Economics by Pratham Singh 1

B.Com (Hons.) – 1st Semester

Micro – Economics (I)

CHAPTER – 1
Ten Principles of Economics
The study of economics has many faces or sides, but it is based on some central ideas. In this
chapter, we look at Ten Principles of Economics. Don’t worry if you don’t understand them all or
if you are not completely convinced. We explore these principles (ideas) more fully in later
chapters. The ten principles are introduced here to give you an overview of what economics is all
about.
These principles has been divided into three parts :
Part – 1 : How people make decisions
Part – 2 : How people interact
Part – 3 : How the economy as a whole works

How People Make Decisions

Principle 1: People Face Trade-offs

You may have heard the old saying, “There is no such thing as a free lunch.”
To get something that we like, we usually have to give up something else that we also like. Making
decisions requires trading off one goal against another goal.
Example of Trade- offs facing by Individual
• Take an example of a student, who must decide how to allocate her time. She can spend all
of her time in studying or she can spend her time in napping, bike riding, watching TV, or
working.
• Take an example of parents, deciding how to spend their family income. They can buy food,
clothing, or a family vacation. Or they can save some of the family income for retirement or
for children’s college education. When they choose to spend an extra rupee on one of these
goods, they have one less rupee to spend on some other good.

Example of Trade- offs facing by Society

When people are grouped into societies, they face different kinds of trade-offs.
• One classic trade-off is between “guns and butter.” The more a society spends on national
defense (guns) to protect its shores (land), the less it can spend on consumer goods (butter).
• Trade-off between a clean environment and a high level of income. Reducing pollution with
law & regulation of pollution raise the cost of producing goods and services. The firms starts
earning small profits, paying lower wages, charging higher prices. Pollution regulations
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provide the benefit of a cleaner environment and the improved health. But at the same time,
it reduces the incomes of the firms’ owners, workers, and customers.
• Another trade-off society faces is between efficiency and equality.
Efficiency means that society is getting the maximum benefits from its scarce resources.
Equality means distribution of income equally among society’s members.
In other words, efficiency refers to the size of the economic pie (GDP), and equality refers
to how the economic pie (GDP) is divided into individual slices.
There are some policies which aimed at equalizing the distribution of economic pie. Like
unemployment insurance, individual income tax etc. When the government redistributes
income from the rich to the poor, it reduces the reward for working hard. As a result, people
work less and produce fewer goods and services. In other words, when the government tries
to cut the economic pie into more equal slices, the pie gets smaller. Although they achieve
greater equality, but these policies reduce efficiency.

Principle 2: The Cost of Something is What You Give Up to Get It

(Opportunity Cost)
Because people face trade-offs, so making decisions requires comparison of the costs and benefits
of action that you want to choose.
In many cases, the cost of an action is not as same as it might appear.
For Example : Consider the decision to go to college.
• The main benefits are intellectual enrichment (knowledge enhancement) and a lifetime of
better job opportunities. And the Costs are : Money spend on tuition, books, room and board
(meal/food).
• But this total does not truly represent your expenditure in college. There are two problems
with this calculation.
a) First, it includes some things that are not really costs of going to college. Even If you quit
college, you need a place to sleep and food to eat. Only additional cost of Room and board
should be included because they are more expensive at college.
b) Second, this calculation ignores the largest cost of going to college—your time. When you
spend a year listening to lectures, reading textbooks, and writing papers, you cannot spend
that time working at a job.
The opportunity cost of an item is what you give up to get that item. When making any decision,
decision makers should be aware of the opportunity. College athletes who can earn millions if they
drop out of college and play professional sports. They are well aware that the opportunity cost of
their attending college is very high as they quit playing.

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Principle 3: Rational People Think at the Margin

Economists normally assume that people are rational. Rational people think at margin, it means
most of the decision we take by thinking at margin. Rational people often make decisions by
comparing benefits and costs of marginal change.
Rational people don’t take decision in form of Black (NO) and White (YES), but usually involves
shades of grey.
For Example :
a) At dinner table, We don’t take decision between fasting and eating. but we take decision,
whether to take extra chapatti or not. So we compare, extra benefit (satisfaction/good health)
that we will derive from extra chapatti with extra cost that we have to pay for extra chapatti
in terms of wheat flour, LPG, time and poor health.
b) When a manager considers whether to increase output or not, he compares the cost of the
needed labour and materials to produce goods with extra revenue generated from that good.
c) Water – diamond paradox : Water is essential, but the marginal benefit of an extra cup is
small because water is plentiful. On the contrary, no one needs diamonds to survive, but
because diamonds are so rare, people consider the marginal benefit of an extra diamond to
be large.

A rational decision maker takes an action if and only if the marginal benefit of the action exceeds
the marginal cost.

Principle 4: People Respond to Incentives

• An incentive is something that induces a person to act. (Normally, Incentive is considered as
positive incentive, but here we are also talking about Negative incentive)
• It is in the form of reward (positive incentive) and punishment (negative incentive). Rewards
like low prices, subsidies, discount etc. Punishment like high prices, tax, fine etc.
• For example :
a) Considering Price of good rises - Higher price of a good provides an incentive for buyers
to consume less and an incentive for sellers to produce more.
b) A tax on gasoline (Like Petrol, CNG etc.) – It encourages people to drive smaller car,
more fuel-efficient cars, take public transportation, taking small route etc. If the tax were
larger, they would switch to electric cars.
That is one reason people drive smaller cars in Europe, where gasoline taxes are high, than
in the United States, where gasoline taxes are low.
c) Car Seat belt law- Today, all cars have seat belts, but this was not true fifty years ago. As
that time, they drive more slowly and carefully. But when seat belts came, it reduce the
benefits of slow and careful driving. People respond to seat belts as they drive faster and
less carefully.

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How People Interact

The first four principles discussed how individuals make decisions. As we go about our lives, many
of our decisions affect not only ourselves but other people as well. The next three principles concern
how people interact with one another.

Principle 5: Trade Can Make Everyone Better Off

• Trade Can Make Everyone Better Off. In other words, trade provides benefit to both the
parties or both the countries.
• Rather than being self sufficient, people can specialize in producing one goods & services
and exchange it for other goods.
• Countries as well as families benefit from the ability to trade with one another.
✓ Countries get better price from abroad for the goods they produce.
✓ Countries buy other goods more cheaply from abroad than could be produced at home.
For example, The cost of rice in India is ₹200 per Kg and for wheat it is ₹50 per Kg. And in
Nepal, the cost of rice is ₹100 per Kg and for wheat it is ₹150 per Kg.
It means, India is specialised in making Wheat and Nepal is Specialized in Making Rice. In
such a case, India should import Rice from Nepal and Nepal should import Wheat from India.
In this way, both the countries get benefitted from trade as they get goods at lower price.

Principle 6: Markets Are Usually a Good Way to Organize Economic Activity

• 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

• In Communist or Socialist countries, government officials were in the best position to allocate
the economy’s scarce resources. These central planners decided what goods and services were
produced, how much was produced, and who produced and consumed these goods and
services.

• A market economy allocates resources through the decentralized decisions of many

households and firms as they interact in markets.
• The decisions is taken by the decisions of millions of firms and households. Firms decide
whom to hire and what to make. Households decide which firms to work for and what to buy
with their incomes.
• Prices & Self interest guide their decision.
• Market economies have proven remarkably successful in organizing economic activity to
promote overall economic well-being.

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But how self interest of individuals can lead to economic well being of all?
Adam Smith in ‘The Wealth of Nations (1776) observes : that interaction of Households and firms
are guided by an “invisible hand” to promote economic well being.
• The invisible hand works through the price mechanism.
• Price mechanism refers to the interaction of buyers and sellers to determine prices.
• Price reflects two things : The value of a good to society
The cost of making good for society.
• Self interested of household & firm unknowingly benefit the society as whole.
• Prices & self-interested guide the households and firms to make decisions that, (in many
cases), maximize society’s economic well-being.

Principle 7: Governments Can Sometimes Improve Market Outcomes

• If the invisible hand of the market is so great, why do we need government?
The invisible hand can work its magic only if the government enforces the rules and
maintains the institutions that are key to a market economy.
• Market economies need institutions to enforce property rights so individuals can own and
control scarce resources.
Examples : A farmer won’t grow food if he expects her crop to be stolen; a restaurant won’t
serve meals unless it is assured that customers will pay before they leave; and an
entertainment company won’t produce DVDs if too many potential customers avoid paying
by making illegal copies. We all rely on government-provided police and courts to enforce
our rights over the things.
• Economists use the term market failure to refer to a situation in which the market on its
own fails to produce an efficient allocation of resources.
Causes of Market Failure :
a) Externality : The impact of one person’s actions on the well-being of a bystander. (a
person who is standing near and sees something that happens, without being involved in it).
b) Market power : refers to the ability of a single person or firm to unduly influence market
prices.(i.e., monopoly)
• Market doesn’t promote equity.
The invisible hand does not ensure that everyone has sufficient food, decent clothing, and
adequate healthcare. This inequality may call for government intervention.
In practice, many public policies (such as the income tax and the welfare system) to achieve
a more equal distribution of economic pie.

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How the economy as a whole works

Principle 8: A Country’s Standard of Living Depends on Its Ability to Produce
Goods and Services
• The most important determinant of Living standard is ‘Productivity’.
• Productivity : the quantity of goods and services produced from each unit of labor input.
There is a difference between Total Product & Productivity.
For example, Gupta family has total income with 2 Person is ₹1,00,000. On the other hand,
Sharma Family has a total income with 10 perosn is ₹2,00,000. Here Total income of sharma
is very much more than Total income of Gupta. But when we talk about Productivity, we can
see that Productivity of Gupta Family (₹50,000 per person) is more than Productivity of Sharma
Family (₹20,000 per person).
• Productivity depends upon
✓ Education, Health, Skills, Training, Technology, Research & Development.
✓ Other factors (e.g., Labour Unions, Competition from abroad) have far less impact on
living standards. They are temporary in Nature.
• In countries, where workers can produce a large quantity of goods and services, people enjoy
a high standard of Living. In nations where workers are less productive, most people suffer
very less existence.
• Average income (Per Capita Income) in rich countries is more than ten time average income in
poor countries.
• To boost living standards, policymakers need to raise productivity by ensuring that workers are
well educated, have the tools they need to produce goods and services, and have access to the
best available technology.

Principle 9: Prices Rise When the Government Prints Too Much Money
• Inflation : Increase in General Price Level. And when price is rises with very extreme speed, it
is called Hyper-Inflation.
Example : In January 1921, a daily newspaper in Germany cost 0.30 marks. Less than two
years later, in November 1922, the same newspaper cost 7,00,00,000 marks. All other prices in
the economy rose by similar amounts.
• What is the reason behind it ?
✓ When a government creates (Prints) large quantities of the nation’s money, the value of the
money falls.
✓ In other words, when government prints large quantities of money, it raises money supply
in the nation. It means now people have more money, but practically there will be fixed
quantity of goods and services (as resources are limited). In such a case, value of money
falls and general price level rises.

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• Take an Example
✓ Suppose the economy produces 1,000 units of output.
✓ Suppose the money supply (number of notes and coins) = ₹10,000
✓ This means that the average price of the output produced will be ₹10 (10,000/1000).
✓ Suppose then that the government print an extra ₹5,000 notes creating a total money supply
of ₹15,000; but, the output of the economy stays at 1,000 units. Effectively, people have
more cash, but, the number of goods is the same. Because people have more cash, they are
willing to spend more to buy the goods in the economy.
✓ Ceteris paribus, the price of the 1,000 units will increase to ₹15 (15,000/1000). The price
has increased, but, the quantity of output stays the same. People are not better off, and the
value of money has decreased; e.g. A ₹10 note buys fewer goods than previously.

• Therefore, if the money supply is increased, but, the output stays the same, everything will just
become more expensive.
• If output increased by 5%. and the money supply increases by 7%. Then inflation will be roughly
2%

Assumptions in the above example

In the real world, it is possible, if the government printed money, people would just decide to save
the extra money and therefore, prices wouldn’t automatically rise. However, to simplify the link
between the money supply and inflation, let us assume that consumers are willing to spend the extra
money.

Conclusion
• Quantity of money has an inverse relationship with value of money, but has a positive relation
with General price level.
• Money Supply Rises → Value of Money falls → Price level Rises

Principle 10: Society Faces a Short-Run Trade-off between Inflation and

Unemployment
• Increasing the amount of money in the economy, increases the overall level of spending and thus
the demand for goods and services.
• Higher demand may cause firms to raise their prices, but in the meantime, it also encourages
them to hire more workers and produce a larger quantity of goods and services.
• More hiring means lower level of unemployment.
This is called a short-run trade-off between inflation and unemployment.

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• This simply means that, over a period of one year

or two, many economic policies push inflation
and unemployment in opposite directions.
• The curve that illustrate the trade off between
inflation and unemployment is called Philips
Curve.
• This curve shows inverse relation between
inflation and unemployment. It means when
inflation increase, it reduce the rate of
unemployment and vice versa.

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