Notes Ch 1 & 2 from book: Principles of Microeconomics Gregory Mankiw 6th

Ed.

Ch1: Ten Principles of Economics

Resources are scarce

o Scarcity: The limited nature of societys nature
Society has limited resources and therefore cannot produce all
the goods and services people wish to have.
Economics: the study of how society manages its scarce resources.
o through combined actions of millions of households and firms.
o Economics study how people make decisions on how to allocate their
scarce resources.

The 10 principles outline:

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 usualy a good way to organize economic activity
7. Governments can sometimes improve market outcomes
How the economy as a whole works
8. A countrys 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

Principle 1: People Face Trade-offs

1. Making decisions requires trading off one goal against another.
a. To get one thing we like, we usually have to give up another thing we
like.
2. Examples of trade-offs
a. Ex. guns and butter
i. Society spends on national defense (guns) to protect its shroes
from foreign aggressors
ii. By doing this though, one spends less on consumer goods
(butter) to raise the standard of living at home.
3. Ex. 2: clean environment and high level of income
a. Increasing expenses on trying to cut down pollution reduces profits.
4. Ex. 3: Efficiency vs. equality
a. Efficiency: when society is getting the maximum benefits from its
scarce resources.
b. Equality: when the economic prosperity/benefits are distributed
uniformly among societys members.

c. Greater equality reduces efficiency.

i. People would work less and produce fewer goods and services if
gov redistributes income form the rich to the poor.
d. Ex. Government trade-off
i. when you increase tax for the rich, efficiency goes down
because they have less incentive for work.
ii. But for equality, because we have increased the income tax of
the rich, and government can use these taxes for government
distribution of Money to poor, equality goes up.
e. Ex. Company trade-off
i. Profit= return-cost
ii. Want to maximize profit, you either need to increase return or
reduce cost
f. Ex. individual
i. Education OR cost/time
5. Conclusion: people are likely to make good decisions only if they understand
the options they have available. Study of economics therefore starts by
acknowledging lifes trade-offs.

Principle 2: The Cost of something is what you give up to get

it: Opportunity Cost
1. Because we make trade-offs, making decisions requires comparing the costs
and benefits of alternative courses of action.
2. Opportunity cost= highest loss
3. Example: Cost of going to college.
a. What is the cost?
i. Wed be tempted just to add up the money we spend on tuition,
books, room and board.
1. 2 problems with this calculation
a. Includes some things that are not really costs of
going to college.
i. Even if we dont go to schoo, we need a
place to sleep and food to eat.
b. This calculation ignores the largest cost of going to
college= our time
4. Opportunity Cost= what you give up to get that item.

Principle 3: Rational People Think at the Margin

1. Economists normally assume people are rational
a. Rational people=people who systematically and purposefully do the
best they can to achieve their objectives, given the available
opportunities.
2. Rational people think at the margin: they make decisions comparing marginal
benefits and marginal costs.
a. Marginal change= small incremental adjustment to an existing plan
of action.
i. Margin= edge

ii. Marginal change= adjustments around the edges of what you

are doing.
3. When company wants to maximize profit, we consider the marginal return vs.
marginal cost.
a. If MR> MC more profit
i. MR= if you increase one unit of this one product, how much
more you get.
ii. MC= if you increase one unit of a product how much more you
have to spend.
4. Example of making a decision thinking of marginal costs
a. An ariline is deciding how to charge passengers who fly standby
i. Flying a 200-seat plane across US costs $100,000
ii. The average cost of each seat is therefore $100,000/200= $500
b. From this, one may be tempted to say that one should NEVER sell a
ticket under $500
c. But, if a standby passenger is waiting at the gate and will pay $300 for
a seat, should the airline sell the ticket?
i. Yes! Because the marginal cost of adding one more passenger in
empty seats is merely the cost of a bag of peanuts and soda
that passenger will consume.
d. As long as the standby passenger pays more than the marginal cost,
selling the ticket is profitable.
5. Example of making a decision thinking of marginal benefit.
a. Why is water so cheap, while diamonds so expensive?
b. Water
i. Humans need water to survive, but the marginal benefit of an
extra cup is small since water is plentiful.
c. Diamond
i. Diamonds are not essential, but the marginal benefit of an extra
diamond is considered to be large.

Principle 4: People Respond to Incentives

1. Incentive= something that induces a person to actsuch as the prospect of
a punishment or reward.
2. Incentives are crucial to analyzing how markets workincentives influence
the behavior of consumers and producers which is crucial for how a market
economy allocates its resources
a. Ex. When apple prices increase, people buy/eat less apples.
b. But at the same time, apple orchards decide to produce more apples
hire more workers harvest more apples.
c. Higher prices in a market provide an incentive for buyers to
consume less and for sellers to produce more.
3. Public policymakers have a strong influence in a market as they can control
incentives
a. Ex. tax on gasoline encourages people to drive smaller, more fuelefficient cars. Which then again influences car producers.
4. Price is high, demand of consumer decrease, and supplier/firm increases.

5. Interesting twist to incentives: the seatbelt case

a. 50 years ago, not all cars had seatbelts. It wasnt enforced by law.
i. No seatbelts= incentive to drive slower, drive more
safely/carefully.
ii. Result: fewer accidents, more deaths caused by accidents.
b. After enforcing the seat belt law
i. With seatbelts= incentive to drive faster, less carefully
ii. Result: larger number of accidentsboth between cars and with
pedestrian accidents.
c. Net result: little changethese laws produced both fewer deaths per
accident and more accidents.
6. Another example of incentives: increase in gasoline prices from 2005-2008
a. b/c of this increase in gas price, people looked for alternatives.
i. Smaller calls, scooters, bicycles, more online courses, less
personal jets
b. Economic downturn that began in 2008 and continued into 2009
reduced world demand for oil price of gas declined substantially
7. Tax increase, incentive decreases; decrease in tax, incentive increases.

Principle 5: Trade Can Make Everyone Better Off

1. Trade between 2 countries can make each country better off
a. Because two countries are in competition does not mean that trade is
unfavorable.
2. Trade allows each person to specialize in the activities he/she does best.
3. By trading, people can buy a greater variety of goods&services at lower cost.

Principle 6: Markets are Usually a Good Way to Organize

Economic Activity
1. Market economy: an economy that allocates resources through the
decentralized decisions of many firms and households as they interact in
markets for goods and services.
a. Firms decide whom to hire and what to make
b. Households decide which firm to work for and what to buy
c. Firms & Households interact in the marketplace, where they are guided
by prices and self-interest.
2. In market economy, no one is looking out for the well-being of the society as
a whole.
a. Buyers and sellers are interested primarily in their own well-being.
3. Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations:
Households and firms interact in markets as if they are guided by an
invisible hand that leads them to desirable market outcomes.
a. Prices= the instrument with which the invisible hand directs economics
activity
1. Price determines:
1. how much to demand (buy)
2. How much to supply (produce)

2. So, price reflects both the value of a good to a society

(demands) and the cost to society of making the good (supply)
3. Prices adjust to guide these buyers and sellers to reach
outcomes that most of the ties maximize the well-being of
society as a whole.
4. When gov. prevents prices form adjusting naturally to supply and demand, it
prevents the invisible hand to do its work of maximizing well-being of firms
and households.
a. Ex. taxes, rent control
5. Market Force
Supply
Equilibriumbest price

Deman
d

Principle 7: Governments Can Sometimes Improve Market

Outcomes
1. If invisible hand can do all the work to maintain a healthy market, why do we
need a government??
2. Reason 1
a. = the invisible hand can work its magic only if (1) the government
enforces the rules and (2) maintains the institutions that are key to a
market economy.
b. (1) gov needs to enforce the rules
i. Most importantly, gov needs to enforce property rights so
individuals can own and control scare resources.
1. Property rights= the ability of an individual to own and
exercise control over scarce resources.
ii. We all rely on police and courts to enforce our rights over the
things we produce.
1. Ex. a farmer wouldnt grow crops if he knew theyd be
stolen
2. Restaurants wouldnt serve meals if customers dont pay
3. Company wouldnt produce DVDs if customers can avoid
paying by making illegal copies
3. Reason 2
a. = the invisible hand is powerful but it is not omnipotent. We need a
gov to promote efficiency and promote equality
i. Market failure: a situation in which the market on its own fails
to produce an efficient allocation of resources.
ii. Possible causes of market failure:

1. Externality: impact of one persons actions on the wellbeing of a bystander

a. Ex. pollution
2. Market power: ability of a single person/small group to
unduly influence market prices
4. Reason 3
a. =market economy/invisible hand yields efficient outcomes most of the
times but still can lead to unequal economic well-being.
b. Inequality because market economy rewards ppl according to their
ability to produce things that will attract people to pay for them.
c. Government/public policies aid to equalize these disparities.
i. Ex. income tax, welfare system..

Principle 8: A Countrys Standard of Living Depends on Its

Ability to Produce Goods and Services
1. There are huge differences in the standard of living around the world.
2. These living standards change over time, and these changes are large
a. Over the past century, average US income rose ~x8
3. What explains these large diff in living standards among countries and over
time?
a. Differences in productivity: the amount of goods and sercices
produced from each unit of labor input.
4. The growth rate of a nations productivity determines the growth rate of its
average income.
5. Policymakers can boost living standards by improving education and other
tools needed to improve productivity.

Principle 9: Prices rise when the government prints too much

money
1. Inflation= an increase in the overall prices in the economy.
2. Why inflation?
a. Government prints out too much moneyvalue of the money falls
prices increase

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

Inflation and Unemployment
1. Cause: increasing quantity of money Effect: increasing level of prices
2. Other short-run effects:
a. Printing out more money stimulates overall level of spending
increases demands for goods&services firms raise their prices hire
more workers to produce larger quantity of goods&services lower
unemployment
3. Conclusion: gradually, inflation increases, unemployment decreases
4. These short-run trade-offs play a critical role in the analysis of the business
cycle

a. Business cycle: fluctuations in economic activity, such as

employment and production.
5. Government has lots of power.
a. By changing the amount gov spends, amount it taxes, amount of
money it prints, they can influence theoverall demand for good and
service.s
6. Example: When President Obama came to presidency in 2008-2009 when US
was facing a deep economic downturn
a. Obama reduced taxes and increased gov spending
b. Federal Reserve increased the supply of money
c. = goal: reduce unemployment
d. But ppl worried about inflation.

Ch2: Thinking Like an Economist

What is distinctive about how economists confront a question?
What does it mean to think like an economist?

Economist as a Scientist
-

Economics is a science
o Uses the scientific method
Economists devise theories, collect data, analyze them and try
to verify/refute their theories

The Scientific Method: Observation, Theory, and More

Observation
1. Interplay between theory and observation occurs in economics
a. Ex. if someone sees prices increasing in a country and devises the
theory of inflation
b. They test to see if there is strong correlation between money growth
and inflation.
2. Experimenting in economics is difficult/sometimes impossible
a. Ex. in case of inflation, hard because economists cannot manipulate a
nations monetary policy just to generate useful data.
3. Experiments are offered by history

The Role of Assumptions

1. Assumptions can simplify the world and make it easier to understand
a. Ex. by assuming 2 countries w/ 2 goods, we can focus our thinking on
the essence of the problem
2. Economists use different assumptions for different experiments/questions
a. Ex. Economists use different assumptions when studying short-run and
long-run effects of a change in the quantity of money.

Economics Models
-

Economists use models to learn about the world

Models are built with assumptions

Our First Model: The Circular-Flow Diagram

1. Circular-flow diagram: model of economy that shows how dollars flow

through markets among households and firms
2. Assumptions:
a. 2 types of decision makers:
i. Firms
ii. Households
3. How it works:
a. Firms produce goods/services using inputs /factors of production
(labor, land, capital) from households
b. Then households consume those goods/services

Our Second Model: The Production Possibilities Frontier

1. Production Possibilities Frontier: graph that shows the combinations of
output that the economy can possibly produce
a. given the available factors of production and
b. the available production technology.
2. Our Model Assumptions:

a. Only 2 goods- cars & computers

b. Car industry and computers industry together use all of economys
factors of production

3. Efficient
a. A & B & F & E
b. Efficiency means that you cannot gain something without sarifiing the
other
c. So every point on the PPF line will be efficient
4. Inefficient
a. D
5. Out of production possibility
a. C
b. Because of limited factors of production of the country , it is not
possible to reach point C
6. Only way to get out of the PPF
a. Things life technological advances
b. TRADE
How to calculate the opportunity cost of a country

Slope of the tangent line to the point of production on the PPF is the
opportunity cost.