The big ideas of economics

A free concert ticket isn't free if it costs you an evening you would have spent working a paid shift. A university degree costs tuition, plus the salary you didn't earn while studying. Economists call the value of the best alternative you gave up the opportunity cost.

For a whole economy, the trade-off appears as the production possibilities frontier: every combination of two goods the economy can make with all its resources. Points on the frontier are efficient, points inside waste resources, and points outside are impossible for now. Moving along the frontier, getting more of one good means making less of the other.

The frontier usually bows outward. The lab's island has workers with different skills. The first coconuts come from the best climbers, who are poor fishers, so they cost little fish. The last coconuts come from expert fishers, so each costs a lot of fish. Opportunity cost rises as you specialize further.

Should a café open an extra hour? Should you study one more hour for an exam? The useful comparison is the marginal benefit of that extra unit against its marginal cost. Averages mislead. The café's average hour may be very profitable while its last hour loses money.

Marginal benefits usually fall: the first slice of pizza is wonderful and the fifth less so. Marginal costs usually rise: the tenth study hour costs more sleep than the first. Net benefit is greatest where the two curves cross. Before that point an extra unit adds more than it costs. After it, an extra unit costs more than it adds.

This explains the diamond–water paradox that puzzled Adam Smith. Water is essential and diamonds aren't, yet diamonds cost more. Prices reflect the value of the marginal unit. Water is abundant, so the last litre is worth little, while the last diamond is scarce.

David Ricardo's example: Portugal can make both wine and cloth with less labour than England. It has an absolute advantage in both. Should Portugal make everything itself? No. What matters is the opportunity cost of each good in each country (idea 1).

In Portugal, a unit of wine costs about 0.89 units of cloth. In England it costs 1.2. So Portugal gives up less to make wine, which is its comparative advantage, and England gives up less to make cloth. If each specializes and they trade at any price between those two ratios, both end up with more of both goods than they could make alone.

The same logic explains why a surgeon who types faster than her assistant should still let the assistant type, and why nearly every household and country buys most of what it uses.

The demand curve shows how much buyers want at each price, and slopes down. The supply curve shows how much sellers offer, and slopes up. Where they cross is the equilibrium. Above it, unsold goods pile up and sellers cut prices. Below it, buyers compete for too few goods and push prices up.

Most price changes are shifts in one curve or the other. A frost that destroys orange trees shifts supply left, and the price rises. A study saying oranges cure colds shifts demand right, and the price rises too, but now quantity rises as well. Knowing which curve moved tells you what to expect.

Price controls stop the adjustment. A price ceiling below equilibrium, like strict rent control, creates a shortage: more people want apartments than are offered. Some trades that both sides wanted don't happen, and that lost value is called deadweight loss.

The price elasticity of demand is the percentage change in quantity divided by the percentage change in price. Demand for insulin or petrol in the short run is inelastic: people keep buying even when the price jumps. Demand for one brand of cereal is elastic: raise the price and shoppers switch.

Elasticity decides what happens to revenue. If demand is inelastic, raising the price raises revenue, because quantity barely falls. If it's elastic, revenue falls. On a straight-line demand curve, elasticity changes from point to point, and revenue is largest exactly where elasticity equals 1.

It also decides who bears a tax. Whichever side is less able to walk away, buyers or sellers, pays most of it, regardless of who hands the money to the government.

A factory selling steel weighs its own costs, not the soot that lands on its neighbours. That soot is an externality: a cost borne by people outside the deal. Because sellers and buyers ignore it, the market produces more than is good for society as a whole. Carbon emissions, traffic congestion and antibiotic resistance are all negative externalities. Vaccines and research have positive ones, so markets produce too little of them.

Arthur Pigou's fix was a tax equal to the external cost per unit. Then the people deciding see the full cost, and the market lands on the socially best quantity on its own. A carbon tax works this way. Ronald Coase pointed out another route: if property rights are clear and bargaining is cheap, the affected parties can negotiate their way to the efficient outcome.

Two suspects are questioned separately. If both stay silent, both get a light sentence. If one confesses and the other doesn't, the confessor goes free and the other gets a harsh term. If both confess, both get a medium sentence. Whatever the other does, confessing is better for you, so both confess, and both end up worse off than if they had stayed silent. This is the prisoner's dilemma.

A Nash equilibrium is a set of choices where nobody can do better by changing their own choice alone. "Both confess" is one. The dilemma explains price wars, arms races and overfishing: individually rational choices that are collectively bad.

Repetition changes things. When the same players meet again and again, cooperation can pay, because defecting today invites retaliation tomorrow. In Robert Axelrod's famous tournaments, the winner was the simplest strategy entered: tit for tat, which cooperates first and then copies whatever the opponent did last time.

George Akerlof's example is used cars. Sellers know whether their car is a good one or a "lemon." Buyers can't tell, so they will pay only for average quality. But at an average price, owners of good cars won't sell. They leave the market, so the average quality of the cars still for sale falls, so buyers offer less, so more good cars leave. The market unravels.

The same logic, called adverse selection, threatens insurance. People who know they're high-risk are keenest to buy, which raises premiums, which drives away the low-risk. That's why health insurance systems often require everyone to join.

Markets fight back. Warranties, inspection reports, brand reputations, online reviews and certification all exist to transfer information from the side that has it to the side that doesn't.

A fish stock regrows each year, fastest when it's at a middle size. A fleet that catches only the regrowth could fish forever. But each boat's owner gets the full value of every extra fish while bearing only a small share of the damage to the stock. So with open access, boats keep coming until the stock collapses or fishing stops being worth it.

This is the tragedy of the commons: overgrazed pastures, depleted groundwater, congested roads and a crowded atmosphere. It's a many-player prisoner's dilemma (idea 7). The fixes are rules that tie each user's take to the health of the resource: catch quotas, tradable permits, property rights, or local institutions that monitor and punish overuse.

Income per person in the richest countries is more than fifty times that in the poorest, and small differences in growth rates compound into these huge gaps. Growing 2% a year doubles income every 35 years. Growing 7% a year doubles it every 10.

Robert Solow's model shows why saving alone can't sustain growth. Workers with more machines (capital) produce more, but each extra machine adds less than the one before. Meanwhile machines wear out. Eventually new investment just replaces worn-out capital, and output per worker stops growing at a steady state. A higher saving rate raises that steady state, but doesn't change the long-run growth rate.

What keeps rich economies growing is technology in the broadest sense: new ideas, better organization, institutions and know-how, which economists measure as total factor productivity. Unlike machines, an idea can be used by everyone at once without wearing out.

Money is a social agreement. It's useful because everyone accepts it for goods, debts and taxes. Its value is what it can buy, so economists separate nominal amounts (in currency) from real amounts (in purchasing power). A pay rise of 3% when prices rise 5% is a real pay cut of about 2%.

The same holds for savings. The interest rate the bank pays is nominal. The real interest rate is roughly the nominal rate minus inflation, and when it's negative your savings lose purchasing power every year.

In the long run, inflation mostly reflects money growth. If the amount of money grows 20% a year while the economy produces only 2% more, prices have to rise to absorb the difference. Every hyperinflation, from Germany in 1923 to Zimbabwe in 2008, came from governments printing money to pay their bills.

Suppose the government spends 100 million on a new bridge. The builders receive 100 million in income. If people spend 80% of each extra unit of income (the marginal propensity to consume), they spend 80 million in shops. The shopkeepers spend 64 million of that, and so on. The rounds add up to 100 / (1 − 0.8) = 500 million of total spending.

This is the multiplier, and it is one reason recessions can feed on themselves. If firms cut jobs, laid-off workers cut spending, which costs other workers their jobs. John Maynard Keynes argued that in a slump, governments should do the opposite of households and increase spending to break the cycle.