Ten Principles of Economics

10/16/21
N. GREGORY MANKIW
Look for the answers to these questions:
PRINCIPLES OF
• What kinds of questions does economics
ECONOMICS address?
Eight Edition
• What are the principles of how people
make decisions?
CHAPTER Ten Principles of • What are the principles of how people
interact?
1 Economics • What are the principles of how the
economy as a whole works?
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Ten Principles of Economics Ten Principles of Economics

• Resources are scarce • Economists study:
• Scarcity: the limited nature of society’s – How people decide what to buy,
resources how much to work, save, and spend
– Society has limited resources – How firms decide how much to produce,
• Cannot produce all the goods and services how many workers to hire
people wish to have – How society decides how to divide its
• Economics resources between national defense,
– The study of how society manages its consumer goods, protecting the
scarce resources environment, and other needs
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 3 as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 4
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How People Make Decisions Principle 1: People Face Trade-offs

• To get something that we like, we have to
Principle 1: People face trade-offs give up something else that we also like
Principle 2: The cost of something is what – Going to a party the night before an exam
• Less time for studying
you give up to get it
– Having more money to buy stuff
Principle 3: Rational people think at the
• Working longer hours, less time for leisure
margin
– Protecting the environment
Principle 4: People respond to incentives
• Resources could be used to produce
consumer goods
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Principle 1: People Face Trade-offs Principle 1: People Face Trade-offs

• Society faces trade-offs: • Efficiency: society gets the most from its
– The more it spends on national defense scarce resources
(guns) to protect its shores • Equality: prosperity is distributed uniformly
• The less it can spend on consumer goods among society’s members
(butter) to raise the standard of living at home
• Tradeoff:
– Pollution regulations: cleaner environment – To achieve greater equality, could
and improved health
redistribute income from wealthy to poor
• But at the cost of reducing the incomes of the
firms’ owners, workers, and customers – But this reduces incentive to work and
produce, shrinks the size of economic “pie”
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Principle 2: The Cost of Something Is Principle 2: The Cost of Something Is

What You Give Up to Get It What You Give Up to Get It
• Making decisions: • The opportunity cost of:
– Compare costs with benefits of – Going to college for a year
alternatives • Tuition, books, and fees
– Need to include opportunity costs • PLUS foregone wages
• Opportunity cost – Going to the movies

• The price of the movie ticket
– Whatever must be given up to obtain
some item • PLUS the value of the time you spend in the
theater
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Principle 3: Rational People Think at the Principle 3: Rational People Think at the
Margin Margin
• Rational people • Examples:
– Systematically and purposefully do the – Cell phone users with unlimited minutes
best they can to achieve their objectives (the minutes are free at the margin)
– Given the available opportunities • Are often prone to making long/frivolous calls
– Make decisions by evaluating costs and • Marginal benefit of the call > 0
benefits of marginal changes – A manager considers whether to increase
• Small incremental adjustments to a plan of output
action • Compares the cost of the needed labor and
materials to the extra revenue
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Principle 4: People Respond to Incentives Active Learning 1 Applying the principles

You are selling your 2007 Mustang. You have
• Incentive already spent $1,000 on repairs. At the last
– Something that induces a person to act minute, the transmission dies. You can pay
• Examples: $900 to have it repaired, or sell the car “as is.”
– When gas prices rise, consumers buy In each of the following scenarios, should you
more hybrid cars and fewer gas guzzling have the transmission repaired? Explain.
SUVs A. Blue book value (what you could get for the
– When cigarette taxes increase, car) is $7,500 if transmission works, $6,200 if it
doesn’t.
teen smoking falls
B. Blue book value is $6,300 if transmission
works, $5,500 if it doesn’t.
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Active Learning 1 Answers How People Interact

Cost of fixing the transmission = $900
A. Blue book value is $7,500 if transmission works,
$6,200 if it doesn’t Principle 5: Trade can make everyone
– Benefit of fixing transmission = $1,300 better off
(= 7500 – 6200) Principle 6: Markets are usually a good way
– Get the transmission fixed to organize economic activity
B. Blue book value is $6,300 if transmission works,
$5,500 if it doesn’t Principle 7: Governments can sometimes
– Benefit of fixing the transmission = $800 improve market outcomes
(= 6300 – 5500)
– Do not pay $900 to fix it
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Principle 5: Trade Can Make Everyone Principle 6: Markets Are Usually a Good
Better Off Way to Organize Economic Activity
• People benefit from trade: • Market
– People can buy a greater variety of goods – A group of buyers and sellers (need not
and services at lower cost be in a single location)
• Countries benefit from trade and • “Organize economic activity” means
specialization determining
– Get a better price abroad for goods they – What goods and services to produce
produce – How much of each to produce
– Buy other goods more cheaply from – Who produced and consumed these
abroad than could be produced at home
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Principle 6: Markets Are Usually a Good Principle 6: Markets Are Usually a Good
Way to Organize Economic Activity Way to Organize Economic Activity
• A market economy allocates resources • Prices:
– Decentralized decisions of many firms and – Determined: interaction of buyers and
households – as they interact in markets sellers
• Famous insight by Adam Smith in – Reflect the good’s value to buyers
The Wealth of Nations (1776): – Reflect the cost of producing the good
– Each of these households and firms acts • Invisible hand:
as if “led by an invisible hand” to promote – Prices guide self-interested households
general economic well-being and firms to make decisions that maximize
society’s economic well-being
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Principle 7: Governments Can Sometimes Principle 7: Governments Can Sometimes

Improve Market Outcomes Improve Market Outcomes
• Government - enforce property rights • Government - promote efficiency
– Enforce rules and maintain institutions that – Avoid market failures: market left on its
are key to a market economy own fails to allocate resources efficiently
• People are less inclined to work, produce, – Externality – source of market failure
invest, or purchase if large risk of their • Production or consumption of a good affects
property being stolen bystanders (e.g. pollution)
– Market power – source of market failure
• A single buyer or seller has substantial
influence on market price (e.g. monopoly)
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Principle 7: Governments Can Sometimes Active Learning 2 Discussion Question

Improve Market Outcomes
In each of the following situations, what is the
• Government - promote equality government’s role?
– Avoid disparities in economic wellbeing Does the government’s intervention improve
– Use tax or welfare policies to change how the outcome?
the economic “pie” is divided 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
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Principle 8: Country’s Standard of Living Depends

How the economy as a whole works on Its Ability to Produce Goods and Services
• Huge variation in living standards

Principle 8: A country’s standard of living – Across countries and over time
depends on its ability to produce goods and – Average income in rich countries
services • Is more than ten times average income in
Principle 9: Prices rise when the poor countries
government prints too much money – The U.S. standard of living today
• Is about eight times larger than 100 years ago
Principle 10: Society faces a short-run
trade-off between inflation and
unemployment
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Principle 8: Country’s Standard of Living Depends Principle 9: Prices Rise When the
on Its Ability to Produce Goods and Services Government Prints Too Much Money
• Productivity: most important determinant • Inflation
of living standards – An increase in the overall level of prices in
– Quantity of goods and services produced the economy
from each unit of labor input • In the long run
– Depends on the equipment, skills, and – Inflation is almost always caused by
technology available to workers excessive growth in the quantity of money,
• Other factors (e.g., labor unions, competition which causes the value of money to fall
from abroad) have far less impact on living
– The faster the government creates money,
standards
the greater the inflation rate
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Principle 10: Society Faces a Short-run Trade-

off between Inflation and Unemployment
Summary
• Short-run trade-off between • Fundamental lessons about individual
unemployment and inflation decision making:
– Over a period of a year or two, many – People face trade-offs among alternative
economic policies push inflation and goals
unemployment in opposite directions – The cost of any action is measured in terms
– Other factors can make this tradeoff more of forgone opportunities
or less favorable, but the tradeoff is – Rational people make decisions by comparing
always present marginal costs and marginal benefits
– People change their behavior in response to
the incentives they face
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Summary Summary
• Fundamental lessons about interactions • Fundamental lessons about the economy
among people: as a whole:
– Trade and interdependence can be mutually – Productivity is the ultimate source of living
beneficial standards
– Markets are usually a good way of – Growth in the quantity of money is the
coordinating economic activity among people ultimate source of inflation
– The government can potentially improve – Society faces a short-run trade-off between
market outcomes by remedying a market inflation and unemployment
failure or by promoting greater economic
equality
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10/16/21

Ten Principles of Economics Ten Principles of Economics

How People Make Decisions Principle 1: People Face Trade-offs

Principle 1: People Face Trade-offs Principle 1: People Face Trade-offs

Principle 2: The Cost of Something Is Principle 2: The Cost of Something Is

• Opportunity cost – Going to the movies

Principle 4: People Respond to Incentives Active Learning 1 Applying the principles

Active Learning 1 Answers How People Interact

Principle 7: Governments Can Sometimes Principle 7: Governments Can Sometimes

Principle 7: Governments Can Sometimes Active Learning 2 Discussion Question

Principle 8: Country’s Standard of Living Depends

• Huge variation in living standards

Principle 10: Society Faces a Short-run Trade-

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