CENGAGE

Learning

Principles of
economics 6th Edition

N. Gregory Mankiw
Copyright © 2004 South-Western/Thomson Learning
 CHAPTER - 1

Principles of
MICROeconomics
(HSS – 1021)

Ten Principles of
Economics
N. Gregory Mankiw
9/10/2019 9:30 AM 2
Copyright © 2004 South-Western/Thomson Learning
A household and an economy
face many decisions:
 Who will work?
 What goods and how many of them should
be produced?
 What resources should be used in
production?
 At what price should the goods be sold?
Society and Scarce Resources:
• The management of society’s resources is
important because resources are scarce.
• Scarcity. . . means that society has limited
resources and therefore cannot produce
all the goods and services people wish to
have.
• Economics is the science of scarcity.
• Scarcity is the condition in which our wants are
greater than our limited resources.
• Since we are unable to have everything we desire,
we must make choices on how we will use our
resources.
• In economics we will study the choices of
individuals, firms, and governments.
• Economics is the study of Choices.
Economics is the study of how society
manages its scarce resources.
Economics, as a social science
concerned with the efficient use of
limited resources to achieve
maximum satisfaction of economic
wants.
• Microeconomics focuses on the individual
parts of the economy.
• How households and firms make decisions and how they
interact in specific markets

• Macroeconomics looks at the economy as a

whole.
• Economy-wide phenomena, including inflation,
unemployment, and economic growth
• These two branches of economics are closely intertwined,
yet distinct – they address different questions.
 Study of the economic actions of individuals
and small groups of individuals
 The study of particular firms, particular
households, individual prices, wages, incomes,
individual industry, particular commodities.
 In its approach, microeconomics proceeds to
examine how output and employment are
allocated among individual industries and
individual firms operating under industry and
how the prices of various products of these
individual firms are established assuming the
total output, total employment and spending for
all goods and services as given.
 Essentially the study of the behaviour and
performance of the economy as a whole
 Deals with the functioning of the economy as a
whole, including how the economy’s total
output of goods and services, the price level of
goods and services and the total employment of
resources are determined and what causes
these magnitudes to fluctuate.
 Studies the relationship and interaction
between the factors and forces that determine
the level and growth of output and employment,
general price level and balance of payment
position of an economy.
Meaning of Utility
 Utility refers to want satisfying power of a
commodity.
 It is the satisfaction, actual or expected, derived
from the consumption of a commodity.
 Utility differs from person- to-person, place-to-place
and time-to-time.
 In short, when a commodity is capable of satisfying
human wants, we can conclude that the commodity
has utility.
How to measure utility
 Several economists including Marshall, suggested the
measurement of utility in monetary terms.
 According to them, utility can be measured in terms of money
or price, which the consumer is willing to pay not the price he
is actually paying.
 For example, if consumer is willing to pay Rs. 20 from
consuming a cup of ice-cream, then he is deriving utility
worth Rs. 20 from that cup of ice-cream. This utility of Rs. 20
from the ice-cream is termed as value of utility in terms of
money.
 It must be noted that it is impossible to measure satisfaction
of a person as it is inherent to the individual and differs
greatly from person-to-person. Still, the concept of utility is
very useful in explaining and understanding the behaviour of
consumer.
 Total Utility (TU) refers to the total satisfaction obtained
from the consumption of all possible units of a commodity.
 It measures the total satisfaction obtained from consumption
of all the units of that good.
 For example, if the 1st cup of ice-cream gives you a
satisfaction of 20 and 2nd one gives 16, then TU from 2 cups
of ice-cream is 20 + 16 = 36. If the 3rd cup of ice-cream
generates satisfaction of 10, then TU from 3 cups of ice-
cream will be 20+ 16 + 10 = 46. Note that the utility is
measured by money you are willing to pay.
TU can be calculated as:
TUn = U1 + U2 + U3 +……………………. + Un, where:
TUn = Total utility from n units of a given commodity
U1, U2, U3,……………. Un = Utility from the 1st, 2nd,
3rd nth unit
n = Number of units consumed
 Marginal Utility (MU) is the utility derived from the last unit of a
commodity consumed.
 It is the additional utility derived from the consumption of one more unit
of the given commodity.
 As per given example, when 3rd cup of ice-cream is consumed, TU
increases from 36 to 46. The additional 10 is the MU derived from the
3rd cup of ice-cream.
 MU can be calculated as: MUn = TUn – TUn-1
Where: MUn = Marginal utility from nth unit;
TUn = Total utility from n units;
TUn-1 = Total utility from n – 1 units; n = Number of units of
consumption
 MU of 3rd cup of ice-cream will be: MU3 = TU3 – TU2 = 46 – 36 = 10
 One More way to Calculate MU is the change in TU when one more unit
is consumed.
 However, when change in units consumed is more than one, then MU can
also be calculated as Change in Total Utility (TU) / Change in number of
units(Q)
 MU = ∆TU/∆Q
Total Utility is Summation of Marginal Utilities:
Total utility can also be calculated as the sum of
marginal utilities from all units, i.e.
TUn= MU1 + MU2 + MU3 +……………………… + MUn or
simply,
TU = ∑MU
The concepts of TU and MU can be better understood
from the following schedule:

Cups of Ice-cream Consumed (No) 1 2 3 4 5 6

Total Utility (TU) (Rs) 20 36 46 50 50 44
Marginal Utility (MU =∆TU/∆C) (Rs.) 20 16 10 4 0 -6
• How people make decisions.
1. People face tradeoffs.
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 with each
other.
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.
• The forces and trends that affect
how the economy as a whole works.
8. The standard of living depends on a
country’s production.
9. Prices rise when the government prints too
much money.
10. Society faces a short-run tradeoff between
inflation and unemployment.
This means that there are “There is
always trade-offs -- to get
more of something we like,
no such
we have to give up thing as a
something else that we like. free lunch!”
For example, if you spend
money on dinner and a
movie, you won't be able to
spend it on new clothes.
To get one thing, we usually have to give up another
thing since resources to satisfy wants are scarce.
Trade-offs are all the alternatives that we give up
whenever we choose one course of action over
others.
• Guns v. butter
• Food v. clothing
• Leisure time v. work
• Efficiency v. equity

Making decisions requires trading

off one goal against another.
• Efficiency v. Equity
• Efficiency means society gets the most that it can
from its scarce resources.
• Equity means the benefits of those resources are
distributed fairly among the members of society.
• Tradeoff:
• To achieve greater equality, Government could
redistribute income from wealthy to poor.
• But this reduces incentive to work and produce,
shrinks the size of the economic “pie.”
• Decisions require comparing costs and benefits of
alternatives.
• Whether to go to college or to work?
• Whether to study or go out on a visit to a place?
• Whether to go to class or sleep in?
• The opportunity cost of an item is what you
give up to obtain that item.
• Going to college for a year is not just the tuition fees,
books, and other 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.
• The opportunity cost of an item is the cost of
next best alternative sacrificed or
foregone.
• The opportunity costs are the costs of
sacrificed alternatives.
• A machine can produce either X or Y. The
opportunity cost of producing a given quantity of X is,
therefore, the quantity of Y which it would have
produced. If that machine can produce 10 units of X
or 20 units of Y, then opportunity cost of producing
10X is 20Y or opportunity cost of producing X is 2Y.
• Rational people
• systematically and purposefully do the best they
can to achieve their objectives.

People make decisions by comparing

costs and benefits at the margin.

• Marginal changes are small,

incremental adjustments to an existing plan
of action.
•Rational decision makers only proceed with an
action if the marginal benefit exceeds the
marginal sacrifice.
•Rational decision maker takes action only if
Marginal benefits ≥ Marginal sacrifice
• You should only attend college for another year if the
benefits from that year of study in college exceed the
cost of attending the college for that year.
• A farmer should cultivate an extra acre of land for rice
only if the benefit (price received in selling rice)
exceeds the cost of producing rice in that extra acre of
land.
 • Rational decision maker – take action only if Marginal
benefits ≥ Marginal costs
• You like the movie Dangal and want to visit the movie as
many times as possible. The cost of visiting movie each
time (round) is Rs. 50/-. The total satisfaction derived
form visiting movie is given in the following table.
1st Time 2nd Time 3rd Time 4th Time 5th Time
Total Satisfaction (Rs) 100 180 250 290 310

Please note- You will get less and less satisfaction each time,
the more you visit the movie
• How many times (rounds) you will visit Dangal?
In determining how many time one will visit movie Dangal, one
will utilize the economic principle, i.e., ‘Rational People think at
margin’. This principle implies that a consumer always goes
on consuming a commodity till marginal benefit (marginal
satisfaction in this case) is greater than or equal to marginal
sacrifice (price per unit of movie ticket in this case). The
moment the consumer feels that the marginal benefit is less
than marginal sacrifice, he stopped his consumption.
Given total satisfaction from different rounds of visit of movie, it
is required to calculate marginal satisfaction from various
rounds of visit of movie which is given below. Marginal
satisfaction is the addition to the total satisfaction when one
visit movie by one additional round.
 1st Time 2nd Time 3rd Time 4th Time 5th Time
Total Satisfaction (Rs) 100 180 250 290 310

Marginal Satisfaction (Rs) 100 80 70 40 20

It is given that price of per round visit of movie is Rs. 50. Now it
is observed from the above table that the marginal satisfaction
from the visit of 3rd round of movie (Rs.70) is greater than the
ticket price (Rs.50). But the marginal satisfaction from the
fourth round visit of movie (Rs. 40) is less than the price
(Rs. 50). So one will visit Dangal for three times (rounds).
If price of visit of movie decreases to Rs.40, one will visit
Dangal for 4 times.
• Other 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 compares the cost of
the needed labor and materials to the
extra revenue.
Exercise
You are selling your 1996 Ambassador. You have already
spent Rs.10000 on repairs.
At the last minute, the transmission dies. You can pay
Rs.6000 to have it repaired, or sell the car “as is.”
In each of the following scenarios, should you have the
transmission repaired?
A. Blue book value is Rs.65000 if transmission works,
Rs.57000 if it doesn’t
B. Blue book value is Rs.60000 if transmission works,
Rs.55000 if it doesn’t
Answer to Exercise
Cost of fixing transmission = Rs.6000
A. Blue book value is Rs.65000 if transmission works,
Rs.57000 if it doesn’t
Benefit of fixing the transmission = Rs.8000
(Rs.65000 – Rs.57000).
It’s worthwhile to have the transmission fixed.
B. Blue book value is Rs.60000 if transmission works,
Rs.55000 if it doesn’t
Benefit of fixing the transmission is only Rs.5000.
Paying Rs.6000 to fix transmission is not
worthwhile.
Answer to Exercise
Observations:
• The Rs.10000 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.
• Incentive : Something that induces a person
to act i.e. the prospect of a reward or punishment
• Higher price
• Buyers - consume less
• Sellers - produce more
• Public policy
• Change costs or benefits
• Change people’s behavior
• When petrol prices rise, consumers buy more hybrid
cars and fewer petrol SUVs.
• When cigarette taxes increase, teen smoking falls.
People gain from their ability to trade with one
another.
Rather than being self-sufficient, people can
specialize in producing one good or service where
they are efficient and exchange it for other goods.
Countries also benefit from trade and
specialization:
Competition results in gains from trading
Get a better price abroad for goods they produce
Buy other goods more cheaply from abroad than could
be produced at home
• Exercise
• Jogesh can produce 40 kg of wheat or 20 kg of fish in 6
hours. Debesh can produce 20 kg of wheat or 40 kg of fish
in 6 hours. Jogesh and Debesh were to work in the
production of wheat and fish. Who would produce wheat,
who would produce fish and why? Explain with the help of
the relevant basic principles of economics.
ANSWER:
Basic Principles utilised- Trade can make everyone better off
Jogesh will produce wheat since he is more efficient or
productive in production of wheat.
Debesh will produce fish since he is more efficient or
productive in the production of fish.
Before trade :
Let both will spend 6 hours for production of both
commodities, i.e., 3 hours for each activity before trade.
Therefore, Jogesh can produce 20 kg of wheat and 10 kg of
fish in 6 hours.
Debesh can produce 10 kg of wheat and 20 kg of fish in 6
hours
After Trade: Each will specialise and spend six hours in the
activity where he is more efficient and exchange 1 kg of
wheat against 1 kg. of fish.
Therefore, Jogesh will produce wheat only (40 kg) and
Debesh will produce Fish only (40 kg) in 6 hours.
Now Jogesh will give 10kg of wheat to Debesh in exchange of
10 kg of fish which they produce earlier before trade.
Gain from Trade:
After exchange of 10 kg of wheat against 10 kg of fish, Jogesh will consume
30 kg of wheat and 10 kg of fish and Debesh will consume 10 kg of wheat and
30 kg of fish.
Therefore, Jogesh will gain 10kg of wheat, Debesh will gain 10 kg of fish and
whole economy will gain 10 kg of wheat and 10 kg of fish when trade takes
place

Person Production and Production Production Gain from

consumption after trade in and Trade
before trade in 6 hours consumption
6 hours after trade
Wheat Fish Wheat Fish Wheat Fish Wheat Fish
Jogesh 20 10 40 - 30 10 10 -
Debesh 10 20 - 40 10 30 - 10
Total 30 30 40 40 40 40 10 10
• A market economy is an economy that
allocates resources through the
decentralized decisions of many firms and
households as they interact in markets for
goods and services.
• Households decide what to buy and who to
work for.
• Firms decide whom 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.”
• Because households and firms look at prices when
deciding what to buy and sell, they unknowingly take
into account the social costs of their actions.
• As a result, prices guide decision makers to reach
outcomes that tend to maximize the welfare of society as
a whole.
We need government
Enforce the rules
Enforce property rights (Ability of an individual to own
and exercise control over scarce resources)
Market failure occurs when the market fails to
allocate resources efficiently.
Market failure may be caused by
an externality, which is the impact of one person or
firm’s actions on the well-being of a bystander.
market power, which is the ability of a single person
or firm to unduly influence market prices.
When the market fails (breaks down)
government can intervene to promote
efficiency and equity.
To promote efficiency : Avoid market
failure
To promote equality : Avoid disparities in
economic wellbeing
If the market’s distribution of economic well-
being is not desirable, tax or welfare policies can
change how the economic “pie” is divided.
Standard of living may be measured
in different ways:
By comparing personal incomes.
 By comparing the total market value of
a nation’s production.
Almost all variations in living
standards are explained by differences
in countries’ productivities.
Productivity is the amount of goods
and services produced from each unit
of labor input.
Inflation is an increase in the overall level
of prices in the economy.
One cause of inflation is the growth in the
quantity of money.
When the government creates large
quantities of money, the value of the
money falls.
The Phillips Curve illustrates the tradeoff
between inflation and unemployment:
 Inflation Unemployment
 It’s a short-run tradeoff!

Short-run effects of monetary injections:

Stimulates - overall level of spending
Higher demand for goods and services
Firms – raise prices; hire more
workers; produce more goods and
services
Lower unemployment
In the long run when expectations adjust to reflect
the actual situation, there is no tradeoff.
In some cases, higher inflation may lead to higher
unemployment because it is a disruptive influence on
the economy
In some decades, due to factors outside of the control
of policymakers, inflation and unemployment are
both high (e.g. 1970s) or both low (e.g. 1990s).
Yet, given these other factors, policymakers can
always reduce unemployment temporarily by
creating more inflation, or vice versa.
• When individuals make decisions, they face
tradeoffs among alternative goals.
• The cost of any action is measured in terms of
foregone opportunities.
• Rational people make decisions by comparing
marginal costs and marginal benefits.
• People change their behavior in response to the
incentives they face.
• Trade can be mutually beneficial.
• Markets are usually a good way of
coordinating trade among people.
• Government can potentially improve market
outcomes if there is some market failure or if
the market outcome is inequitable.
• Productivity is the ultimate source of living
standards.
• Money growth is the ultimate source of inflation.
• Society faces a short-run tradeoff between
inflation and unemployment.
1. After you graduate, you have decided to accept a position
working at the Bureau of Engineering Research for
Rs.10,00,000 a year. The other offers you received were
for Rs. 8,00,000, Rs. 9,50,000 and Rs. 8,50,000. What
is the opportunity cost of accepting the position at Bureau
of Engineering Research?
2. Paul runs a shop that sells printers. Paul is a perfect
competitor and can sell each printer for a price of
Rs.3000. The marginal cost of selling one printer a day is
Rs.2000; the marginal cost of selling a second printer is
Rs.2500; and the marginal cost of selling a third printer is
Rs.3500. To maximize his profit, how much printer should
Paul sell?
3. You like chocolate. Your utility function for
chocolate given by the following table:
Chocolates Consumed (No) 0 1 2 3 4 5 6 7
Total Utility (Rs.) 0 30 55 75 90 100 105 108
(a) Calculate the marginal utility schedule corresponding to
total utility schedule given in the above table.
(b) Utilising the principle of “rational people think at margin”,
determine how many chocolates you will consume if
chocolate is sold at Rs. 20 per unit?
(c) If price of chocolate increases to Rs.25 per unit, how
many chocolates would you consume now?
4. People respond to incentives. Governments can
alter incentives and, hence, behaviour with public
policy. Find how people respond to the following
public policies.
a) To reduce its budget deficit and limit environmental pollution,
the government raises the tax on petrol by Rs. 5.00 per litre.
b) To reduce the consumption of drugs, the government makes
drugs illegal.
c) To improve the welfare of European sugar beet growers, the
EU bans imports of sugar from South America.
d) To improve the living conditions of poor people, Government
provides 30 kg of rice to each family living below poverty line
at a subsidised price of Rs. 1 per kg.
5. Mrinmoyee can prepare 15 drinks per hour or grill 5
dinners per hour. Sneha can prepare 10 drinks per
hour or grill 8 dinners per hour. Mrinmoyee and Sneha
were to work in a bar and grille. Who would prepare
drinks, who would prepare the dinners and why?
Explain with the help of the relevant basic principles of
economics you have studied.
6. Mrinal can produce 50 kg of rice or 20 kg of fish in 5
hours. Kunal can produce 20 kg of rice or 50 kg of fish
in 5 hours. Mrinal and Kunal were to work in the
production of rice and fish. If trade is allowed who
would produce which commodity and why? Explain
with the help of the relevant basic principles of
economics.