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Ten Principles of
Economics

Source: Harcourt, Inc. (2001)

Economics

Economics is the study of how society

manages its scarce resources.
or
the study of how society meets its
unlimited wants and needs with its
limited resources.

Source: Harcourt, Inc. (2001)

Main contents
How People Make Decisions
1: People Face Trade-offs
2: The Cost of Something Is What You Give Up to Get It
3: Rational People Think at the Margin
4: People Respond to Incentives
How People Interact
5: Trade Can Make Everyone Better Off
6: Markets Are Usually a Good Way to Organize Economic Activity
7: Governments Can Sometimes Improve Market Outcomes
How the Economy as a Whole Works
8: A Country’s Standard of Living Depends on Its Ability to Produce
Goods and Services
9: Prices Rise When the Government Prints Too Much Money
10: Society Faces a Short-Run Trade-off between Inflation and
Unemployment

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How People Make Decisions

1. People face tradeoffs.

“There is no such
thing as a free lunch!”

2. The cost of something is

what you give up to get it.

The opportunity cost of an

item is the next best
alternative choice that you
give up to obtain that item.

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3. Rational people think at the

margin.

People make decisions by comparing

costs and benefits at the margin.

Marginal changes are small,

incremental adjustments to
an existing plan of action.

4. People respond to incentives.

LA Laker basketball star

Kobe Bryant chose to skip
college and go straight to

the NBA from high school

when offered a $10 million
contract.

How People Interact

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5. Trade can make everyone

better off.
! Trade allows people to specialize in what
they do best.
! Trade increases the variety of goods and
services available.
! Trade lowers costs for consumers

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6. Markets are usually a good way

to organize economic activity.
!In a market economy, households freely
decide what to buy and who to work for and
firms freely decide who to hire and what to
produce.

Adam Smith made the observation that households

and firms interacting in markets act as if guided by
an “invisible hand.”

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7. Governments can sometimes

improve market outcomes.
When the market fails, government can
intervene to promote efficiency and equity.

Market failure occurs when the market

fails to allocate resources efficiently.

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How the Economy as a Whole

Works

13

8. A country’s standard of living depends

on its ability to produce goods & services.

Standard of living may be measured in different ways:

! By comparing personal incomes.
! By comparing the total market value of a nation’s
production.

Therefore, how much each

worker can produce per hour of
work determines overall living
standards within a nation.

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9. Prices rise when the government

prints too much money.

Inflation is an increase in the

overall level of prices in the
economy.
• The more money there is available
within an economy, the more people
are willing to pay for goods and
services (inflation), therefore each
dollar is buying less and less.

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10. Society faces a short-run

tradeoff between inflation and
unemployment.

The Phillips Curve illustrates the tradeoff between

inflation and unemployment:

Lower prices are the result of high unemployment and

Higher prices are the result of low unemployment.

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26 PART I INTRODUCTION
CHAPTER 2 THINKING LIKE AN ECONOMIST 25

complex and realistic circular-flow model would include, for instance, the roles

11
CHAPTER 2 THINKING LIKE AN ECONOMIST 25

I INTRODUCTION
Economic Models of government and international trade. (A portion of that dollar you gave to
Figure Starbucks might be used to pay taxes or to buy coffee beans from a farmer in
Figure
Brazil.) Yet these details are not crucial for a basic understanding of how the
MARKETS TheCircular
CircularFlow
Flow
complex and realistic circular-flow model would include, for
MARKETS
instance, the rolesThe
Thisdiagram
diagramis ais schematic
a schematic economy is organized. Because of its simplicity, this circular-flow diagram is
Revenue Revenue FOR FOR Spending
Spending This
of government and international trade.
GOODS (A
GOODS AND Firms
portion
AND
SERVICES
SERVICES of that dollar you gave torepresentation of the organization
representation of the organization useful to keep in mind when thinking about how the pieces of the economy fit
sell of the economy. Decisions are
Starbucks might be used and to services
pay taxes
Goods
FirmsorsellHouseholds
to buybuycoffee services
beans from a farmer inmade
Goods and

Goods sold
Brazil.) Yet these details are not crucial for a basic Goods and
understanding
bought
of thebyeconomy.
householdsDecisions
and firms.are
of how theHouseholds and firms interact in
together.
and services Households buy services made
the by households
markets andservices
for goods and firms.
economy is organized. Because of its simplicity, this circular-flow diagram is(where households are buyers and
Households and firms interact in
sold bought
useful to keep in mindFIRMSwhen thinking about how the piecesHOUSEHOLDS
of the economy fitfirms
thethe
for
are sellers) and in the markets
markets
factors for goods and(where
of production
Our
services Second Model: The Production
together. Produce and sell Buy and consume
goods and services
Hire and use factors
goods and services
firms are buyers and households
(where households are buyers and
Own and sell factors
are sellers). The outer set of arrows Possibilities Frontier
firms are
shows sellers)
the flow and inand
of dollars, the markets
Our Second FIRMSModel: The Production
of production of production
HOUSEHOLDS Most economic models, unlike the circular-flow diagram, are built using the tools
the inner set of arrows shows the
for the factorsflowof of
production
corresponding inputs and (where
Produce and sell
Possibilities Frontier Buy and consume of mathematics. Here we use one of the simplest such models, called the produc-
firms are buyers and households
outputs.
goods and services goods and services
Most economicHire andmodels,
use factorsunlike the circular-flow
Factors of
production
MARKETS diagram, are built using the toolsare sellers). The outer set of arrows
Labor, land,
Own
and and sell factors
capital
tion possibilities frontier, to illustrate some basic economic ideas.
FOR
of mathematics. Here we use one of the
of production simplest
FACTORS such models,
OF PRODUCTION called the produc-
of production shows the flow of dollars, and Although real economies produce thousands of goods and services, let’s
tion possibilities frontier, to illustrate someFirms Households sell
basic
buy economic ideas.
the inner set of arrows shows the
Wages, rent,
and profit
Income
assume an economy that produces only two goods—cars and computers.
let’scorresponding flow of inputs andTogether, the car industry and the computer industry use all of the economy’s
! Flow of inputs
Although real economies produce thousands of goods andandservices, outputs
assume an economy that produces only two goods—cars !and Flow of computers.
dollars outputs.
Together, the car industry and the computer industry useland,all of the economy’s production factors of production. The production possibilities frontier is a graph that shows
Factors of Labor,
duction factors of production. The production MARKETS
possibilities frontier is
and capital a graph that shows possibilities frontier the various combinations of output—in this case, cars and computers—that the
production FOR
sibilities frontier the varioustheir
combinations of output—in
labor, land, and capital
thisfirms
case, in the markets for the factors of pro- a graph that shows the
cars and computers—that the economy can possibly produce given the available factors of production and the
FACTORStoOFthePRODUCTION
ph that shows the
binations of output
economy can
17 possibly
duction.
available production
loop ofand
are sold
the
produce
The firms
in turnWages, rent,
technology
then given
that
diagram representsFirms
the factors
use these
to householdsHouseholds
available
sell
in the markets
firms use to
factors goods
to produce
turnforIncome
of production
and services,
goods and services. The outer
these factors into
andwhich
the combinations of output
output.
corresponding flow of dollars. The households that the economy can
the buy
available production technology that firms use to turn these factors into output.
Figure 2 shows this economy’s production possibilities frontier. If the economy
profit
the economy can Figure 2spend
shows this economy’s
money to buy goodsproduction
and servicespossibilities
from the firms. frontier.
The! Flow Ifof the
firms use economy
inputssome of the
bly produce given uses all itsrevenue
resources fromin these
the car industry,
sales to pay forit produces
the factors1,000 cars and
of production, and outputs as the wages possibly produce given
no computers.
such uses all its resources in the car industry, it produces 1,000 cars and no computers.
vailable factors
of their workers. What’s left is the profit of the firm owners, who themselves are
If it uses all its resources
members in the computer industry, it produces
of households. 3,000
! Flow computers the available factors
of dollars If it uses all its resources in the computer industry, it produces 3,000 computers
oduction and the and no cars. Let’s
The two
take endpoints
a tour of theofcircular
the production possibilities
flow by following a dollarfrontier it makes its of production and the
bill as represent and no cars. The two endpoints of the production possibilities frontier represent
way from person to person through the economy. Imagine that the dollar begins
able production these extreme possibilities.
at a household, say, in your wallet. If you want to buy a cup of coffee, you take available production these extreme possibilities.
nology More likely, the toeconomy
the dollar one of thedivides
economy’sits resources
markets forbetween goods andthe two industries,
services, such as your
More likely, the economy divides its resources between the two industries,
Starbucks coffee shop. There, you spend it on your favorite drink. When the technology
producinglocal
some cars and some computers. For example, it can produce 600 cars
dollar moves into the Starbucks cash register, it becomes revenue for the firm.
The dollar doesn’t stay at Starbucks for long, however, because the firm uses it to
producing some cars and some computers. For example, it can produce 600 cars
their labor,
buyland,
inputs and capital
in the markets to the firms
for the in the
factors markets for
of production. the factors
Starbucks might of
usepro-
the
duction. The firms
dollar to paythenrentuse these
to its factors
landlord to produce
for the goods or
space it occupies and Economic Models
services,
to pay which
the wages of

2
its workers. In either case, the dollar enters the income of some household and,
in turn areonce
sold to households
again, in the markets
is back in someone’s wallet. Atforthatgoods
point, the andstoryservices.
of the The outer
economy’s
e

2
loop of thecircular
diagram flowrepresents
starts once the corresponding flow of dollars. The households
again.
TheQuantity of
circular-flow diagram in Figure 1 is a very simple model of the econ-
spend money
duction Possibilities Frontier
omy.to It buy goodswith
dispenses
Computers anddetails
services
that,from the firms.
for some purposes, The are firms use someAofmore
significant. Figure
the
duction possibilities frontierrevenue from these Producedsales to pay for the factors of production, such as the wages Quantity of
he combinations of output—in of their workers. What’s left is the profit of the firm owners, who themselves are The Production Possibilities Frontier
Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Computers
, cars and computers—thatmembers
the of households. The production possibilities frontier
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Produced
y can possibly produce. The Let’s take a tour3,000 of the circular
F flow by following a dollar bill as it makes shows its the combinations of output—in
C
y can produce any combination
way from person to person through the economy. Imagine that the dollar begins this case, cars and computers—that the
side the frontier. Points outside
at
tier are not feasible given the a household, say, in
2,200 your wallet. If you A want to buy a cup of coffee, you take
economy can possibly produce. The 3,000 F C
y’s resources. the dollar to one of2,000 the economy’s markets forB goods and services, such as your economy can produce any combination
Production
local Starbucks coffee shop. There, you spend it on your favorite drink. When the on or inside the frontier. Points outside
possibilities
dollar moves into the Starbucks cash register, it becomes A
frontier revenue for the firm. the frontier are not feasible given the 2,200
1,000 D
2,000 B
The dollar doesn’t stay at Starbucks for long, however, because the firm uses iteconomy’s to resources.
buy inputs in the markets for the factors of production. E Starbucks might use the Production
dollar to pay rent to its landlord for the space it occupies or to pay the wages of possibilities
its workers. In either case, 0 the 300 600 700the income
dollar enters 1,000 of some Quantity of
household and, frontier
1,000 D
Cars Produced
once again, is back in someone’s wallet. At that point, the story of the economy’s
circular flow starts once again. E
The circular-flow diagram in Figure 1 is a very simple model of the econ-
omy. It dispenses with details that, for some purposes, are significant. A more 0 300 600 700 1,000 Quantity of
18 Cars Produced

ngage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Copyright
emed that any suppressed content does2011
not Cengage
materiallyLearning.
affect theAll Rights
overall Reserved.
learning May notCengage
experience. be copied, scanned,
Learning or duplicated,
reserves the right in
to whole
removeoradditional
in part. Due to electronic
content rights,
at any time some thirdrights
if subsequent partyrestrictions
content may be suppressed
require it. from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 6
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
 at point E, the resources best suited to making cars are already in the car industry. Producing an additional car means moving some of the best computer techni-
Producing an additional car means moving some of the best computer techni- cians out of the computer industry and making them autoworkers. As a result,
cians out of the computer industry and making them autoworkers. As a result, producing an additional car will mean a substantial loss of computer output. The
producing an additional car will mean a substantial loss of computer output. The opportunity cost of a car is high, and the frontier is steep.
opportunity cost of a car is high, and the frontier is steep. The production possibilities frontier shows the trade-off between the out-
The production possibilities frontier shows the trade-off between the out- puts of different goods at a given time, but the trade-off can change over time.
puts of different goods at a given time, but the trade-off can change over time.
For example, suppose a technological advance in the computer industry raises
For example, suppose a technological advance in the computer industry raises
the number of computers that a worker can produce per week. This advance
expands society’s set of opportunities. For any given number of cars, the
the number of computers that a worker can produce per week. This advance
expands society’s set of opportunities. For any given number of cars, the 3/29/23
economy can make more computers. If the economy does not produce any economy can make more computers. If the economy does not produce any
computers, it can still produce 1,000 cars, so one endpoint of the frontier stays computers, it can still produce 1,000 cars, so one endpoint of the frontier stays
the same. But the rest of the production possibilities frontier shifts outward, the same. But the rest of the production possibilities frontier shifts outward,
as in Figure 3. as in Figure 3.
This figure illustrates economic growth. Society can move production from a
This figure illustrates economic growth. Society can move production from a
point on the old frontier to a point on the new frontier. Which point it chooses
depends on its preferences for the two goods. In this example, society moves from point on the old frontier to a point on the new frontier. Which point it chooses
point A to point G, enjoying more computers (2,300 instead of 2,200) and more depends on its preferences for the two goods. In this example, society moves from
cars (650 instead of 600). point A to point G, enjoying more computers (2,300 instead of 2,200) and more
The production possibilities frontier simplifies a complex economy to highlight cars (650 instead of 600).
some basic but powerful ideas: scarcity, efficiency, trade-offs, opportunity cost, The production possibilities frontier simplifies a complex economy to highlight
some basic but powerful ideas: scarcity, efficiency, trade-offs, opportunity cost,
Economic Models
3
3
Quantity of
n the Production
ties Frontier
Computers
Produced
Figure
Quantity of
logical advance in the Computers
A Shift in the Production
r industry enables the Produced
to produce more computers
4,000 Possibilities Frontier
iven number of cars. As a A technological advance in the
e production possibilities computer industry enables the
3,000 4,000
hifts outward. If the economy economy to produce more computers
om point A to point G, then for any given number of cars. As a
uction of both cars and 2,300 G
result, the production possibilities
rs increases. 2,200 3,000
A frontier shifts outward. If the economy
moves from point A to point G, then
the production of both cars and 2,300 G
computers increases. 2,200
A

0 600 650 1,000 Quantity of

Cars Produced

19 0 600 650 1,000 Quantity of

Cars Produced
gage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
med that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

Thank you!!!

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