Decision Making

We live in a world of scarcity. There just isn't enough of anything. Not enough money to buy everything we'd like. Not enough time to do all the things we'd like to do. That means people have to decide how to allocate their time or money or any other resource that is in scarce supply. Decision making is the essence of economics. All of economics is about the allocation of scarce resources. Resources are allocated by people making decisions. It's people deciding how much to work, people deciding what to buy, firms deciding what to sell and what kind of labor to hire. It all comes down to decisions in the end. Economics is the study of how societies manage their resources. In most countries, resources are allocated through decisions made by millions of households and firms. That's why economists study how people make decisions about what they buy, how much they work and how much they earn. and how much they save. My favorite definition of economics is over a century old. It's from Alfred Marshall, from his great textbook in the late 19th century. Marshall said that economics is the study of mankind in the ordinary business of life. And that captures economics perfectly. Every moment of your life, just about, your waking life, is involved with economics in one way or the other. Should I get married? Should I not get married? It's an emotional decision, but it's also an economic decision, because two salaries, one salary, child is born, how much does it cost to raise a child? All these are economic decisions. How an economy behaves reflects the behavior of all the individuals who make up that economy. So let's look at some central ideas of economics that deal with how individuals make decisions. People face trade-offs. Whenever any individual makes a decision, he's deciding between alternative courses of action. An individual has to decide how much to work, for example. So he faces a trade-off between work and leisure. A person goes to the store, he faces a trade-off between buying one good and buying another. All of our decisions at their heart involve trade-offs. is a college senior majoring in Latin American Studies. He's hoping to go to Washington when he graduates and work in international relations. So this fall, he's spending a lot of time at the Career Resource Center. Hello. Hi. Can I help you? Yeah, I'm here for an 11 o'clock meeting. Okay. Who's it with? Mike Sciola. Okay. I'll give him a call. As a college student, Eric faces a daily challenge. How to allocate his precious time. Thank you. Mm-hmm. Should he spend his time researching jobs in Washington for next year? Or should he be at the library studying for an upcoming exam? So when you decide to do something, like come to the Career Resource Center, then you do know that you're cutting out time that you could be spending reading or preparing for a job. preparing for a class. It's just a thing you have to prioritize about. Eric faces a trade-off. Society as a whole also faces trade-offs. Consider the decision facing a congressman, for example. He has to decide how much to allocate to the defense budget. That involves an essential trade-off for society. How much does society want to devote its resources to national defense? Guns. To what extent does it want to devote resources to producing consumer goods? Butter. Guns versus butter is one of the fundamental trade-offs that all societies face. Another kind of trade-off that societies face involves the environment. We all want cleaner air, but the trade-off can mean the loss of income or even the loss of jobs for some Americans. The Central Ohio Coal Company employed about 1,200 people when coal production was at its peak here in the late 1980s. But the coal from this region has a high sulfur content, and the Federal Clean Air Act restricts power plants from using such coal because it produces acid rain. J.D. Neiswanger is the president of the local mining union. We had our first layoff here in March. 1991, they laid off 160 people, and from there it's just kept going down and down. The mining company laid off its last employees in April 2000. What you're seeing behind us is... end of an era. When the last layoff occurred, this pit was shut down and our mining operation here in this area ceased. The finality of it is that we're finished is what's happened because of the Clean Air Act. It's a trade-off for cleaner air but also trades off jobs and good livelihood for a lot of people. That's what it does. Whenever you take regulation to control the environment or control pollution, you're incurring costs on a particular society. And those costs might come in terms of lost jobs, plant closings, mines being closed by using alternative to various fossil fuels. So that's a trade-off you'd make in the name of the environment. The cost of something is what you give up to get it. Jen Nascimento is a college junior and an English major. She's made the choice to go to college for four years. So what's the cost of her college education? There's the cost of tuition and the cost of buying books. In fact, one of the biggest costs of going into college is the fact that you spend your time there. And what you're giving up to go to college is the lost wages that you could have otherwise earned. So thinking about the cost, we shouldn't think of just the out-of-pocket cost. We need to think of the full opportunity cost, which means everything you've given up, including the wages from that job that you couldn't take. Nothing comes for free. Our time is worth something. If you decide that you're going to go to a ball game, you're going to give up something. What are you going to give up? Well, what else could you have done with those three hours? Perhaps you could have worked at a McDonald's and earned $15. Perhaps you could have written a prize-winning paper or painted a prize-winning painting and made thousands of dollars. or perhaps you could have had a nice cup of tea with your grandmother. There are trade-offs there. The cost of doing anything is what do you give up by doing it, and students always need to keep that in mind as they budget their time. The opportunity cost of going to college varies for different students. For Jen and most students, the cost is relatively low. since the likely alternative is a low-paying entry-level job. Julian Blanks, cross half court, taken away by Kobe Bryant, who is going to go the distance up and slams it home. But for a star high school athlete like Kobe Bryant, the opportunity cost of going to college was much higher. Perhaps the clearest example of opportunity cost comes in the case of athletes who are so good they can go straight from high school into the pros. What is the opportunity cost of going to college for someone like that? Well, take Kobe Bryant. Kobe Bryant was a star high school basketball player. He had the opportunity to go into the pros for several million dollars a year. If he decided to go to college instead, he would have had to give up that several million dollar a year salary. That's a very, very large opportunity cost. It's not surprising that athletes like that decide often not to pay the opportunity cost and to go straight into professional athletics. Rational people think at the margin. Few decisions in life are black and white. Most things involve some shade of gray. What that means is we're thinking not about doing something in its entirety or doing something not at all, but doing a little bit more here or there. thinking at the margin. Jadon Wright is a college student who thinks at the margin. Jadon is a senior with a heavy course load. She needs a lot of time to go to classes and to study at the library, but she also needs to make some spending money. So twice a week she works for several hours at the college's alumni office. Hi, Mr. Cohen. Hi, my name is Jadon Wright and I'm calling from Wesleyan University's Annual Fund. Jadon's problem is that she doesn't always have enough time to work at her campus job. But she doesn't have to quit her job. She can adjust her schedule in increments. I try to see what's coming up in the week and balance those things out. Sometimes I may have a lot of school work to do, so I may... I'm not sure. cut back on my working hours and sometimes I may not have that much school work to do and so I'll increase my working hours. Jadon makes her best decisions by thinking at the margin. That's what businesses do. General Motors, other auto companies do that kind of analysis all the time. Should we produce one more car or should we call it quits? If we produce one more car, what if nobody buys it? What if we drive down the price of our own product by oversupplying, by creating a glut? So again, the marginal analysis question is not, where have I been, but where do you stand now? What could you do with the next dollar in your pocket, with the next five minutes of time that you have to allot? The theater business in New York City also practices marginal analysis. In recent years, Broadway has been setting attendance records. But even in good times, many seats still go unsold. So theater owners and producers created TKTS. It's a discount sales outlet in Times Square, where theatergoers can buy half-priced seats a few hours before the performance. It's a great deal for everyone. The customers get a bargain, and the theater owners and producers increase their revenues. If you're a theater manager and I look at my house and I look at the theater and I realize, I've only sold three quarters of my tickets. Well, I'm willing to discount the remaining quarter of the tickets because I'd rather have one quarter of the price or one half the price of a ticket rather than have those tickets go, have those seats go totally empty. So at the margin, at the marginal cost, marginal revenue I'm gaining is really the choice between an empty seat or a seat sold at half price. Economists assume that rational people will only act if the marginal benefit of an action exceeds the marginal cost. JeDawn will adjust her schedule so that she can make money at her job and still have enough time to study. Broadway theater producers will price their tickets to maximize their profits. They'll both make better decisions by thinking at the margin. Whether it's how to manage her time, in Jadon's case, or how to price unsold theatre seats. People respond to incentives. Since people make decisions by comparing costs and benefits, their behavior may change when the costs and benefits change. People respond to incentives. Well, if I want my son to wash my car, I'll say, if you wash the car, you can use it tonight. That's an incentive. If I say, if you wash the car, I'll cut your allowance, he won't do it. That's a disincentive. A good example of people responding to incentives is how people respond to the price of gasoline. Across countries, we see very large differences in the price of gasoline. and we observe very large differences in the kinds of cars that people drive. The Europeans are heavily taxed on their gasoline. As a result, the Europeans drive very small cars. They can't afford to drive big cars with bad fuel economy. But in America we have relatively cheap oil still, and that means that we are able to fly, drive, pretty much wherever we want at low prices. In more recent years, when the The price of oil has been very low in real terms, especially compared to the early 1970s. Americans have switched back to driving really large cars. Sport utility vehicles are larger and often less fuel efficient than the cars that Americans were driving before the first oil crisis, which shows how much we respond to incentives. A few years ago, the mayor of New York declared a sales tax moratorium. He said, for this weekend, we're not going to charge taxes. Well, that was a tremendous incentive for people to do their shopping that weekend. And what do you know? The stores were flooded. The subways were crowded. Commuters clogged the bridges and tunnels from New Jersey and Long Island and Connecticut just to come in to do shopping. People do respond to incentives. Incentives regarding taxes from the government. Incentives regarding for sale signs and discount signs in store windows. The powerful impact of incentives on human behavior is important for those who design public policy. Smoking among young people is a health problem that concerns a lot of government officials. One of the surest ways of reducing youth smoking is to increase the price of cigarettes. Today I call for a combination of industry payments and penalties to increase the price of cigarettes by up to a dollar and a half a pack. One of the reasons that Congress and the President and other policymakers have been pushing for higher cigarette prices is that there's evidence that when the price of cigarettes rises, teens smoke less. And that's one of the reasons why there's a lot of attention to cigarette prices today, trying to make sure that they stay high enough so that teenagers are discouraged from smoking for that reason alone. Changing human behavior through the use of incentives or... disincentives can be a tricky business. Sometimes public policies can have effects that officials did not intend. Take safety belts for example. Safety belts are now required on cars and the intention of that is to save lives. And indeed other things being the same, wearing a safety belt does save a person's life in an accident. But of course other things aren't the same. There's evidence that behavior does change in response to the use of safety belts. In particular people tend to... drive faster and generally less carefully when they're wearing safety belts because they feel safer and that tends to increase accidents and offsets. Partially, and some people argue completely, the direct effect of safety bills. Many government policies are like that. If we mandate that everyone has a government pension, say, or that everyone participates in Social Security so that everyone is going to get retirement benefits through the Social Security system, people are going to have less incentive to save for retirement on their own. And that's an example of how a government policy can have the unintended consequences of altering people's behavior by altering their private incentives. The first four principles deal with how individuals make decisions. But in life, many of our decisions affect other people. The next three principles concern how people interact with each other. Trade can make everyone better off. One of the obvious but very important features of the modern economy is that people are not self-sufficient. That is, people don't grow their own food, make their own clothes, cut their own hair. People specialize. People do particular tasks and rely on other people to do other tasks for them. It's... Really the essence of why it is that economies can grow, why it is that markets are important, why it is that the whole science of economics is important. The idea that you... have something and I have something and if we exchange, each one of us is going to be better off is fundamentally what economics is all about. For example, take food production in the United States. The U.S. enjoys the cheapest food in the world, but it's grown by a very small percentage of the population, who use high technology to produce very efficiently. We could all grow our own food in our own backyard. That would be quite difficult. Instead, what we do is we rely on a few people to be farmers. They specialize in farming and become very good at it. And we buy the food from them and we produce what we're particularly good at. That specialization allows everyone, farmers and non-farmers, to achieve a higher standard of living. In medieval times, people were limited to buying what was grown or what was made in their small feudal community. As civilization has expanded, we've gained the ability to buy things from all around the world. Now, as a result of the internet, if you want lamb chops, you don't just have to stick with your local butcher. You can... Go online and order lamb chops directly from Auckland, New Zealand. So we've expanded the boundaries of trade, and that has created a more efficient economy. It has given consumers far wider variety of choices. At the same time, it's helped keep prices under control. Countries, as well as families, benefit from the ability to trade with one another. Well, the basic reason countries trade... ...is to get things cheaper from foreign countries than they could otherwise make at home, and to sell their products, which they're very good at making, to foreign countries. For example, say in Mexico, people are assembling TV sets. That's a labor-intensive process, not a very high-tech situation. The United States people are, say, manufacturing airplanes. Well, airplanes are a very high-tech process. It doesn't make sense for the U.S. to focus on making both because the cost of manufacturing... your television set, assembling them in the U.S., would be more expensive by using a higher-priced labor source. By doing it with Mexico, the Mexicans are able to focus and utilize their labor supply and a labor-intensive industry, then ship those goods across the border, and in exchange are able to import airplanes and other products from the U.S. that are higher tech. Markets are usually a good way to organize economic activity. The trading floor of the New York Mercantile Exchange is a microcosm of our free market economy. It's just like any other market, only a lot noisier. Here, deals are made, prices are negotiated, and that price information is transmitted to the outside world. A market is fundamentally a place in which people make exchanges, and when we say a market, we... generally mean that the exchanges are governed by prices. That prices changing are the method by which goods and services are allocated from one person to another or that prices are the means by which goods and services are rationed. A good example of that is a wholesale fruit market where farmers come to sell their fruit and vegetables and supermarket owners come to buy fruits and vegetables which they are then going to resell on to consumers. A stamp show is another kind of market that brings buyers and sellers together in one place. There's a lot of browsing and a lot of bargaining. Those two together. Can you do anything else? I already did. I already did. I did it as we went. I gave you a very good deal on this stamp in particular. It's like the stock market. You know, if somebody has an ask price, you give a bid price, and you know, if they're not happy with your price, they'll try to shop it around to other dealers, and they'll go for it. It's just plain R-190. We call our system a market economy. It's made up of huge numbers of markets like this one. Resources are allocated through the decisions of millions of firms and millions of households. Firms decide what to make and who to hire. ...higher. Individuals decide who to work for and how to spend their income. Everyone interacts in the marketplace. The man who first tried to explain how a market system works was Adam Smith. Smith was a brilliant philosopher who lived in Scotland in the 18th century. He published the first great book about economics, The Wealth of Nations, in 1776. One of the big surprises about market economies is that they work at all. Because after all, market economies are decentralized. There are thousands of buyers and thousands of sellers in many markets. Why does this degenerate into complete chaos? Well, Adam Smith said that markets in fact work very well. He said they're guided as if by an invisible hand that leads to a desirable allocation of resources. And one of the reasons to study economics is to understand how that invisible hand works. How is it that buyers and sellers interacting with one another in what could be a chaotic world, chaotic setting leads to a desirable outcome. The invisible hand that Adam Smith wrote about is the workings of self-interest by individuals in the economy. So his assumption is that if you look out for yourself and try to maximize your benefits and everyone else tries to do the same thing, everyone wins. So for example, if you have a catcher's mitt and I have $25, let's say, and I want to buy this catcher's mitt from you for $25 and you want to sell it to me, we both win. You wanted the $25 more than the mitt and I wanted the mitt more than the $25. And that's the invisible hand that works throughout the economy and makes things operate. How does the invisible hand work its magic? How does it lead markets to a desirable outcome? Well, it turns out that prices are are the key instrument. Prices are what signal to buyers how much to buy, and prices are what signal to sellers how much to produce and sell. Prices are, in some sense, the baton with which the invisible hand conducts the economic orchestra. One of the most important changes in the world during the past half century was the collapse of communism in Russia and Eastern Europe. Communism failed because it replaced the free market with government central planners. In the old Soviet Union, the government decided what was produced, how much was produced, and at what price to sell it. The system never really worked and was abandoned. They failed because communism basically puts power in the hands of bureaucrats. How is it bureaucrats are to know how much should be produced? If there are not price signals, if there's not supply and demand telling producers to produce more or create less, then... bureaucrats merely have to guess. One socialist economist had said, well, the bureaucrats can just see people lining up for goods, and that would tell them that more needs to be produced. Well, communism certainly produced long lines, but it didn't produce the goods and certainly didn't produce them in an advanced state at an economically efficient price. Government can sometimes improve market outcomes. Economists believe that markets are a very powerful way of organizing a society's scarce resources. But that doesn't mean that market outcomes are always absolutely perfect. And there's two essential reasons why the government might intervene. One is the market might fail to allocate resources. efficiently because of some market failure, or the market may fail to allocate resources in an equitable way. So the government might want to intervene either to correct the market failure or to achieve a better distribution of income. One reason markets fail to work efficiently is due to what economists call an externality. An externality is when a company or an individual creates something that has an impact beyond the immediate buyers and sellers of that product. If I buy a ghetto blaster and I put my favorite tape into it and I play it loudly, I don't have to pay any price when I play it loudly in a public space. for instance, and I affect other people's well-being or I affect other people's ability to enjoy their music from their ghetto blaster. So the fact that I don't have to pay anything to them means that the market price that I pay for my ghetto blaster and I pay for my music tape is really too low compared to the societal price of my enjoying my consumption from these two items. Air pollution is an example of an externality. When a power plant generates electricity, for example, its smokestacks may be belching out smoke that is carried for miles and miles. That smoke might be causing health problems for people. The company doesn't pay for that. The market doesn't force it to pay for that. And yet, there may be people choking in the streets. There may be people dying of emphysema. So there is a role for the government at that point to say, is there any way to make the situation better, to make the company somehow bear the costs, the social costs imposed on the community? Regulators in the economy over the last 30 years have tried to figure out how to handle that situation. Another possible cause of market failure is unchecked market power, such as a monopoly. Market power occurs when... one of the players in a market, either a firm or a person who's selling his services, is large relative to the market and is able to control some part of the market and manipulate prices. A good example is airline hubs. Airline hubs exist for a very good technical reason. It helps an airline if it can have flights that are all going out of one city because it helps coordinate passengers. So there's a good reason for airline hubs to exist. But if you live in a city... Say Pittsburgh, where a major airline has its hub, it's very hard to choose to fly on an airline that doesn't have its hub in Pittsburgh. And that means that the airline that has its hub in Pittsburgh has market power and generally can set the prices a little bit higher for local Pittsburgh residents than it would be able to set the prices if those people could choose among 10 airlines equally well or 20 airlines equally well. Your local television cable company may be another example, if it's the only supplier in your neighborhood. What that means is that that cable company has tremendous power over the price. It charges you. And that means that on its own, the cable company is not going to charge what price it would charge you. would under competition, but charge a much higher price. And that leaves open the possibility of market failure, and it leaves open the possibility that the government can step in and improve the situation. Often, government does step in. In 1999, the federal government helped satellite television companies become more competitive with the cable companies. It did so by ending restrictions against transmitting local television channels by satellite. Another reason government intervenes in the economy is to promote greater equity or fairness. Our market economy left on its own doesn't guarantee that wealth gets distributed evenly. A market system rewards people according to their ability to produce things that other people are willing to pay for. Professional athletes command million-dollar salaries. Child care workers are often poorly paid. The invisible hand of the market doesn't ensure that everyone receives enough to eat or adequate health care. The role of public policy is often, I think, is a check on markets. Some people believe that public policy should be designed to promote market activity and let the market find a way no matter what happens. You know, wouldn't it take all? Some other people believe that markets, because they have no conscience and they may not necessarily trust individuals to make the right social choices, will impose various ways of redistributing wealth, from taxes to promoting programs such as affirmative action to setting minimum wages. These type of social public policy programs are designed to be a balancing effort against unchecked market power. The problem is when you find the market making a mistake, when you find a market imperfection, it's very tempting to say, well, government fix this. But it simply raises the question, can the problem be fixed? How can the government solve the problem? And that's where economists over the last 50 years have changed their point of view. They used to be more eager for the government to step in and correct the problem. Now they recognize how complex a situation it is. whenever the government does get involved. We began this video talking about how individuals make economic decisions. We've just been looking at how people interact with one another in the marketplace. All those decisions and interactions make up the economy. Now, we'll look at the economy as a whole. A country's standard of living depends on its ability to produce goods and services. Differences in living standards around the world are dramatic. In 1998, the average American had a yearly income of $31,500. In Mexico, the average yearly income was $8,300. And in India, the figure was just above $1,700 a year. Not surprisingly, these differences in income are reflected in the various measures of quality of life. Americans have more cars, better nutrition, and longer life expectancies than citizens in a country like India. What explains these large differences in living standards among nations? If we compare the rich countries and the poor countries, the difference that explains it is productivity. That is, the rich countries... have workers that are very productive. They can produce a lot of goods and services for every hour of work, whereas poor countries have workers that are less productive. That is, they produce fewer goods and services for every hour of work. Now, that raises the question, of course, of what explains those differences in productivity. And of course, there are many different explanations for that. It includes things like accumulation of capital. It includes the skills of the workforce. It includes the openness of the economy. There are a lot of explanations for productivity. But whenever you want to explain differences between rich and poor countries, productivity is the key. The relationship between productivity and living standards is a challenge to government policies. Since rising productivity is critical to economic well-being, how can government provide the best support? One way in which the government can stimulate rapid growth and productivity is through a better educated workforce. And indeed, one of the reasons the government often cares about education policy is because of its impact on the skills of the workforce. and in turn influences the productivity of workers down the line. Typically, the US, Western Europe and Japan are states that are very economically free, that they've encouraged development, that they've encouraged entrepreneurship, that they've encouraged technological advantages, with relatively low levels of government involvement in the economy. In the US, the government is really involved in about one-twentieth, one-fifth of the economy. In states that are less well developed, you find the government is really the dominant buyer, the dominant actor in the economy. economy. And we've seen the problems with planned economies and those economies that don't have economic freedom, their productivity is really suppressed. In the U.S., we do everything we can, hopefully, to promote productivity by promoting economic freedom and liberty. In the United States, we are becoming a wealthier society, not because we're mining more from mine shafts, not because we're smelting more, not because we're vulcanizing more. We're becoming wealthier because of our brains, because of our brains. of the software algorithms, because of the formula that pharmaceutical scientists come up with, because of the software, because of the entertainment products that George Lucas and Steven Spielberg create. So it's the creativity, the patents, the research and development that create the ability to become wealthier. Other countries may be just as smart, maybe have more geniuses. The genius though of the U.S. economy and of democratic capitalist economies is that they take brain power and they figure out how to channel it into a free market and consumers in the end benefit from this. Prices rise when the government prints too much money. The 1970s were a period of steeply rising prices, or inflation. At the worst, in the late 1970s, inflation was running at 10%. That means the average price in the economy, typical price, was rising about 10% per year. In the 1970s, inflation started with some shocks driven by OPEC, the Organization of Petroleum Exporting Countries. Oil prices skyrocketed, and that started inflation in the United States. Economists define inflation as a rise in the overall level of prices. Inflation is any time the supply of money has increased. I say the government printing more money so that we have more dollars chasing the same number of goods and the price of goods rises simply to reflect the increase in the amount of money that is available. That's classic inflation. The Federal Reserve Board in the United States determines how much money is in circulation. It's very tempting to print lots of money. If you print lots of money, people temporarily feel wealthier. Politicians generally... urged the Federal Reserve Board, historically have urged the Federal Reserve Board to be easy with money, to print lots of it. Why not? It doesn't cost anything to run the printing press other than a little bit of electricity and a little bit of paper, and yet it makes people feel good when the bills are floating around the country. In the long run, actually in the medium term, within months, if the Federal Reserve Board is not responsible, if it's printing too much money, then that begins pushing prices up in the economy. As money becomes more available, its value shrinks and prices rise. Once inflation starts spiraling upwards, it's hard to get it under control. In the 1990s, we haven't had very much inflation, and the main reason is that we've had a lot of stability in the money supply of the United States. The government hasn't been printing a lot of extra money, and goods and services have been growing at about the same rate as the amount of money that's available in the economy. And if they grow at about the same rate, then we don't end up with very much inflation, because we never have this situation where we have too much money chasing. too few goods. The slow inflation of the 90s is a result of vigilant anti-inflationary policies at the Federal Reserve. It has slowed down the printing presses and maintained slow, stable growth in the quantity of money circulating in the economy. Society faces a short-run trade-off between inflation and unemployment. The Federal Reserve Chairman is considered by many to be the second most powerful person in Washington, next to the President. But a Fed Chairman like Alan Greenspan has a most difficult job. He's supposed to keep inflation under control and also ensure that unemployment stays low. He can't achieve both those goals. He holds only one policy instrument. the money supply. If he prints a lot of money, that's going to stimulate the economy and reduce unemployment, but it's also going to lead to inflation in the long run. By contrast, if he contracts the money supply, that's going to tend to raise unemployment and mean lower inflation in the long run. So while he'd like both unemployment and inflation to be low all the time, since he only has one policy instrument, he can't always achieve that. The short-run trade-off between inflation and unemployment, economists call the Phillips Curve, after the man who first studied this relationship. The Phillips Curve is a relationship between inflation and unemployment that says that when inflation is high, unemployment is low, and when inflation is low, unemployment is high. What it basically means is that when monetary and fiscal policy makers expand the economy by increasing government purchases, cutting taxes, or printing money, That's going to tend to drive inflation up and unemployment down. Conversely, if they tend to contract the economy by printing less money, or contracting the money supply, by raising taxes or cutting government spending, that's going to tend to raise unemployment and lower inflation. Today, the Phillips Curve is a controversial topic among economists. Some believe that the trade-off between inflation and unemployment no longer exists. They point to the past several years. years when inflation and unemployment declined in tandem. The Phillips curve was really a simple model that plotted on one graph the unemployment rate and the inflation rate. And it showed during the 1960s and part of the 1970s that there seemed to be a kind of trade-off. That if you wanted to battle unemployment, you could give up the fight against inflation and vice versa. We've learned over the last 20 years that trade-off is not really there. the markets have become much more efficient, much more rational. I would predict that the Phillips curve will again look like it is operative. If it doesn't within the next 10 years, I would be extremely surprised. I think that this is a relatively unique period in our economic history, as opposed to a new regime that is going to persist forever. There are always periods in economic history when the Phillips curve has not looked like it is applying. for at least some period of time, but it tends to come back again and again as a historical or an empirical relationship that we observe. Economists may disagree about its validity today, but the Phillips curve is crucial for understanding many developments in the economy. Policymakers in Washington can influence the course of inflation and employment by changing what government spends and taxes, or the amount of money it prints. Because these actions are potentially so powerful, economic policy making is always a subject of fierce debate. So here they are, the basic concepts of economics. They're the intellectual backbone of what you will be studying in economics. They offer insights into how economists think about people and their decision-making, about markets and entire economies. You'll see that a few fundamental ideas can be applied to many different situations.

We live in a world of scarcity. There just isn't enough of anything. Not enough money to buy everything we'd like.

Not enough time to do all the things we'd like to do. That means people have to decide how to allocate their time or money or any other resource that is in scarce supply. Decision making is the essence of economics. All of economics is about the allocation of scarce resources. Resources are allocated by people making decisions.

It's people deciding how much to work, people deciding what to buy, firms deciding what to sell and what kind of labor to hire. It all comes down to decisions in the end. Economics is the study of how societies manage their resources.

In most countries, resources are allocated through decisions made by millions of households and firms. That's why economists study how people make decisions about what they buy, how much they work and how much they earn. and how much they save.

My favorite definition of economics is over a century old. It's from Alfred Marshall, from his great textbook in the late 19th century. Marshall said that economics is the study of mankind in the ordinary business of life. And that captures economics perfectly.

Every moment of your life, just about, your waking life, is involved with economics in one way or the other. Should I get married? Should I not get married? It's an emotional decision, but it's also an economic decision, because two salaries, one salary, child is born, how much does it cost to raise a child?

All these are economic decisions. How an economy behaves reflects the behavior of all the individuals who make up that economy. So let's look at some central ideas of economics that deal with how individuals make decisions. People face trade-offs.

Whenever any individual makes a decision, he's deciding between alternative courses of action. An individual has to decide how much to work, for example. So he faces a trade-off between work and leisure.

A person goes to the store, he faces a trade-off between buying one good and buying another. All of our decisions at their heart involve trade-offs. is a college senior majoring in Latin American Studies. He's hoping to go to Washington when he graduates and work in international relations.

So this fall, he's spending a lot of time at the Career Resource Center. Hello. Hi.

Can I help you? Yeah, I'm here for an 11 o'clock meeting. Okay.

Who's it with? Mike Sciola. Okay.

I'll give him a call. As a college student, Eric faces a daily challenge. How to allocate his precious time.

Thank you. Mm-hmm. Should he spend his time researching jobs in Washington for next year? Or should he be at the library studying for an upcoming exam? So when you decide to do something, like come to the Career Resource Center, then you do know that you're cutting out time that you could be spending reading or preparing for a job.

preparing for a class. It's just a thing you have to prioritize about. Eric faces a trade-off.

Society as a whole also faces trade-offs. Consider the decision facing a congressman, for example. He has to decide how much to allocate to the defense budget. That involves an essential trade-off for society. How much does society want to devote its resources to national defense?

Guns. To what extent does it want to devote resources to producing consumer goods? Butter. Guns versus butter is one of the fundamental trade-offs that all societies face.

Another kind of trade-off that societies face involves the environment. We all want cleaner air, but the trade-off can mean the loss of income or even the loss of jobs for some Americans. The Central Ohio Coal Company employed about 1,200 people when coal production was at its peak here in the late 1980s.

But the coal from this region has a high sulfur content, and the Federal Clean Air Act restricts power plants from using such coal because it produces acid rain. J.D. Neiswanger is the president of the local mining union.

We had our first layoff here in March. 1991, they laid off 160 people, and from there it's just kept going down and down. The mining company laid off its last employees in April 2000. What you're seeing behind us is...

end of an era. When the last layoff occurred, this pit was shut down and our mining operation here in this area ceased. The finality of it is that we're finished is what's happened because of the Clean Air Act.

It's a trade-off for cleaner air but also trades off jobs and good livelihood for a lot of people. That's what it does. Whenever you take regulation to control the environment or control pollution, you're incurring costs on a particular society. And those costs might come in terms of lost jobs, plant closings, mines being closed by using alternative to various fossil fuels.

So that's a trade-off you'd make in the name of the environment. The cost of something is what you give up to get it. Jen Nascimento is a college junior and an English major. She's made the choice to go to college for four years. So what's the cost of her college education?

There's the cost of tuition and the cost of buying books. In fact, one of the biggest costs of going into college is the fact that you spend your time there. And what you're giving up to go to college is the lost wages that you could have otherwise earned.

So thinking about the cost, we shouldn't think of just the out-of-pocket cost. We need to think of the full opportunity cost, which means everything you've given up, including the wages from that job that you couldn't take. Nothing comes for free. Our time is worth something.

If you decide that you're going to go to a ball game, you're going to give up something. What are you going to give up? Well, what else could you have done with those three hours?

Perhaps you could have worked at a McDonald's and earned $15. Perhaps you could have written a prize-winning paper or painted a prize-winning painting and made thousands of dollars. or perhaps you could have had a nice cup of tea with your grandmother. There are trade-offs there.

The cost of doing anything is what do you give up by doing it, and students always need to keep that in mind as they budget their time. The opportunity cost of going to college varies for different students. For Jen and most students, the cost is relatively low.

since the likely alternative is a low-paying entry-level job. Julian Blanks, cross half court, taken away by Kobe Bryant, who is going to go the distance up and slams it home. But for a star high school athlete like Kobe Bryant, the opportunity cost of going to college was much higher.

Perhaps the clearest example of opportunity cost comes in the case of athletes who are so good they can go straight from high school into the pros. What is the opportunity cost of going to college for someone like that? Well, take Kobe Bryant.

Kobe Bryant was a star high school basketball player. He had the opportunity to go into the pros for several million dollars a year. If he decided to go to college instead, he would have had to give up that several million dollar a year salary.

That's a very, very large opportunity cost. It's not surprising that athletes like that decide often not to pay the opportunity cost and to go straight into professional athletics. Rational people think at the margin. Few decisions in life are black and white. Most things involve some shade of gray.

What that means is we're thinking not about doing something in its entirety or doing something not at all, but doing a little bit more here or there. thinking at the margin. Jadon Wright is a college student who thinks at the margin. Jadon is a senior with a heavy course load.

She needs a lot of time to go to classes and to study at the library, but she also needs to make some spending money. So twice a week she works for several hours at the college's alumni office. Hi, Mr. Cohen.

Hi, my name is Jadon Wright and I'm calling from Wesleyan University's Annual Fund. Jadon's problem is that she doesn't always have enough time to work at her campus job. But she doesn't have to quit her job.

She can adjust her schedule in increments. I try to see what's coming up in the week and balance those things out. Sometimes I may have a lot of school work to do, so I may... I'm not sure.

cut back on my working hours and sometimes I may not have that much school work to do and so I'll increase my working hours. Jadon makes her best decisions by thinking at the margin. That's what businesses do. General Motors, other auto companies do that kind of analysis all the time. Should we produce one more car or should we call it quits?

If we produce one more car, what if nobody buys it? What if we drive down the price of our own product by oversupplying, by creating a glut? So again, the marginal analysis question is not, where have I been, but where do you stand now?

What could you do with the next dollar in your pocket, with the next five minutes of time that you have to allot? The theater business in New York City also practices marginal analysis. In recent years, Broadway has been setting attendance records.

But even in good times, many seats still go unsold. So theater owners and producers created TKTS. It's a discount sales outlet in Times Square, where theatergoers can buy half-priced seats a few hours before the performance.

It's a great deal for everyone. The customers get a bargain, and the theater owners and producers increase their revenues. If you're a theater manager and I look at my house and I look at the theater and I realize, I've only sold three quarters of my tickets. Well, I'm willing to discount the remaining quarter of the tickets because I'd rather have one quarter of the price or one half the price of a ticket rather than have those tickets go, have those seats go totally empty.

So at the margin, at the marginal cost, marginal revenue I'm gaining is really the choice between an empty seat or a seat sold at half price. Economists assume that rational people will only act if the marginal benefit of an action exceeds the marginal cost. JeDawn will adjust her schedule so that she can make money at her job and still have enough time to study.

Broadway theater producers will price their tickets to maximize their profits. They'll both make better decisions by thinking at the margin. Whether it's how to manage her time, in Jadon's case, or how to price unsold theatre seats. People respond to incentives. Since people make decisions by comparing costs and benefits, their behavior may change when the costs and benefits change.

People respond to incentives. Well, if I want my son to wash my car, I'll say, if you wash the car, you can use it tonight. That's an incentive. If I say, if you wash the car, I'll cut your allowance, he won't do it. That's a disincentive.

A good example of people responding to incentives is how people respond to the price of gasoline. Across countries, we see very large differences in the price of gasoline. and we observe very large differences in the kinds of cars that people drive. The Europeans are heavily taxed on their gasoline.

As a result, the Europeans drive very small cars. They can't afford to drive big cars with bad fuel economy. But in America we have relatively cheap oil still, and that means that we are able to fly, drive, pretty much wherever we want at low prices.

In more recent years, when the The price of oil has been very low in real terms, especially compared to the early 1970s. Americans have switched back to driving really large cars. Sport utility vehicles are larger and often less fuel efficient than the cars that Americans were driving before the first oil crisis, which shows how much we respond to incentives.

A few years ago, the mayor of New York declared a sales tax moratorium. He said, for this weekend, we're not going to charge taxes. Well, that was a tremendous incentive for people to do their shopping that weekend.

And what do you know? The stores were flooded. The subways were crowded.

Commuters clogged the bridges and tunnels from New Jersey and Long Island and Connecticut just to come in to do shopping. People do respond to incentives. Incentives regarding taxes from the government. Incentives regarding for sale signs and discount signs in store windows.

The powerful impact of incentives on human behavior is important for those who design public policy. Smoking among young people is a health problem that concerns a lot of government officials. One of the surest ways of reducing youth smoking is to increase the price of cigarettes.

Today I call for a combination of industry payments and penalties to increase the price of cigarettes by up to a dollar and a half a pack. One of the reasons that Congress and the President and other policymakers have been pushing for higher cigarette prices is that there's evidence that when the price of cigarettes rises, teens smoke less. And that's one of the reasons why there's a lot of attention to cigarette prices today, trying to make sure that they stay high enough so that teenagers are discouraged from smoking for that reason alone. Changing human behavior through the use of incentives or...

disincentives can be a tricky business. Sometimes public policies can have effects that officials did not intend. Take safety belts for example. Safety belts are now required on cars and the intention of that is to save lives. And indeed other things being the same, wearing a safety belt does save a person's life in an accident.

But of course other things aren't the same. There's evidence that behavior does change in response to the use of safety belts. In particular people tend to... drive faster and generally less carefully when they're wearing safety belts because they feel safer and that tends to increase accidents and offsets. Partially, and some people argue completely, the direct effect of safety bills.

Many government policies are like that. If we mandate that everyone has a government pension, say, or that everyone participates in Social Security so that everyone is going to get retirement benefits through the Social Security system, people are going to have less incentive to save for retirement on their own. And that's an example of how a government policy can have the unintended consequences of altering people's behavior by altering their private incentives.

The first four principles deal with how individuals make decisions. But in life, many of our decisions affect other people. The next three principles concern how people interact with each other.

Trade can make everyone better off. One of the obvious but very important features of the modern economy is that people are not self-sufficient. That is, people don't grow their own food, make their own clothes, cut their own hair. People specialize. People do particular tasks and rely on other people to do other tasks for them.

It's... Really the essence of why it is that economies can grow, why it is that markets are important, why it is that the whole science of economics is important. The idea that you...

have something and I have something and if we exchange, each one of us is going to be better off is fundamentally what economics is all about. For example, take food production in the United States. The U.S. enjoys the cheapest food in the world, but it's grown by a very small percentage of the population, who use high technology to produce very efficiently. We could all grow our own food in our own backyard.

That would be quite difficult. Instead, what we do is we rely on a few people to be farmers. They specialize in farming and become very good at it. And we buy the food from them and we produce what we're particularly good at.

That specialization allows everyone, farmers and non-farmers, to achieve a higher standard of living. In medieval times, people were limited to buying what was grown or what was made in their small feudal community. As civilization has expanded, we've gained the ability to buy things from all around the world.

Now, as a result of the internet, if you want lamb chops, you don't just have to stick with your local butcher. You can... Go online and order lamb chops directly from Auckland, New Zealand.

So we've expanded the boundaries of trade, and that has created a more efficient economy. It has given consumers far wider variety of choices. At the same time, it's helped keep prices under control. Countries, as well as families, benefit from the ability to trade with one another. Well, the basic reason countries trade...

...is to get things cheaper from foreign countries than they could otherwise make at home, and to sell their products, which they're very good at making, to foreign countries. For example, say in Mexico, people are assembling TV sets. That's a labor-intensive process, not a very high-tech situation. The United States people are, say, manufacturing airplanes.

Well, airplanes are a very high-tech process. It doesn't make sense for the U.S. to focus on making both because the cost of manufacturing... your television set, assembling them in the U.S., would be more expensive by using a higher-priced labor source. By doing it with Mexico, the Mexicans are able to focus and utilize their labor supply and a labor-intensive industry, then ship those goods across the border, and in exchange are able to import airplanes and other products from the U.S. that are higher tech.

Markets are usually a good way to organize economic activity. The trading floor of the New York Mercantile Exchange is a microcosm of our free market economy. It's just like any other market, only a lot noisier.

Here, deals are made, prices are negotiated, and that price information is transmitted to the outside world. A market is fundamentally a place in which people make exchanges, and when we say a market, we... generally mean that the exchanges are governed by prices. That prices changing are the method by which goods and services are allocated from one person to another or that prices are the means by which goods and services are rationed. A good example of that is a wholesale fruit market where farmers come to sell their fruit and vegetables and supermarket owners come to buy fruits and vegetables which they are then going to resell on to consumers.

A stamp show is another kind of market that brings buyers and sellers together in one place. There's a lot of browsing and a lot of bargaining. Those two together.

Can you do anything else? I already did. I already did.

I did it as we went. I gave you a very good deal on this stamp in particular. It's like the stock market.

You know, if somebody has an ask price, you give a bid price, and you know, if they're not happy with your price, they'll try to shop it around to other dealers, and they'll go for it. It's just plain R-190. We call our system a market economy.

It's made up of huge numbers of markets like this one. Resources are allocated through the decisions of millions of firms and millions of households. Firms decide what to make and who to hire.

...higher. Individuals decide who to work for and how to spend their income. Everyone interacts in the marketplace. The man who first tried to explain how a market system works was Adam Smith. Smith was a brilliant philosopher who lived in Scotland in the 18th century.

He published the first great book about economics, The Wealth of Nations, in 1776. One of the big surprises about market economies is that they work at all. Because after all, market economies are decentralized. There are thousands of buyers and thousands of sellers in many markets.

Why does this degenerate into complete chaos? Well, Adam Smith said that markets in fact work very well. He said they're guided as if by an invisible hand that leads to a desirable allocation of resources.

And one of the reasons to study economics is to understand how that invisible hand works. How is it that buyers and sellers interacting with one another in what could be a chaotic world, chaotic setting leads to a desirable outcome. The invisible hand that Adam Smith wrote about is the workings of self-interest by individuals in the economy.

So his assumption is that if you look out for yourself and try to maximize your benefits and everyone else tries to do the same thing, everyone wins. So for example, if you have a catcher's mitt and I have $25, let's say, and I want to buy this catcher's mitt from you for $25 and you want to sell it to me, we both win. You wanted the $25 more than the mitt and I wanted the mitt more than the $25. And that's the invisible hand that works throughout the economy and makes things operate.

How does the invisible hand work its magic? How does it lead markets to a desirable outcome? Well, it turns out that prices are are the key instrument.

Prices are what signal to buyers how much to buy, and prices are what signal to sellers how much to produce and sell. Prices are, in some sense, the baton with which the invisible hand conducts the economic orchestra. One of the most important changes in the world during the past half century was the collapse of communism in Russia and Eastern Europe. Communism failed because it replaced the free market with government central planners.

In the old Soviet Union, the government decided what was produced, how much was produced, and at what price to sell it. The system never really worked and was abandoned. They failed because communism basically puts power in the hands of bureaucrats. How is it bureaucrats are to know how much should be produced?

If there are not price signals, if there's not supply and demand telling producers to produce more or create less, then... bureaucrats merely have to guess. One socialist economist had said, well, the bureaucrats can just see people lining up for goods, and that would tell them that more needs to be produced. Well, communism certainly produced long lines, but it didn't produce the goods and certainly didn't produce them in an advanced state at an economically efficient price.

Government can sometimes improve market outcomes. Economists believe that markets are a very powerful way of organizing a society's scarce resources. But that doesn't mean that market outcomes are always absolutely perfect.

And there's two essential reasons why the government might intervene. One is the market might fail to allocate resources. efficiently because of some market failure, or the market may fail to allocate resources in an equitable way. So the government might want to intervene either to correct the market failure or to achieve a better distribution of income.

One reason markets fail to work efficiently is due to what economists call an externality. An externality is when a company or an individual creates something that has an impact beyond the immediate buyers and sellers of that product. If I buy a ghetto blaster and I put my favorite tape into it and I play it loudly, I don't have to pay any price when I play it loudly in a public space. for instance, and I affect other people's well-being or I affect other people's ability to enjoy their music from their ghetto blaster.

So the fact that I don't have to pay anything to them means that the market price that I pay for my ghetto blaster and I pay for my music tape is really too low compared to the societal price of my enjoying my consumption from these two items. Air pollution is an example of an externality. When a power plant generates electricity, for example, its smokestacks may be belching out smoke that is carried for miles and miles. That smoke might be causing health problems for people.

The company doesn't pay for that. The market doesn't force it to pay for that. And yet, there may be people choking in the streets.

There may be people dying of emphysema. So there is a role for the government at that point to say, is there any way to make the situation better, to make the company somehow bear the costs, the social costs imposed on the community? Regulators in the economy over the last 30 years have tried to figure out how to handle that situation.

Another possible cause of market failure is unchecked market power, such as a monopoly. Market power occurs when... one of the players in a market, either a firm or a person who's selling his services, is large relative to the market and is able to control some part of the market and manipulate prices.

A good example is airline hubs. Airline hubs exist for a very good technical reason. It helps an airline if it can have flights that are all going out of one city because it helps coordinate passengers.

So there's a good reason for airline hubs to exist. But if you live in a city... Say Pittsburgh, where a major airline has its hub, it's very hard to choose to fly on an airline that doesn't have its hub in Pittsburgh.

And that means that the airline that has its hub in Pittsburgh has market power and generally can set the prices a little bit higher for local Pittsburgh residents than it would be able to set the prices if those people could choose among 10 airlines equally well or 20 airlines equally well. Your local television cable company may be another example, if it's the only supplier in your neighborhood. What that means is that that cable company has tremendous power over the price. It charges you. And that means that on its own, the cable company is not going to charge what price it would charge you.

would under competition, but charge a much higher price. And that leaves open the possibility of market failure, and it leaves open the possibility that the government can step in and improve the situation. Often, government does step in.

In 1999, the federal government helped satellite television companies become more competitive with the cable companies. It did so by ending restrictions against transmitting local television channels by satellite. Another reason government intervenes in the economy is to promote greater equity or fairness.

Our market economy left on its own doesn't guarantee that wealth gets distributed evenly. A market system rewards people according to their ability to produce things that other people are willing to pay for. Professional athletes command million-dollar salaries.

Child care workers are often poorly paid. The invisible hand of the market doesn't ensure that everyone receives enough to eat or adequate health care. The role of public policy is often, I think, is a check on markets.

Some people believe that public policy should be designed to promote market activity and let the market find a way no matter what happens. You know, wouldn't it take all? Some other people believe that markets, because they have no conscience and they may not necessarily trust individuals to make the right social choices, will impose various ways of redistributing wealth, from taxes to promoting programs such as affirmative action to setting minimum wages.

These type of social public policy programs are designed to be a balancing effort against unchecked market power. The problem is when you find the market making a mistake, when you find a market imperfection, it's very tempting to say, well, government fix this. But it simply raises the question, can the problem be fixed?

How can the government solve the problem? And that's where economists over the last 50 years have changed their point of view. They used to be more eager for the government to step in and correct the problem.

Now they recognize how complex a situation it is. whenever the government does get involved. We began this video talking about how individuals make economic decisions. We've just been looking at how people interact with one another in the marketplace. All those decisions and interactions make up the economy.

Now, we'll look at the economy as a whole. A country's standard of living depends on its ability to produce goods and services. Differences in living standards around the world are dramatic.

In 1998, the average American had a yearly income of $31,500. In Mexico, the average yearly income was $8,300. And in India, the figure was just above $1,700 a year.

Not surprisingly, these differences in income are reflected in the various measures of quality of life. Americans have more cars, better nutrition, and longer life expectancies than citizens in a country like India. What explains these large differences in living standards among nations? If we compare the rich countries and the poor countries, the difference that explains it is productivity. That is, the rich countries...

have workers that are very productive. They can produce a lot of goods and services for every hour of work, whereas poor countries have workers that are less productive. That is, they produce fewer goods and services for every hour of work.

Now, that raises the question, of course, of what explains those differences in productivity. And of course, there are many different explanations for that. It includes things like accumulation of capital.

It includes the skills of the workforce. It includes the openness of the economy. There are a lot of explanations for productivity. But whenever you want to explain differences between rich and poor countries, productivity is the key.

The relationship between productivity and living standards is a challenge to government policies. Since rising productivity is critical to economic well-being, how can government provide the best support? One way in which the government can stimulate rapid growth and productivity is through a better educated workforce. And indeed, one of the reasons the government often cares about education policy is because of its impact on the skills of the workforce. and in turn influences the productivity of workers down the line.

Typically, the US, Western Europe and Japan are states that are very economically free, that they've encouraged development, that they've encouraged entrepreneurship, that they've encouraged technological advantages, with relatively low levels of government involvement in the economy. In the US, the government is really involved in about one-twentieth, one-fifth of the economy. In states that are less well developed, you find the government is really the dominant buyer, the dominant actor in the economy.

economy. And we've seen the problems with planned economies and those economies that don't have economic freedom, their productivity is really suppressed. In the U.S., we do everything we can, hopefully, to promote productivity by promoting economic freedom and liberty.

In the United States, we are becoming a wealthier society, not because we're mining more from mine shafts, not because we're smelting more, not because we're vulcanizing more. We're becoming wealthier because of our brains, because of our brains. of the software algorithms, because of the formula that pharmaceutical scientists come up with, because of the software, because of the entertainment products that George Lucas and Steven Spielberg create. So it's the creativity, the patents, the research and development that create the ability to become wealthier.

Other countries may be just as smart, maybe have more geniuses. The genius though of the U.S. economy and of democratic capitalist economies is that they take brain power and they figure out how to channel it into a free market and consumers in the end benefit from this. Prices rise when the government prints too much money.

The 1970s were a period of steeply rising prices, or inflation. At the worst, in the late 1970s, inflation was running at 10%. That means the average price in the economy, typical price, was rising about 10% per year.

In the 1970s, inflation started with some shocks driven by OPEC, the Organization of Petroleum Exporting Countries. Oil prices skyrocketed, and that started inflation in the United States. Economists define inflation as a rise in the overall level of prices. Inflation is any time the supply of money has increased. I say the government printing more money so that we have more dollars chasing the same number of goods and the price of goods rises simply to reflect the increase in the amount of money that is available.

That's classic inflation. The Federal Reserve Board in the United States determines how much money is in circulation. It's very tempting to print lots of money. If you print lots of money, people temporarily feel wealthier.

Politicians generally... urged the Federal Reserve Board, historically have urged the Federal Reserve Board to be easy with money, to print lots of it. Why not? It doesn't cost anything to run the printing press other than a little bit of electricity and a little bit of paper, and yet it makes people feel good when the bills are floating around the country. In the long run, actually in the medium term, within months, if the Federal Reserve Board is not responsible, if it's printing too much money, then that begins pushing prices up in the economy.

As money becomes more available, its value shrinks and prices rise. Once inflation starts spiraling upwards, it's hard to get it under control. In the 1990s, we haven't had very much inflation, and the main reason is that we've had a lot of stability in the money supply of the United States.

The government hasn't been printing a lot of extra money, and goods and services have been growing at about the same rate as the amount of money that's available in the economy. And if they grow at about the same rate, then we don't end up with very much inflation, because we never have this situation where we have too much money chasing. too few goods. The slow inflation of the 90s is a result of vigilant anti-inflationary policies at the Federal Reserve.

It has slowed down the printing presses and maintained slow, stable growth in the quantity of money circulating in the economy. Society faces a short-run trade-off between inflation and unemployment. The Federal Reserve Chairman is considered by many to be the second most powerful person in Washington, next to the President. But a Fed Chairman like Alan Greenspan has a most difficult job. He's supposed to keep inflation under control and also ensure that unemployment stays low.

He can't achieve both those goals. He holds only one policy instrument. the money supply.

If he prints a lot of money, that's going to stimulate the economy and reduce unemployment, but it's also going to lead to inflation in the long run. By contrast, if he contracts the money supply, that's going to tend to raise unemployment and mean lower inflation in the long run. So while he'd like both unemployment and inflation to be low all the time, since he only has one policy instrument, he can't always achieve that.

The short-run trade-off between inflation and unemployment, economists call the Phillips Curve, after the man who first studied this relationship. The Phillips Curve is a relationship between inflation and unemployment that says that when inflation is high, unemployment is low, and when inflation is low, unemployment is high. What it basically means is that when monetary and fiscal policy makers expand the economy by increasing government purchases, cutting taxes, or printing money, That's going to tend to drive inflation up and unemployment down. Conversely, if they tend to contract the economy by printing less money, or contracting the money supply, by raising taxes or cutting government spending, that's going to tend to raise unemployment and lower inflation. Today, the Phillips Curve is a controversial topic among economists.

Some believe that the trade-off between inflation and unemployment no longer exists. They point to the past several years. years when inflation and unemployment declined in tandem. The Phillips curve was really a simple model that plotted on one graph the unemployment rate and the inflation rate.

And it showed during the 1960s and part of the 1970s that there seemed to be a kind of trade-off. That if you wanted to battle unemployment, you could give up the fight against inflation and vice versa. We've learned over the last 20 years that trade-off is not really there.

the markets have become much more efficient, much more rational. I would predict that the Phillips curve will again look like it is operative. If it doesn't within the next 10 years, I would be extremely surprised. I think that this is a relatively unique period in our economic history, as opposed to a new regime that is going to persist forever.

There are always periods in economic history when the Phillips curve has not looked like it is applying. for at least some period of time, but it tends to come back again and again as a historical or an empirical relationship that we observe. Economists may disagree about its validity today, but the Phillips curve is crucial for understanding many developments in the economy.

Policymakers in Washington can influence the course of inflation and employment by changing what government spends and taxes, or the amount of money it prints. Because these actions are potentially so powerful, economic policy making is always a subject of fierce debate. So here they are, the basic concepts of economics.

They're the intellectual backbone of what you will be studying in economics. They offer insights into how economists think about people and their decision-making, about markets and entire economies. You'll see that a few fundamental ideas can be applied to many different situations.

Transcript for:Key Concepts in Economics and Decision Making

Transcript for:
Key Concepts in Economics and Decision Making