PRINCIPLES OF

Microeconomics
By N. Gregory Mankiw

1
 1
Ten Principles of
Economics

2
 What Economics Is All About

 Scarcity refers to
the limited nature
of society’s
resources.

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 3

 What Economics Is All About
Economics is the study of how society
manages its scarce resources, including

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 4

 HOW PEOPLE MAKE DECISIONS

Principle
Principle #1:
#1: People
People Face
Face Tradeoffs
Tradeoffs
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 might
otherwise be used to produce
consumer goods.
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 HOW PEOPLE MAKE DECISIONS
Principle
Principle #1:
#1: People
People Face
Face Tradeoffs
Tradeoffs
 Society faces an important tradeoff: efficiency vs. equality
 efficiency:
• Society is getting the maximum benefits from its scarce resources
• Refers to “the size of the economic pie”
• Example: the economy is operating at full potential
- There is no unemployed labor
- There is no unused capital
 Equality:
• Benefits are uniformly distributed among members of a society
• Refers to “how the economic pie is slided”
• Example: Every household in the country has the same level of
income
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 HOW PEOPLE MAKE DECISIONS
Principle
Principle #1:
#1: People
People Face
Face Tradeoffs
Tradeoffs

 The “cost” of increased equality is a reduction in the

efficient use of our scare resources

 Tradeoff: To increase equality, can redistribute

income from the well-off to the poor.

 But this reduces the incentive to work and produce,

and shrinks the size of the economic “pie.”
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 HOW PEOPLE MAKE DECISIONS
Principle
Principle #2:
#2: The
The Cost
Cost ofof Something
Something Is
Is What
What
You
You Give
Give Up
Up to
to Get
Get ItIt

 Making decisions requires comparing the costs

and benefits of alternative choices.
 It is the relevant cost for decision making.
 It is not always as obvious as they might appear

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 HOW PEOPLE MAKE DECISIONS

Principle
Principle #2:
#2: The
The Cost
Cost ofof Something
Something Is
Is What
What
You
You Give
Give Up
Up to
to Get
Get ItIt

What are the costs associated with a college

education?
• Money spent on tuition, fees, room and board,
books…
• Even if you were not in college, you would still need
to eat & have a place to live.
What would you be doing if you were not in college?
• Working-Earning a wage
Forgone wages are cost of going to college
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 HOW PEOPLE MAKE DECISIONS
Principle
Principle #2:
#2: The
The Cost
Cost ofof Something
Something Is
Is What
What
You
You Give
Give Up
Up to
to Get
Get ItIt
 The opportunity cost of any item is whatever
must be given up to obtain it.
 The accounting cost of an item is the total
monetary value of expenditures for an item.
 Opportunity costs=economic costs
 Opportunity costs are different from accounting
costs
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 HOW PEOPLE MAKE DECISIONS

Principle
Principle #2:
#2: The
The Cost
Cost ofof Something
Something Is
Is What
What
You
You Give
Give Up
Up to
to Get
Get ItIt

 Opportunity costs of
going college
• Tuition and fees
• Books
• Without wages

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 11

 HOW PEOPLE MAKE DECISIONS

Principle
Principle #3:
#3: Rational
Rational People
People Think
Think at
at the
the Margin
Margin

 A person is rational if he systematically and

purposefully does the best she can achieve his
objectives.
 Many decisions are not “all or nothing,”
but involve marginal changes – incremental
adjustments to an existing plan.
 Evaluating the costs and benefits of marginal
changes is an important part of decision making.
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 HOW PEOPLE MAKE DECISIONS

Principle
Principle #3:
#3: Rational
Rational People
People Think
Think at
at the
the
Margin
Margin
Examples:
 A student considers
whether to go to college
for an additional year,
comparing the fees &
foregone wages to the extra
income he could earn with
an extra year of education.
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 HOW PEOPLE MAKE DECISIONS

Principle
Principle #3:
#3: Rational
Rational People
People Think
Think at
at the
the
Margin
Margin
Examples:
 A firm considers
whether to increase
output, comparing the
cost of the needed
labor and materials to
the extra revenue.

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 HOW PEOPLE MAKE DECISIONS
Principle
Principle #4:
#4: People
People Respond
Respond to
to Incentives
Incentives

 Incentive: something
that induces a person
to act, i.e. the prospect
of a reward or
punishment.
 Rational people
respond to incentives
because they make
decisions by comparing
costs and benefits.
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 HOW PEOPLE MAKE DECISIONS
Principle
Principle #4:
#4: People
People Respond
Respond to
to Incentives
Incentives

 Examples:
• In response to higher gas prices,
sales of “hybrid” cars (e.g., Toyota Prius) rise.
• In response to higher cigarette taxes,
teen smoking falls.

 Incentives implemented by the government

change the marginal costs or benefits and hence
may change behavior.

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 HOW PEOPLE INTERACT
Principle
Principle #5:
#5: Trade
Trade Can
Can Make
Make
Everyone
Everyone Better
Better Off
Off
 Rather than being self-sufficient, 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
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 Principle
Principle #5:
#5: Trade
Trade Can
Can Make
Make
Everyone
Everyone Better
Better Off
Off
Gains From Trade
Examples:
 Vietnam excels at coffee production but is not
good at manufacturing autos
 Japan's land and climate are not suitable for
growing coffee but has a highly efficient auto
industry
 It is wise for each country to specialize in the
activity where they have the advantage and then
trade with the other
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 HOW PEOPLE INTERACT
Principle
Principle #6:
#6: Markets
Markets Are
Are Usually
Usually A
A
Good
Good Way
Way toto Organize
Organize Economic
Economic Activity
Activity

 A market is a group of buyers and sellers.

(They 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
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 HOW PEOPLE INTERACT

Principle
Principle #6:
#6: Markets
Markets Are
Are Usually
Usually A
A
Good
Good Way
Way toto Organize
Organize Economic
Economic Activity
Activity

 In a market economy, these decisions result from

the interactions of many households and firms.
 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.

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 HOW PEOPLE INTERACT

Principle
Principle #6:
#6: Markets
Markets Are
Are Usually
Usually A
A Good
Good
Way
Way to
to Organize
Organize Economic
Economic Activity
Activity
 The invisible hand works through the price system:
• The interaction of buyers and sellers
determines prices of goods and services.
• 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.
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 HOW PEOPLE INTERACT
Principle
Principle #7:
#7: Governments
Governments Can
Can
Sometimes
Sometimes Improve
Improve Market
Market Outcomes
Outcomes
 Important role for govt: enforce property rights
(with police, courts)
 People are less inclined to work, produce, invest, or
purchase if large risk of their property being stolen.
• A restaurant won’t serve meals if customers
do not pay before they leave.
• A music company won’t produce CDs if too many
people avoid paying by making illegal copies.

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 HOW PEOPLE INTERACT

Principle
Principle #7:
#7: Governments
Governments Can
Can
Sometimes
Sometimes Improve
Improve Market
Market Outcomes
Outcomes
 Govt may alter market outcome to promote efficiency
 Market failure, when the market fails to allocate
society’s resources efficiently. Causes:
• Externalities, when the production or consumption
of a good affects bystanders (e.g. pollution)
• Market power, a single buyer or seller has
substantial influence on market price (e.g. monopoly)
 In such cases, public policy may increase efficiency.
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 HOW PEOPLE INTERACT

Principle
Principle #7:
#7: Governments
Governments Can
Can Sometimes
Sometimes
Improve
Improve Market
Market Outcomes
Outcomes

 Govt may alter market outcome to promote equity

 If the market’s distribution of economic well-being
is not desirable, tax or welfare policies can change
how the economic “pie” is divided.

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 HOW THE ECONOMY AS A WHOLE WORKS

Principle
Principle #8:
#8: A A country’s
country’s standard
standard of
of living
living
depends
depends onon its
its ability
ability to
to produce
produce goods
goods & &
services.
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.
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 HOW THE ECONOMY AS A WHOLE WORKS

Principle
Principle #8:
#8: A A country’s
country’s standard
standard of
of living
living
depends
depends onon its
its ability
ability to
to produce
produce goods
goods & &
services.
services.

 The most important determinant of living standards:

productivity, the amount of goods and services
produced per unit of labor.
 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.
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 HOW THE ECONOMY AS A WHOLE WORKS

Principle
Principle #9:
#9: Prices
Prices rise
rise when
when the
the government
government
prints
prints too
too much
much money.
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 govt creates money,
the greater the inflation rate.

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 HOW THE ECONOMY AS A WHOLE WORKS

Principle
Principle #10:
#10: Society
Society faces
faces aa short-run
short-run
tradeoff
tradeoff between
between inflation
inflation and
and unemployment
unemployment
 In the short-run (1 – 2 years),
many economic policies push
inflation and unemployment in
opposite directions.
 Other factors can make this
tradeoff more or less favorable,
but the tradeoff is always
present.

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 CONCLUSION
 Economics offers many insights about the
behavior of people, markets, and economies.
 It is based on a few ideas that can be applied
in many situations.

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