Ten Principles of Economics 1

In this chapter,
look for the answers to these questions:
What kinds of questions does economics address?
What are the principles of how people make decisions?
What are the principles of how people interact?
What are the principles of how the economy as a whole works?

TEN PRINCIPLES OF ECONOMICS
What Economics Is All About
Scarcity: the limited nature of society’s resources
Economics: the study of how society manages its scarce resources, e.g.
how people decide what to buy,
how much to work, save, and spend
how firms decide how much to produce,
how many workers to hire
how society decides how to divide its resources between national defense, consumer goods, protecting the environment, and other needs

The principles of
HOW PEOPLE
MAKE DECISIONS

TEN PRINCIPLES OF ECONOMICS
HOW PEOPLE MAKE DECISIONS
All decisions involve tradeoffs. Examples:
Going to a party the night before your midterm leaves less time for studying.
Having more money to buy stuff requires working longer hours, which leaves less time for leisure.
Protecting the environment requires resources
that could otherwise be used to produce
consumer goods.
Principle #1: People Face Tradeoffs

TEN PRINCIPLES OF ECONOMICS
HOW PEOPLE MAKE DECISIONS
Society faces an important tradeoff: efficiency vs. equality
Efficiency: when society gets the most from its scarce resources
Equality: when prosperity is distributed uniformly among society’s members
Tradeoff: To achieve greater equality,
could redistribute income from wealthy to poor.
But this reduces incentive to work and produce, shrinks the size of the economic “pie.”
Principle #1: People Face Tradeoffs

TEN PRINCIPLES OF ECONOMICS
HOW PEOPLE MAKE DECISIONS
Making decisions requires comparing the costs and benefits of alternative choices.
The opportunity cost of any item is
whatever must be given up to obtain it.
It is the relevant cost for decision making.
Principle #2: The Cost of Something Is
What You Give Up to Get It

TEN PRINCIPLES OF ECONOMICS
HOW PEOPLE MAKE DECISIONS
Examples:
The opportunity cost of…
…going to college for a year is not just the tuition, books, and fees, but also the foregone wages.
…seeing a movie is not just the price of the ticket,
but the value of the time you spend in the theater.
Principle #2: The Cost of Something Is
What You Give Up to Get It

TEN PRINCIPLES OF ECONOMICS
HOW PEOPLE MAKE DECISIONS
Rational people
systematically and purposefully do the best they can to achieve their objectives.
make decisions by evaluating costs and benefits of marginal changes – incremental adjustments to an existing plan.
Principle #3: Rational People Think at the Margin

TEN PRINCIPLES OF ECONOMICS

TEN PRINCIPLES OF ECONOMICS
HOW PEOPLE MAKE DECISIONS
Examples:
When a student considers whether to go to college for an additional year, he compares the fees & foregone wages to the extra income
he could earn with the extra year of education.
When a manager considers whether to increase output, he/she compares the cost of the needed labor and materials to the extra revenue.
Principle #3: Rational People Think at the Margin

TEN PRINCIPLES OF ECONOMICS
HOW PEOPLE MAKE DECISIONS
Incentive: something that induces a person to act, i.e. the prospect of a reward or punishment.
Rational people respond to incentives.
Examples:
When gas prices rise, consumers buy more hybrid cars and fewer gas guzzling SUVs.
When cigarette taxes increase,
teen smoking falls.
Principle #4: People Respond to Incentives

You are selling your 1996 Mustang. You have already spent $1000 on repairs.
At the last minute, the transmission dies. You can pay $600 to have it repaired, or sell the car “as is.”
In each of the following scenarios, should you have the transmission repaired? Explain.
A. Blue book value is $6500 if transmission works,
$5700 if it doesn’t
B. Blue book value is $6000 if transmission works,
$5500 if it doesn’t
A C T I V E L E A R N I N G 1
Applying the principles

Cost of fixing transmission = $600
A. Blue book value is $6500 if transmission works,
$5700 if it doesn’t
Benefit of fixing the transmission = $800
($6500 – 5700).
It’s worthwhile to have the transmission fixed.
B. Blue book value is $6000 if transmission works,
$5500 if it doesn’t
Benefit of fixing the transmission is only $500.
Paying $600 to fix transmission is not worthwhile.
A C T I V E L E A R N I N G 1
Answers

Observations:
The $1000 you previously spent on repairs is irrelevant. What matters is the cost and benefit
of the marginal repair (the transmission).
The change in incentives from scenario A
to scenario B caused your decision to change.
A C T I V E L E A R N I N G 1
Answers

The principles of
HOW PEOPLE
INTERACT

TEN PRINCIPLES OF ECONOMICS
HOW PEOPLE INTERACT
Rather than being self-sufficient,
people can specialize in producing one good or service and exchange it for other goods.
Countries also benefit from trade & specialization:
Get a better price abroad for goods they produce
Buy other goods more cheaply from abroad than could be produced at home
Principle #5: Trade Can Make Everyone
Better Off

TEN PRINCIPLES OF ECONOMICS
HOW PEOPLE INTERACT
Market: a group of buyers and sellers (need not be in a single location)
“Organize economic activity” means determining
what goods to produce
how to produce them
how much of each to produce
who gets them
Principle #6: Markets Are Usually A Good Way to Organize Economic Activity

TEN PRINCIPLES OF ECONOMICS
HOW PEOPLE INTERACT
A market economy allocates resources through the decentralized decisions of many households and firms as they interact in markets.
Famous insight by Adam Smith in
The Wealth of Nations (1776):
Each of these households and firms
acts as if “led by an invisible hand”
to promote general economic well-being.
Principle #6: Markets Are Usually A Good Way to Organize Economic Activity

TEN PRINCIPLES OF ECONOMICS
HOW PEOPLE INTERACT
The invisible hand works through the price system:
The interaction of buyers and sellers
determines prices.
Each price reflects the good’s value to buyers and the cost of producing the good.
Prices guide self-interested households and firms to make decisions that, in many cases, maximize society’s economic well-being.
Principle #6: Markets Are Usually A Good Way to Organize Economic Activity

TEN PRINCIPLES OF ECONOMICS
HOW PEOPLE INTERACT
Important role for govt: enforce property rights (with police, courts)
People are less inclined to work, produce, invest, or purchase if large risk of their property being stolen.
Principle #7: Governments Can Sometimes Improve Market Outcomes

TEN PRINCIPLES OF ECONOMICS
HOW PEOPLE INTERACT
Market failure: when the market fails to allocate society’s resources efficiently
Causes:
Externalities, when the production or consumption
of a good affects bystanders (e.g. pollution)
Market power, a single buyer or seller has substantial influence on market price (e.g. monopoly)
In such cases, public policy may promote efficiency.
Principle #7: Governments Can Sometimes Improve Market Outcomes

TEN PRINCIPLES OF ECONOMICS
HOW PEOPLE INTERACT
Govt may alter market outcome to promote equity
If the market’s distribution of economic well-being
is not desirable, tax or welfare policies can change how the economic “pie” is divided.
Principle #7: Governments Can Sometimes Improve Market Outcomes

In each of the following situations, what is the government’s role? Does the government’s intervention improve the outcome?
a. Public schools for K-12
b. Workplace safety regulations
c. Public highways
d. Patent laws, which allow drug companies to charge high prices for life-saving drugs
A C T I V E L E A R N I N G 2
Discussion Questions

The principles of
HOW THE ECONOMY
AS A WHOLE WORKS

TEN PRINCIPLES OF ECONOMICS
HOW THE ECONOMY AS A WHOLE WORKS
Huge variation in living standards across countries and over time:
Average income in rich countries is more than ten times average income in poor countries.
The U.S. standard of living today is about
eight times larger than 100 years ago.
Principle #8: A country’s standard of living depends on its ability to produce goods & services.

TEN PRINCIPLES OF ECONOMICS
HOW THE ECONOMY AS A WHOLE WORKS
The most important determinant of living standards: productivity, the amount of goods and services produced per unit of labor.
Productivity depends on the equipment, skills, and technology available to workers.
Other factors (e.g., labor unions, competition from abroad) have far less impact on living standards.
Principle #8: A country’s standard of living depends on its ability to produce goods & services.

TEN PRINCIPLES OF ECONOMICS
HOW THE ECONOMY AS A WHOLE WORKS
Inflation: increases in the general level of prices.
In the long run, inflation is almost always caused by excessive growth in the quantity of money, which causes the value of money to fall.
The faster the govt creates money,
the greater the inflation rate.
Principle #9: Prices rise when the government prints too much money.

TEN PRINCIPLES OF ECONOMICS
HOW THE ECONOMY AS A WHOLE WORKS
In the short-run (1 – 2 years),
many economic policies push inflation and unemployment in opposite directions.
Other factors can make this tradeoff more or less favorable, but the tradeoff is always present.
Principle #10: Society faces a short-run tradeoff between inflation and unemployment

TEN PRINCIPLES OF ECONOMICS
FYI: How to Read Your Textbook
1. Read before class.
You’ll get more out of class.
2. Summarize, don’t highlight.
Highlighting is a passive activity that won’t improve your comprehension or retention.
Instead, summarize each section in your own words. Then, compare your summary to the one
at the end of the chapter.

TEN PRINCIPLES OF ECONOMICS
FYI: How to Read Your Textbook
3. Test yourself.
Try the “Quick Quiz” that follows each section before moving on to the next section.
Write your answers down, compare them to the answers in the back of the book. If your answers are incorrect, review the section before moving on.
4. Practice, practice, practice.
Work through the end-of-chapter review questions and problems. They are often good practice for the exams. And the more you use your new knowledge, the more solid it will become.

TEN PRINCIPLES OF ECONOMICS
FYI: How to Read Your Textbook
5. Go online.
The book comes with excellent web resources, including practice quizzes, tools to strengthen your graphing skills, helpful video clips, and other resources to help you learn the textbook material more easily and effectively. Visit:
http://academic.cengage.com/economics/mankiw
6. Study in groups.
Get together with a few classmates to review each chapter, quiz each other, and help each other understand the material.

TEN PRINCIPLES OF ECONOMICS
FYI: How to Read Your Textbook
7. Teach someone.
The best way to learn something is to teach it to someone else, such as a study partner or friend.
8. Don’t skip the real world examples.
Read the Case Studies and “In The News” boxes in each chapter. They will help you see how the new terms, concepts, models, and graphs apply to the real world. As you read the newspaper or watch the evening news, see if you can find the connections with what you’re learning in the textbook.

CHAPTER SUMMARY
The principles of decision making are:
People face tradeoffs.
The cost of any action is measured in terms of foregone opportunities.
Rational people make decisions by comparing marginal costs and marginal benefits.
People respond to incentives.

CHAPTER SUMMARY
The principles of interactions among people are:
Trade can be mutually beneficial.
Markets are usually a good way of coordinating trade.
Govt can potentially improve market outcomes if there is a market failure or if the market outcome is inequitable.