Economics is the study of how people make choices under conditions of scarcity and of the results of those choices for society. Economic analysis of human behavior begins with the assumption that people are rational—that they have well-defined goals and try to achieve them as best they can. In trying to achieve their goals, people normally face trade-offs: Because material and human resources are limited, having more of one good thing means making do with less of some other good thing.
Our focus in this chapter has been on how rational people make choices among alternative courses of action. Our basic tool for analyzing these decisions is cost-benefit analysis. The cost-benefit principle says that a person should take an action if, and only if, the benefit of that action is at least as great as its cost. The benefit of an action is defined as the largest dollar amount the person would be willing to pay in order to take the action. The cost of an action is defined as the dollar value of everything the person must give up in order to take the action.
Often the question is not whether to pursue an activity but rather how many units of it to pursue. In these cases, the rational person pursues additional units as long as the marginal benefit of the activity (the benefit from pursuing an additional unit of it) exceeds its marginal cost (the cost of pursuing an additional unit of it).
In using the cost-benefit framework, we need not presume that people choose rationally all the time. Indeed, we identified four common pitfalls that plague decision makers in all walks of life: a tendency to treat small proportional changes as insignificant, a tendency to ignore opportunity costs, a tendency not to ignore sunk costs, and a tendency to confuse average and marginal costs and benefits.
Positive economics deals with "what is" or facts. Positive statements predict how people will behave and therefore are testable. Normative economics deals with "what ought to be"—that is, with value judgments and opinions about how people should behave.
The Incentive Principle states that incentives matter. That is, a person is more likely to take an action if benefits rise and less likely to take an action if costs rise.
Microeconomics is the study of individual choices and of group behavior in individual markets, while macroeconomics is the study of the performance of national economies and of the policies that governments use to try to improve economic performance.
