Basic Principles

Four Principles of Decision Making in Economics

Updated Oct 26, 2020

Simply put, an economy is a bunch of people interacting with each other. Therefore, the behavior and decisions people make shape the economy they live in. So, to understand how the economy works, we first have to understand how people work. To do that, we’re going to look at four basic principles of individual decision making that are important in an economic context: (1) People face trade-offs, (2) Trade-offs lead to opportunity cost, (3) People think at the margin, and (4) People respond to incentives.

1. People face Trade-offs

We can’t always get everything we want in life, so we have to make choices. That means, to get something we like, we usually have to give up something else we like as well. Or as many economists put it,  “there ain’t no such thing as a free lunch”.

To illustrate this, meet Bobby. Bobby has 10 dollars to buy lunch. Like most people, he likes pizza and burgers. For the sake of this example, we’ll assume that both of them cost exactly 10 dollars. Now, because Bobby only has 10 dollars to spend, he cannot afford to buy both. Instead, he has to choose either the pizza or the burger. Tough choice, indeed.

It’s important to note that every decision involves a trade-off, not just the ones related to money. So even if Bobby was offered a meal for free, he’d still have to choose between the pizza and the burger.

2. Trade-offs lead to opportunity cost

Opportunity cost describes the value of what we have to give up in order to get something else. You can think of it as the price we pay for choosing one thing over another. This is pretty easy to understand if both of these things have a price tag attached to them. However, most decisions involve other non-monetary factors such as lost time, pleasure, or other relevant benefits that must be considered as well.

For example, in the case of our pizza vs. burger example from earlier, Bobby’s opportunity cost of buying a pizza is one burger, which is worth 10 dollars. Now, to make this a little more interesting, let’s assume that Bobby’s friend asks him to skip lunch to help him fix his car instead. If Bobby agrees, he can earn 50 dollars for helping his friend. In that scenario, the opportunity cost increases, because Bobby could leave as much as 50 bucks on the table, depending on his decision.

However, things get even more interesting if we assume that his friend doesn’t offer Bobby any financial compensation whatsoever. In that case, Bobby has to compare the costs and benefits of spending time with his friend and helping him to a delicious pizza without any financial reference values. Not an easy task.

3. People Think at the Margin

Most of the choices we face aren’t black and white. In most cases, they’re some shade of grey in between. That means, most decisions aren’t about fundamental choices, but rather about incremental adjustments. Small changes to our current situation that help us to reach a slightly better outcome and to maximize our utility.

For example, when Bobby gets his pizza, he doesn’t immediately have to choose between eating the whole thing or nothing at all. Instead, he can just start with the first slice, and then simply eat additional slices until he’s full. So the decision he faces is not whether he should eat in general, but whether he should eat that last slice or not… although in the case of pizza, that’s almost always a yes.

4. People Respond to Incentives

Because we make decisions based on a cost/benefit analysis, our behavior is likely to change as soon as the costs and benefits of that decision change. That means, we often change our minds even after we have made an initial decision.

Just imagine if the price of pizza had doubled overnight. In that case, Bobby would probably change his mind and get a burger. After all, he likes both and the burger has just become much cheaper compared to the pizza.

Of course, there are many other incentives that can also have an effect on people’s decisions, like fashion, new technologies, or social expectations. However, in an economic context, you can assume that – unless stated otherwise – price is the most important incentive. What can I say… once again, it’s all about the money.

Summary

In an economic context, four basic principles of individual decision-making are important: First, people face trade-offs. That means, we have to make choices because we can’t get everything we want. Second, trade-offs lead to opportunity cost, which means that whenever we choose one thing over another, we lose the potential benefits of the alternative. Third, people think at the margin. That means, most decisions are about incremental adjustments as opposed to fundamental choices. And finally, people respond to incentives, which means that our behavior is likely to change as soon as the costs and benefits of a decision change.