How People Make Economic Decisions
How People Make Economic Decisions PaperECO/219May 3, 2010How People Make Economic Decisions How people make economic decisions start by using four basic individual decision-making principles. An economy is just a group of people interacting with one another as they go through their lives. The four principles are as follows: people face trade-offs, the cost of something is what you give up to get it, rational people think at the margin, and people respond to incentives.
Principle one where people face trade-offs means making decisions requires trading off one goal against another. An example of this is in society where trade-offs are made between efficiency and equity. Efficiency means that society is getting the maximum benefits from its scare resources. Equity means that those benefits are distributed fairly among society??™s members. In other words, efficiency refers to the size of the economic pie, and equity refers to how the pie is divided. This comes down to making the decisions as to what to give up to get something else in return.
Principle two is the cost of something is what you give up to get it. Making decisions requires comparing the costs and benefits of alternative courses of action. In many cases the decision-makers have to consider both the obvious and implicit costs of their actions. For example, one would have a package of M & Ms and a Snickers candy bar, the M & Ms are seventy-five cents and the Snickers forty-five cents. When one chooses the Snickers it loses the value of gain because you are not gaining a profit.
Principle three is rational people think at the margin. Rational people are people who systematically and purposefully do the best they can do to achieve their objectives. Rational people know that decisions in life are rarely black and white but usually involve shades of gray. A rational decision maker takes an action if and only if the marginal benefit of the action exceeds the marginal cost. This principle can explain why airlines are willing to sell a ticket below cost and why people are willing to pay more for diamonds than for water.
Principle four is how people respond to incentives. Behavior changes when costs or benefits change. Because rational people make decisions by comparing costs to benefits, they respond to incentives. Incentives are crucial to analyzing how the market works. An incentive is something that induces a person to act.
An example of a decision in which you compared the marginal benefits and the marginal costs associated with that decision would be for instance the company I am employed with cut back on employees when the economy took a turn. The company dismissed the employees employed by the temporary company to decrease the costs of running the business. Also the permanent employees were forced to take unpaid furloughs for a week once a month until business turned around. The company I am employed with is a cash only based company. So even though we are still cut back, the benefit is the employees seem to be more productive and work better together. So now that the economy is picking back up there will be slight changes to our office. We will be able to have a receptionist again and permanent employees will not have to continue taking furloughs. I feel that there would not be any incentives that could have led to make a different decision. Overall there was not that much of a down sizing and the decision made employees more grateful to have a position. The principles of economics affect decision-making, interaction and the workings of the economy as a whole by analyzing forces and trends that affect the economy as a whole, including the growth in average income, the fraction of the population that cannot find work, and the rate at which prices are rising.References
Mankiw, N. (2007). Principles of Economics (4th ed.). Thomson South-Western, Mason, OH.