PRINCIPLES OF

Economics
By N. Gregory Mankiw

Principles of Economics
N. Gregory Mankiw
 Chapter

LECTURE 1
INTRODUCTION
 Chapter

1. The basic concept of Economics

2. Ten principles of Economics
3. Economist as a scientist
4. Economist as an advisor
 Chapter

Ten Principles of Economics

 Ten Principles of Economics
• Economy – “oikonomos” (Greek)
– “One who manages a household”
• Household - many decisions
– Allocate scarce resources
• Ability, effort, and desire
• Society - many decisions
– Allocate resources
– Allocate output
• Resources are scarce
5
 Ten Principles of Economics
• Scarcity - limited nature of society’s resources
• Economics
– Study of how society manages its scarce
resources
• Economists study:
– How people make decisions
– How people interact with one another
– Analyze forces and trends that affect the
economy as a whole
6
 How People Make Decisions
Principle 1: People face trade-offs
• Making decisions
– Trade off one goal against another
– Student – time
– Parents – income
– Society
• National defense vs. consumer goods
• Clean environment vs. high level of income
• Efficiency vs. equality

7
 How People Make Decisions
Principle 1: People face trade-offs
• Efficiency
– Society - maximum benefits from its scarce
resources
– Size of the economic pie
• Equality
– Benefits - uniformly distributed among
society’s members
– How the pie is divided into individual slices
8
 How People Make Decisions
Principle 2: The cost of something is what you
give up to get it
• People face trade-offs
– Make decisions
• Compare cost with benefits of alternatives
– Opportunity cost
• Whatever most be given up to obtain one item

9
 How People Make Decisions
Principle 3: Rational people think at the margin
• Rational people
– Systematically & purposefully do the best
they can to achieve their objectives
• Marginal changes
– Small incremental adjustments to a plan of
action
• Rational decision maker – take action only if
– Marginal benefits > Marginal costs
10
 How People Make Decisions
Principle 4: People respond to incentives
• Incentive
– Something that induces a person to act
– Higher price
• Buyers - consume less
• Sellers - produce more
– Public policy
• Change costs or benefits
• Change people’s behavior

11
 How People Make Decisions
Principle 4: People respond to incentives
– Gasoline tax
• Car size & fuel efficiency; carpool; public
transportation
– Unintended consequences
• Policymakers fail to consider how their policies
affect incentives

12
 How People Interact
Principle 5: Trade can make everyone better off
• Trade
– Specialization
• Allows each person/country to specialize in the
activities he/she does best
– People/countries can buy a greater variety of
goods and services at lower cost

13
 How People Interact
Principle 6: Markets are usually a good way to
organize economic activity
• Communist countries – central planning
– Government officials (central planners)
• Allocate economy’s scarce resources
– Decided
» What goods & services were produced
» How much was produced
» Who produced & consumed these goods & services
• Theory: only the government could organize
economic activity to promote economic well-
being for the country as a whole 14
 How People Interact
Principle 6: Markets are usually a good way to
organize economic activity
• Market economy - allocates resources
– Decentralized decisions of many firms and
households
– As they interact in markets for goods and
services
– Guided by prices and self interest
– Adam Smith’s “invisible hand”
15
 How People Interact
Principle 7: Governments can sometimes
improve market outcomes
• We need government
– Enforce the rules
– Maintain institutions - key to market economy
• Enforce property rights
• Property rights
– Ability of an individual to own and exercise
control over scarce resources
16
 How People Interact
Principle 7: Governments can sometimes
improve market outcomes
• Government intervention
– Change allocation of resources
– To promote efficiency
• Avoid market failure
– To promote equality
• Avoid disparities in economic wellbeing

17
 How People Interact
• Market failure
– Situation in which the market on its own fails
to produce an efficient allocation of resources
• Causes for market failure
– Externality
• Impact of one person’s actions on the well-being
of a bystander
– Market power
• Ability of a single person (or small group) to
unduly influence market prices
18
 How People Interact
• Disparities in economic wellbeing
– Market economy
• Rewards people - ability to produce things that
other people are willing to pay for
– Government intervention
• Public policies
– May diminish inequality
– Process far from perfect

19
 How the Economy as a Whole Works
Principle 8: A country’s standard of living
depends on its ability to produce goods and
services

20
 How the Economy as a Whole Works
Principle 9: Prices rise when the government
prints too much money

21
 How the Economy as a Whole Works
Principle 10: Society faces a short-run trade-off
between inflation and unemployment

22
 2

Thinking Like an Economist

 The Economist as a Scientist
• Economics = science
• Economists = scientists
– Devise theories
– Collect data
– Analyze these data
• Verify or refute their theories
• Scientific method
– Dispassionate development and testing of
theories about how the world works
24
 The Economist as a Scientist
The scientific method: observation, theory, and
more observation
• Observation
• Theory
• Conducting experiments
– Difficult / impossible
• Observation
– Close attention to natural experiments -
history
25
 The Economist as a Scientist
The role of assumptions
• Assumptions
– Can simplify the complex world
• Make it easier to understand
– Focus our thinking - essence of the problem
• Different assumptions
– To answer different questions
– Short-run effects
– Long-run effects
26
 The Economist as a Scientist
Economic models
• Diagrams & equations
• Omit many details
• Allow us to see what’s truly important
• Built with assumptions
• Simplify reality to improve our understanding
of it

27
 The Economist as a Scientist
Our first model: The circular-flow diagram
• Circular-flow diagram
– Visual model of the economy
– Shows how dollars flow through markets
among households and firms
• Decision makers
• Firms & Households
• Markets
• For goods and services
• For factors of production 28
 The Economist as a Scientist
Our first model: The circular-flow diagram
• Firms
– Produce goods and services
– Use factors of production / inputs
• Households
– Own factors of production
– Consume goods and services

29
 The Economist as a Scientist
Our first model: The circular-flow diagram
• Markets for goods and services

• Markets for inputs

30
 1
The circular flow

31
 The Economist as a Scientist
Our second model: The production possibilities
frontier
• Production possibilities frontier
– A graph
– Combinations of output that the economy
can possibly produce
– Given the available
• Factors of production
• Production technology

32
 2
The production possibilities frontier
Quantity of
Computers The production possibilities
Produced frontier shows the
combinations of output - in
C this case, cars and
3,000 F
computers - that the
Production
economy can possibly
A Possibilities
2,200 produce.
B Frontier
2,000 The economy can produce
any combination on or
inside the frontier.
D Points outside the frontier
1,000
are not feasible given the
E
economy’s resources.

0 300 600 700 1,000 Quantity of

Cars
Produced
33
 The Economist as a Scientist
• Efficient levels of production
– Economy’s getting all it can
• From the scarce resources available
– Points on the production possibilities frontier
– Trade-off:
• The only way to get more of one good is to get
less of the other good
• Inefficient levels of production
– Points inside production possibilities frontier

34
 The Economist as a Scientist
• Opportunity cost of one good
– Give up the other good
• Bowed out production possibilities frontier
– Opportunity cost of a car – highest
• Economy - producing many cars and fewer
computers
– Opportunity cost of a car – lower
• Economy - producing fewer cars and many
computers
– Resource specialization
35
 The Economist as a Scientist
• Technological advance
– Outward shift of the production possibilities
frontier
– Economic growth
– Produce more of both goods

36
 3
A shift in the production possibilities frontier
Quantity of
Computers
Produced A technological advance in
4,000 the computer industry
enables the economy to
produce more computers
3,000 for any given number of
2,300 G cars. As a result, the
2,200 production possibilities
A frontier shifts outward. If
the economy moves from
point A to point G, then the
production of both cars and
computers increases.

0 600 650 1,000 Quantity of

Cars Produced

37
 The Economist as a Scientist
Microeconomics and Macroeconomics
• Microeconomics
– The study of how households and firms make
decisions
– And how they interact in markets
• Macroeconomics
– The study of economy-wide phenomena,
including inflation, unemployment, and
economic growth
38
The Economist as a Policy Advisor (Self-study)
Economists in Washington
– Council of Economic Advisers
• Advise the president of the United states
• Write the annual Economic Report of the
President
– Department of Treasury
– Department of Labor
– Department of Justice
– Congressional Budget Office
– The Federal Reserve
39
The Economist as a Policy Advisor (Self-study)
Why economists’ advice is not always followed
• President
– Economic advisors - Economic policy
– Communication advisors
– Press advisors
– Legislative affairs advisors
– Political advisors

40
 Why Economists Disagree
• Economists - may disagree
– Validity of alternative positive theories about
how the world works
• Economists - may have different values
– Different normative views about what policy
should try to accomplish

41
 Why Economists Disagree
Differences in scientific judgments
• Different hunches about
– Validity of alternative theories
– Size of important parameters
• Measure how economic variables are related
• E.g.: Tax household’s income or consumption
• Different normative views about the tax system
• Different positive views about the responsiveness
of saving to tax incentives

42
 Why Economists Disagree
Differences in values
• Peter and Paula - take the same amount of
water from the town well
– Peter’s income= $50,000
• Tax= $5,000 (10%)
– Paula’s income= $10,000
• Tax= $2,000 (20%)

43
 Why Economists Disagree
Perception vs. Reality
• Rent control - adversely affects availability
and quality of housing
– Costly way of helping the neediest members
of society
– Many cities use rent control
• Trade barriers – economist oppose it
– Import on certain goods - restricted

44
Table 1
Ten principles of economics
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
45