Ten Principles of Economics

Microeonomics
PRINCIPLES OF

N. Gregory Mankiw
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?
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
What Economics Is All About
Resources are allocated through the combined choices
of millions of households and firms
Economists analyze these commercial choices, the
forces and trends that effect the economy as a whole,
including:
Growth in average income
The fraction of the population that cannot find work
Prices etc.

How people make decisions?

Ten Principles of Economics
Principle 1: People Face Trade-offs
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.

Decisions are made by individuals, firms and society as a whole

The main trade-off society faces is between Efficiency and Equality
Ten Principles of Economics
Principle 1: People Face Trade-offs
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.”
Ten Principles of Economics
Principle 2: The Cost of Something Is What You Give Up
to Get It

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.
Ten Principles of Economics
Principle 2: The Cost of Something Is What You Give Up
to Get It
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.
Ten Principles of Economics
Principle 3: Rational People Think at the Margin

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..
 Rational decision maker takes an action if and only if the marginal benefit of
the action exceeds the marginal cost

Economists normally assume that people are rational and make

rational choices
Ten Principles of Economics
Principle 3: Rational People Think at the Margin
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, she
compares the cost of the needed labor and materials to the
extra revenue.
Ten Principles of Economics
Principle 4: People Respond to Incentives
Incentive: something that induces a person to act, i.e. the
prospect of a reward or punishment.
Because rational people make decisions by comparing costs and
benefits, they 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.
Ten Principles of Economics
The first 4 principles answer the question of how people
make the decisions
Because economy reflects the behavior of the individuals
who make up the economy, individual decision making
process is vitally important
What are they:
Principle 1: People Face Trade-offs
Principle 2: The Cost of Something Is What You Give Up to
Get It
Principle 3: Rational People Think at the Margin
Principle 4: People Respond to Incentives
Ten Principles of Economics
We have discussed how individuals make decisions
But economy also depends not only on ourselves but
other people as well
Next we will analyze How People Interact
Ten Principles of Economics
Principle 5: Trade Can Make Everyone Better Off
Rather than being self-sufficient or isolated, 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
Trade allows societies to specialize in what they do best
and to enjoy a greater variety of goods and services
Ten Principles of Economics
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)
“Organized Economic Activity” - where officials allocate the economy’s scarce
resources. These central planners decided:
It means, central planners decide
what goods to produce
how to produce them
how much of each to produce
who gets them

The theory behind it was that government could organize economic activity in a
way that promoted economic well-being for the country as a whole
Ten Principles of Economics
Principle 6: Markets Are Usually a Good Way to Organize Economic Activity

Market Economy: economy that allocates resources through the decentralized

decisions of many firms and households as they interact in market for goods and
services
Central planners are replaced by decisions of million of firms and households. They
make the decisions who to hire, what to produces, how much to produce etc.
These firms and households interact in the marketplace, where prices and self-
interest guide their decisions
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.
Ten Principles of Economics
Principle 6: Markets Are Usually a Good Way to Organize Economic
Activity
In Market Economy, prices are the instruments with which the
“invisible hand” directs economic activities
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.
As a result, decisions that buyers and sellers make, market prices
reflect both the value of a good to society and the cost to society of
making the good.
Ten Principles of Economics
Principle 7: Government Can Sometimes Improve Market
Outcomes

We need government to enforce rules and maintain

institutions that are key to a market economy, to allow
the “invisible hand” do its magic
Important role for government: enforce property rights
(with police, courts)
People are less inclined to work, produce, invest, or
purchase if large risk of their property being stolen.
Ten Principles of Economics
Principle 7: Government Can Sometimes Improve Market
Outcomes
Another reason, is the government to intervene in the economy and
change the allocation of resources that people would choose on their
own: to promote efficiency and to promote equality
Market Failure, situation in which the market on its own fails to
produce an efficient allocation of resources
Two main reasons:
Externality - the impact of one person’s actions on the well-being
of bystander (pollution, security etc)
Market Power, the ability of a single person or firm to unduly
influence market prices (monopoly)
Ten Principles of Economics
Principle 7: Government Can Sometimes Improve Market
Outcomes
Another reason, market economy does not ensure that
everyone has sufficient food, decent clothing, and adequate
healthcare. It promotes yielding efficient outcomes
Therefore in many cases governments introduces many
public policies, such as the income tax or the welfare system,
to achieve a more equal distribution of economic well-being
If the market’s distribution of economic well-being
is not desirable, tax or welfare policies can change how the
economic “pie” is divided.
Ten Principles of Economics
Principles 5 through 7 study How People Interact:
Principle 5: Trade Can Make Everyone Better Off
Principle 6: Markets Are Usually a Good Way to
Organize Economic Activity
Principle 7: Government Can Sometimes Improve Market
Outcomes
All these decisions and interactions that we have
covered, make up the economy. Therefore last three
principles study How the Economy as a Whole Works
Ten Principles of Economics
Principle 8: A Country’s Standard of Living Depends on Its
Ability to Produce Goods and Services

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.
We need to pay attention to Productivity meaning the quantity
of goods and services produced from each unity of labor input
Ten Principles of Economics
Principle 8: A Country’s Standard of Living Depends on Its Ability to
Produce Goods and Services

The most important determinant of living standards is productivity level.

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.

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
Ten Principles of Economics
Principle 9: Prices Rise When the Government Prints Too
Much Money
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 government creates money, the greater
the inflation rate.
Ten Principles of Economics
Principle 10: Society Faces a Short-Run Trade-off between
Inflation and Unemployment
In the short-run (1 – 2 years), many economic policies push
inflation and unemployment in opposite directions.
Increasing the amount of money in the economy stimulates
overall spending, thus demand for goods and services
Higher demand cause firms to raise their prices and encourage
to hire more worker and produce more
More hiring means lower unemployment
Other factors can make this tradeoff more or less favorable,
but the tradeoff is always present.
Ten Principles of Economics
Principle 10: Society Faces a Short-Run Trade-off between Inflation
and Unemployment

This short-run trade-off plays a key role in the analysis of a business

cycle – irregular and largely unpredictable fluctuations in economic
activity, such as employment and production
Policymakers can exploit the trade-off by:
Changing the government spending
Tax
Amount of money it prints etc
At the end they influence the overall demand for goods and services
Use of such instruments is subject of wide debate
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.
Government can potentially improve market outcomes
if there is a market failure or if the market outcome is
inequitable.
Chapter Summary
The principles of the economy as a whole are:
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.