Chapter 1

Ten Principles of
Economics

© 2002 by Nelson, a division of Thomson Canada Limited

 In this chapter you will…
 Learn
Learn that
that economics
economics is is about
about the
the
allocation
allocation of
of scarce
scarce resources.
resources.
 Examine
Examine some
some ofof the
the tradeoffs
tradeoffs that
that
people
people face.
face.
 Learn
Learn the
the meaning
meaning of of opportunity
opportunity
cost.
cost.
 See
See how
how to
to use
use marginal
marginal reasoning
reasoning
when
when making
making decisions.
decisions.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 2
 In this chapter you will…
 Discuss
Discuss how
how incentives
incentives affect
affect
people’s
people’s behaviour.
behaviour.
 Consider
Consider why
why trade
trade among
among people
people or
or
nations
nations can
can be
be good
good forfor everyone.
everyone.
 Discuss
Discuss why
why markets
markets areare aa good,
good, but
but
not
not perfect,
perfect, way
way to
to allocate
allocate
resources.
resources.
 Learn
Learn what
what determines
determines some
some trends
trends
in
in the
the overall
overall economy.
economy.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 3
 The Word Economy Comes
From…

…
…the
the Greek
Greek word
word for
for ““one
one who
who
manages
manages aa household
household.” .”

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 4
 TEN PRINCIPLES OF ECONOMICS
•• AA household
household and
and an
an economy
economy
face
face many
many decisions:
decisions:
–– Who
Who will
will work?
work?
–– What
What goods
goods and
and how
how many
many of
of them
them
should
should be
be produced?
produced?
–– What
What resources
resources should
should be
be used
used inin
production?
production?
–– At
At what
what price
price should
should the
the goods
goods be be sold?
sold?

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 5
 TEN PRINCIPLES OF ECONOMICS
Society
Society and
and Scarce
Scarce Resources:
Resources:
–– The
The management
management of of society’s
society’s
resources
resources is is important
important because
because
resources
resources are are scarce.
scarce.
–– Scarcity.
Scarcity. .. .. means
means that
that society
society has
has
limited
limited resources
resources and and therefore
therefore cannot
cannot
produce
produce allall the
the goods
goods and
and services
services
people
people wish
wish to to have.
have.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 6
 TEN PRINCIPLES OF ECONOMICS
 Economics
Economics is is the
the study
study ofof how
how society
society
manages
manages its its scarce
scarce resources.
resources.
 Economists
Economists studystudy how
how people
people make
make
decisions:
decisions:
 How
How much
much theythey work
work
 What
What they
they buy
buy
 How
How much
much theythey save
save
 How
How they
they invest
invest their
their savings
savings

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 7
 TEN PRINCIPLES OF ECONOMICS
 Economists
Economists alsoalso study
study how
how people
people
interact
interact such
such asas buyers
buyers and
and sellers.
sellers.
 Price
Price determination.
determination.
 Economists
Economists alsoalso analyze
analyze forces
forces and
and
trends
trends that
that affect
affect the
the economy
economy as as aa whole.
whole.
 Growth
Growth inin average
average income
income
 The
The rate
rate of
of price
price increase.
increase.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 8
 HOW PEOPLE MAKE DECISIONS
 There
There is is no
no mystery
mystery toto what
what an
an “economy”
“economy”
is.
is.
 It’s
It’s aa group
group people
people interacting
interacting with
with one
one
another
another as as they
they go
go about
about their
their lives.
lives.
 We
We start
start the
the study
study of
of economics
economics with with four
four
principles
principles of of individual
individual decision
decision making:
making:
 People
Peopleface
facetradeoffs
tradeoffs
 The
Thecost
costof
ofsomething
somethingis iswhat
what you
yougive
giveup
upto
to
get
get it.
it.
 Rational
Rational people
peoplethink
think at
atthe
the margin.
margin.
 People
Peoplerespond
respondtotoincentives.
incentives.
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 1: Page 9
 Principle 1: People Face Tradeoffs
“There
“Thereis isno
nosuch
suchthing
thingas asaafree
freelunch”
lunch”
 To
To get
get something
somethingwe welike
likewe weusually
usuallyhave
havetotogive
give
up
up something
somethingwe wedon’t
don’t like.
like.
 AAstudent
studentandand her
her time:
time:
 Studying
Studying vs.
vs. napping
nappingor orcycling.
cycling.
 Society’s
Society’s tradeoffs:
tradeoffs:
 Guns
Gunsvs.vs. Butter
Butter
 Clean
Cleanenvironment
environment and andhigher
higherincome
income
 you
youmight
mightget
getaafree
freebowl
bowlof of soup
soupatatthe
thestudent
studentco-
co-
op,
op, but
butthe
thesoup
soupisisnot
not free
freebecause
becauseyou youhave
have to
togive
give
up
up35-minutes
35-minutes waiting
waitingininline
lineto tobe
beserved.
served.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 10
 Principle 1: People Face Tradeoffs
 Society’s
Society’s tradeoffs
tradeoffs (cont’d):
(cont’d):
 Efficiency
Efficiency vs.
vs. Equity
Equity
 Efficiency:
Efficiency: Society
Society getting
getting the
the most
most itit
can
can from
from its
its scarce
scarce resources.
resources.
 Equity:
Equity: Distributing
Distributing economic
economic
prosperity
prosperity fairly
fairly among
among the
the members
members of of
society.
society.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 11
 •• Making decisions
Making decisionsrequires
requirestrading
tradingoff
offone
onegoal
goalagainst
againstanother.
another.
•• Consider
Consideraastudent
studentwhowhomust
mustdecide
decidehowhowtotoallocate
allocateher
hermost
most
valuable
valuableresource-her
resource-hertime. time.
•• She
Shecan spend
can spendall allof
ofher
hertime
timestudying
studyingeconomics;
economics;she shecan
can
spend
spendallallof
ofher
hertime
timestudying
studyingpsychology;
psychology;or orshe
shecan divide
can divideher
her
time
timebetween
betweenthe thetwo
twofields.
fields.For
Forevery
everyhour
hourshe
shestudies
studiesone
one
subject,
subject,she
shegives
givesup upananhour
hourshe could
she couldhavehaveused
usedstudying
studyingthe
the
other.
other.And
Andfor forevery
everyhour
hoursheshespends
spendsstudying,
studying,she
shegives
givesup
upan
an
hour
hourthat
thatshe could
she couldhave havespent
spentnapping,
napping,bike
bikeriding,
riding,watching
watching
TV,
TV,or
orworking
workingat ather
herpart-time
part-timejob
jobfor
forsome
someextra spending
extra spending
money.
money.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 12
 •• Or
Or consider
consider parents
parents deciding
deciding howhow toto spend
spend
their
their family
family income.
income.
•• They
They cancan buy
buy food,
food, clothing,
clothing, oror a family
a family
vacation.
vacation. Or Or they
they can
can save
save some
some of of the
the family
family
income
income for for retirement
retirement or or the
the children’s
children’s
college education.
college education.
•• When
When theythey choose
choose to to spend
spend an an extra
extra rupee
rupee
on
on one
one of of these
these goods,
goods, they
they have
have one
one less
less
rupee
rupee to spend
to spend on on some
some otherother good.
good.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 13
 •• When
Whenpeople
peopleare aregrouped
groupedinto intosocieties,
societies,theytheyface
facedifferent
differentkinds
kindsofof
trade
tradeoffs.
offs.
•• The
Theclassic
classictrade
tradeoff
offis between
is between“guns “gunsandandbutter.”
butter.”
•• The
Themore
morewe wespend
spendon onnational
nationaldefense
defense(guns)
(guns)totoprotect
protectour ourshores
shores
from foreign
from foreignaggressors,
aggressors,the theless
lesswe wecan
canspend
spendononconsumer
consumergoods goods
(butter)
(butter)totoraise
raiseour
ourstandard
standardofofliving
livingat home.
at home.
•• Also
Alsoimportant
importantininmodern
modernsociety
societyisisthe
thetrade-off
trade-offbetween
betweenaaclean clean
environment
environmentand andaahigh
highlevel
levelof income.
of income.
•• Laws
Lawsthat
thatrequire
requirefirms
firmsto toreduce
reducepollution
pollutionraise
raisethe
thecost
costofofproducing
producing
goods
goods and services. Because of the higher costs, these firmsend
and services. Because of the higher costs, these firms endupup
earning
earningsmaller
smallerprofits,
profits,paying
payinglower
lowerwages,
wages,charging higher
charging higherprices,prices,oror
some
somecombination
combinationofofthese thesethree.
three.
•• Thus,
Thus,while
whilepollution
pollutionregulations
regulationsgive giveususthe
thebenefit
benefitof a
of acleaner
cleaner
environment
environmentand andthe
theimproved
improvedhealth
healththat
thatcomes
comeswithwithit,it,they
theyhave
havethe
the
cost
costof
ofreducing
reducingthe incomes
the incomesofofthe thefirms’
firms’owners,
owners,workers,
workers,and and
customers
customers

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 14
 •• Another
Another trade-off
trade-off society
society faces
faces is
is between
between
efficiency
efficiency andand equity.
equity.
•• Efficiency
Efficiency means
means thatthat society
society is getting
is getting the
the
maximum
maximum benefits
benefits from
from its
its scarce
scarce resources.
resources.
Equity
Equity means
means thatthat those
those benefits
benefits areare
distributed fairly
distributed fairly among
among society’s
society’s members.
members. InIn
other
other words,
words, efficiency
efficiency refers
refers to
to the
the size
size of
of
the
the economic
economic pie, pie, and equity
and equity refers
refers toto how
how
the
the pie
pie is
is divided.
divided.
•• Often,
Often, when
when government
government policies
policies are
are
designed,
designed, thesethese two
two goals conflict.
goals conflict.
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 1: Page 15
 •• Consider,
Consider,for forinstance,
instance,policies
policiesaimed
aimedat atachieving
achievingaa
more
moreequal
equaldistribution
distributionofofeconomic
economicwell-being.
well-being.
•• Some
Someof ofthese
thesepolicies,
policies,such
suchasasthe
thewelfare
welfaresystem
system
or unemployment
or unemployment insurance,
insurance, trytryto
tohelp
help the
themembers
members
of society
of societywhowhoarearemost
most ininneed.
need.
•• Others,
Others, such
suchas the
as theindividual
individualincome
incometax,tax, ask
askthe
the
financially
financiallysuccessful
successfulto contribute
to contributemore
morethan
thanothers
others
to
tosupport
supportthe thegovernment.
government.
•• Although
Although these
these policies
policieshave
have the
thebenefit
benefit of achieving
of achieving
greater
greater equity,
equity, they
they have
haveaacost
cost in
interms
termsofof reduced
reduced
efficiency.
efficiency.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 16
 •• When
Whenthe thegovernment
governmentredistributes
redistributesincome
incomefrom fromthe
therich
richtotothe
thepoor,
poor,itit
reduces
reducesthe thereward
rewardforforworking
workinghard;
hard;as asaaresult,
result,people work
people workless lessand
and
produce
producefewer
fewergoods
goodsand andservices.
services.
•• InInother
otherwords,
words,when
whenthe thegovernment
governmenttries triestotocut
cutthe economic
the economicpie pieinto
into
more
moreequal
equalslices,
slices,the
thepie
piegets
getssmaller. 
smaller. 
•• Recognizing
Recognizingthat thatpeople
peoplefacefacetrade-offs
trade-offsdoes
doesnot notbybyitself
itselftell
tellus
uswhat
what
decisions
decisionstheytheywill
willor
orshould
shouldmake. 
make. 
•• AAstudent
studentshould
shouldnotnotabandon
abandonthe thestudy
studyofofpsychology
psychologyjust justbecause
because
doing
doingso sowould
wouldincrease
increasethe thetime available
time availablefor forthe
thestudy
studyofofeconomics.
economics.
•• Society
Societyshould
shouldnotnotstop
stopprotecting
protectingthe theenvironment
environmentjust just
because environmental
because environmentalregulations
regulationsreduce
reduceour ourmaterial
materialstandard
standardofof
living.
living.
•• The
Thepoor
poorshould
shouldnot notbe
beignored
ignoredjustjustbecause helping
because helpingthem themdistorts
distortswork
work
incentives.
incentives.
•• Nonetheless,
Nonetheless,acknowledging
acknowledginglife’s life’strade-offs
trade-offsisisimportant
important
because people
because peopleare arelikely
likelytotomake
makegood gooddecisions
decisionsonlyonlyififthey
they
understand the options that they have
understand the options that they have available. available.
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 1: Page 17
 Principle 2: The Cost of Something
is what You Give Up
 Making
Making decisions
decisions requires
requires comparing
comparing
the
the costs
costs and
and benefits
benefits of
of alternative
alternative
courses
courses of
of actions.
actions.
 To
Togo
goto
touniversity
universityor
ornot
not to
togo?
go?
 Opportunity
Opportunity cost:
cost: Whatever
Whatever must
must be
be
given
given up
up to
to obtain
obtain some
some item.
item.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 18
 •• Making
Making aa decision
decision requires
requires comparing
comparing the the
costs
costs and
and benefits
benefits ofof alternative
alternative courses
courses of of
action.
action. The
The cost
cost of
of one
one option
option isis not
not how
how
much
much itit will
will cost
cost in
in rupee
rupee terms,
terms, butbut rather
rather the
the
value
value ofof your
your second
second best
best alternative.
alternative.
•• Cost-benefit
Cost-benefit analysis
analysis involves
involves weighing
weighing up up
the
the total
total expected
expected costs
costs and
and benefits
benefits ofof one
one
course
course of of action
action against
against another.
another.
•• Having
Having done
done this,
this, you
you will
will be
be able
able to
to
formulate
formulate aa more
more well-thought-out
well-thought-out solution
solution to to
the
the business
business problem.
problem.
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 1: Page 19
 •• Consider,
Consider,for forexample,
example,the thedecision
decisionto togo
goto tocollege.
college.Intellectual
Intellectual
enrichment
enrichmentand anda lifetime
a lifetimeofofbetter
betterjob
jobopportunities.
opportunities.But Butwhat
whatisis
the
thecost?
cost?To Toanswer
answerthis
thisquestion,
question,you youmight
mightbe betempted
temptedto add
to add
up
upthe
themoney
moneyyou youspend
spendon ontuition,
tuition,books,
books,room,room,and andboard.
board.YetYet
this
thistotal
totaldoes
doesnotnottruly
trulyrepresent what
represent whatyou yougivegiveup uptotospend
spendaa
year
yearinincollege.
college.
•• The
Thefirst
firstproblem
problemwith
withthis
thisanswer
answerisisthat
thatititincludes
includessome somethings
things
that
thatare
arenotnotreally
reallycosts
costsof ofgoing
goingto college.
to college.Even Evenififyou
youquit
quit
school,
school,you youneed
needaaplace
placetotosleep
sleepandandfood
foodto toeat.
eat.Room
Roomand and
board
boardare arecosts
costsof going
of goingto tocollege
collegeonly
onlytotothetheextent
extentthat
thatthey
they
are
aremore
moreexpensive
expensiveat atcollege
collegethan
thanelsewhere.
elsewhere.Indeed,Indeed,the the
cost of
cost ofroomroomand andboard
boardat atyour
yourschool
schoolmight
mightbe beless
lessthan
thanthe
the
rent
rentand
andfoodfoodexpenses
expensesthatthatyou
youwould
wouldpaypayliving on
living onyour
yourown.
own.
In
Inthis
thiscase,
case,thethesavings
savingson onroom
roomandandboard
boardare areaabenefit
benefitof of
going
goingto tocollege.
college.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 20
 •• The
Thesecond
secondproblem
problemwithwiththis
thiscalculation
calculationofofcosts
costsisisthat
thatititignores
ignoresthethe
largest
largestcost
costofofgoing
goingtotocollege
collegeyour time.
your time.When
Whenyou youspend
spendaayear year
listening
listeningtotolectures,
lectures,reading
readingtextbooks,
textbooks,and
andwriting
writingpapers,
papers,you you
cannot spend
cannot spendthat thattime
timeworking
workingatataajob:
job:For
Formost
moststudents,
students,the thewages
wages
given
givenup uptotoattend
attendschool
schoolarearethe
thelargest single
largest singlecost
costofoftheir
theireducation.
education.
•• The
Theopportunity
opportunitycostcostofofan
anitem
itemisiswhat
whatyou
yougive
giveupuptotoget
getthatthatitem.
item.
•• When
Whenmaking
makingany anydecision,
decision,such as
such aswhether
whethertotoattend
attendcollege,
college,decision
decision
makers should be aware of the opportunity costs that accompany each
makers should be aware of the opportunity costs that accompany each
possible
possibleaction.
action.
•• InInfact,
fact,they
theyusually
usuallyare
areCollege
Collegeathletes
athleteswho
whocancanearn
earnmillions
millionsififthey
they
drop
dropoutoutof school
of schoolandandplay
playprofessional
professionalsports
sportsarearewell
wellaware
awarethat thatthe
the
opportunity
opportunitycost costofofcollege
collegeisisvery
veryhigh.
high.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 21
 Principle 3: Rational People Think
at the Margin
 Marginal
Marginal changes:
changes: Small
Small incremental
incremental
adjustments
adjustments to to marginal
marginal changes.
changes.
 Individuals
Individuals andand firms
firms can
can make
make better
better
decisions
decisions by by thinking
thinking at
at the
the margin.
margin.
 By
By comparing
comparing the the marginal
marginal benefits
benefits
(MB)
(MB) with
with the
the associated
associated marginal
marginal costs
costs
(MC)
(MC) of
of aa decision.
decision.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 22
 •• People
Peoplemakemakedecisions
decisionsbybycomparing
comparingthe themarginal
marginal
benefit
benefitwith
withthe
themarginal
marginalcost.
cost.
•• For
For example,
example,you youmight
mightbuy
buyoneone cup
cupof of coffee
coffeein inthe
the
morning
morning because
because itit helps
helps you
youstart
start the
theday,
day,butbut you
you
might
might notnot buy
buyaa second
second cup
cupbecause
becausethis thisgives
givesyouyou
nonoextra
extrabenefit
benefit(and
(andcosts another
costs another RupeeRupee10).10).
•• Rational
Rationalpeople
peoplesystematically
systematicallyand andpurposely
purposelydo dothe
the
best
best they
they can
cantotoachieve
achievetheir
theirobjectives,
objectives, given
giventhe the
available
available opportunities.
opportunities.
•• AArational
rationaldecision
decisionmaker
maker takes
takesananaction
actionifif and
andonly
only
ififthe
themarginal
marginalbenefit
benefitof
ofthe
theaction
actionexceeds
exceedsthe the
marginal
marginalcostcost

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 23
 •• The
Thefirst
first example
exampleisisdinner.dinner.The Thechoice,
choice,Mankiw
Mankiwsays,
says,
isisnot
not between
betweenfastingfastingand and eating
eating like
like aapig,
pig, but
but
whether
whetherto toeat
eat another
anotherspoonful
spoonfulof ofmashed
mashedpotatoes.
potatoes.
•• AtAtexam
exam time,
time,the thechoice
choiceisisnot notblowing
blowing them
them off
off
versus
versuspulling
pullingall-nighters,
all-nighters,but but whether
whetherto toput
put in
inan
an
hour
houron on your
your notes
notesinstead
instead of of watching
watchingTV. TV.
•• His
Hisnext
next example
exampleisisseat seat prices
pricesforforairplanes.
airplanes. The
The
airline
airlineshould
shouldsell sellseats
seatsat at the
theprice
priceabove
abovethethe
marginal
marginalcost cost ofof flying
flying the
the passenger.
passenger.
•• Then
Thenwe weget getthethewater/diamonds
water/diamondsexample. example. Water
Water isis
essential
essentialfor for life,
life,but
but it’s
it’scheap.
cheap. Diamonds
Diamondsare areanan
extravagance,
extravagance,but butthey
theyarearevery
veryexpensive.
expensive.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 24
 •• Suppose
Supposethat flying
that flyingaa200-seat
200-seatplane planeacross
acrossthe theUnited
UnitedStates
Statescosts
coststhe
the
airline
airlineRs.
Rs.100,000.
100,000.
•• In
Inthis
thiscase,
case,the theaverage
averagecost costof each
of eachseatseatisisRs.100,000/200,
Rs.100,000/200,which whichisis
Rs.
Rs.500.
500.OneOnemight
mightbebetempted
temptedto toconclude
concludethatthatthetheairline
airlineshould
should
never sell
never sellaaticket
ticketfor
forless
lessthan
thanRs.Rs.500.
500.
•• In
Infact,
fact,however,
however,the theairline
airlinecancanraise
raiseits
itsprofits
profitsby bythinking
thinkingatatthe
the
margin. Imagine
margin. Imaginethat thataaplane
planeisisabout
abouttototake
takeoffoffwith
withtentenempty
emptyseats,
seats,
and
and a standby passenger waiting at the gate will pay Rs.300 for aseat.
a standby passenger waiting at the gate will pay Rs.300 for a seat.
•• Should
Shouldthe theairline
airlinesell
sellthe
theticket?
ticket?Of Ofcourse
courseititshould.
should.IfIfthe
theplane
planehas has
empty
emptyseats,
seats,the thecost
costofofadding
addingone onemore
morepassenger
passengerisisminuscule.
minuscule.
•• Although
Althoughthe theaverage
averagecostcostofofflying
flyingaapassenger
passengeris Rs.is Rs.500,
500,the
the
marginal
marginalcost costisismerely
merelythe thecost
costof ofthe
thebag
bagofofpeanuts
peanutsand andcan
canof ofsoda
soda
that
thatthetheextra
extrapassenger will
passenger willconsume.
consume.
•• As
Aslong
longas asthe
thestandby
standbypassenger
passengerpays paysmore
morethanthanthethemarginal
marginalcost,
cost,
selling
sellingthetheticket
ticketis profitable.
is profitable.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 25
 •• Here
Hereisisa classic
a classicquestion.
question.WhyWhyisiswater
watersosocheap,
cheap,while
whilediamonds
diamondsare are
so
soexpensive:
expensive:Humans
Humansneedneedsurvive. while
survive. whilediamonds
diamondsareareunnecessary
unnecessary
but
butfor
forsome
somereason,
reason,people
peoplearearewilling
willingto
topay
paymuch
muchmore
morefor
foraa
diamond than
diamond thanfor foraacup
cupofofwater.
water.There’s
There’sthe
thewater/diamonds
water/diamondsexample.
example.
Here’s
Here’sMankiw’s
Mankiw’sexplanation:
explanation:
•• The
Thereason
reasonis isthat
thataaperson’s
person’swillingness
willingnessto topay
payfor
foraagood
goodis is
based
basedon onthethemarginal
marginalbenefit
benefitthat
thatananextra
extraunit
unitof
ofthe
thegood
goodwould
would
yield.
yield.
•• The
Themarginal
marginalbenefit,
benefit,ininturn,
turn,depends
dependson onhow
howmany
manyunits
unitsaa
person
personalready
alreadyhas.has.
•• Water
Wateris isessential,
essential,but butthe
themarginal
marginalbenefit
benefitofofan
anextra
extracup
cupisissmall
small
because
becausewater
wateris isplentiful.
plentiful.
•• By
Bycontrast,
contrast,no noone
oneneeds
needsdiamonds
diamondsto tosurvive,
survive,but
butbecause
because
diamonds
diamondsare aresosorare,
rare,people
peopleconsider
considerthe themarginal
marginalbenefit
benefitofofan
an
extra diamond to be
extra diamond to be large.large.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 26
 Principle 4: People Respond to
Incentive
•• Marginal
Marginal changes
changes inin costs
costs or
or benefits
benefits
motivate
motivate people
people to
to respond.
respond.
–– When
When the
the price
price of
of apples
apples rise…
rise…
•• The
The decision
decision to
to choose
choose oneone alternative
alternative
over
over another
another occurs
occurs when
when that
that
alternative’s
alternative’s marginal
marginal benefits
benefits exceed
exceed its
its
marginal
marginal costs!
costs!

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 27
 •• Behaviour
Behaviour changes
changes whenwhen costs
costs or
or benefits
benefits
change.
change.
•• For
For example,
example, ifif your
your hourly
hourly wage
wage increases
increases
then
then you
you are
are likely
likely to
to work
work more
more (unless
(unless of
of
course
course your
your income
income is is already too
already too high).
high).

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 28
 •• AnAnincentive
incentiveisissomething
something(such (suchasasthe
theprospect
prospectof ofaa
punishment
punishmentor oraareward)
reward)that
thatinduces
inducesaaperson
personto toact. 
act. 
•• Because
Becauserational
rationalpeople
peoplemake
makedecisions
decisionsby bycomparing
comparingcostscosts
and
andbenefits,
benefits,they
theyrespond
respondto toincentives.
incentives.
•• Incentives
Incentivesarearecrucial
crucialto toanalyzing
analyzinghow howmarkets
marketswork.
work.For
For
example,
example,whenwhenthe theprice
priceofofananapple
applerises,
rises,people
peopledecide
decideto toeat
eat
more
morepears
pearsand
andfewer
fewerapples
applesbecause
becausethe thecost
costofofbuying
buyingan an
apple
appleisishigher.
higher.
•• AtAtthe same
the sametime,
time,apple
appleorchards
orchardsdecide
decideto tohire
hiremore
moreworkers
workers
and
andharvest
harvestmore
moreapples
applesbecause
becausethe thebenefit
benefitof selling
of sellingananapple
apple
isisalso
alsohigher.
higher.
•• AsAswewewill
willsee,
see,the
theeffect
effectof
ofaagood’s
good’sprice
priceononthe
thebehavior
behaviorof of
buyers
buyersand sellers
and sellersininaamarket-in
market-inthis
thiscase,
case,the
themarket
marketforfor
apples-is
apples-iscrucial
crucialforforunderstanding
understandinghow howthetheeconomy allocates
economy allocates
scarce
scarceresources.
resources.
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 1: Page 29
 •• Public
Publicpolicymakers
policymakersshouldshouldnever
neverforget
forgetabout
aboutincentives
incentives
because
becausemany manypolicies
policieschange
changethe thecosts
costsor benefits
or benefitsthat
thatpeople
people
face
faceand,
and,therefore,
therefore,alteraltertheir
theirbehavior.
behavior.
•• AAtax
taxonongasoline,
gasoline,for forinstance,
instance,encourages people
encourages peopleto todrive
drive
smaller,
smaller,moremorefuel-efficient
fuel-efficientcars.
cars.
•• That
Thatisisoneonereason
reasonpeople
peopledrive
drivesmaller
smallercars
carsininEurope, where
Europe, where
gasoline
gasolinetaxes
taxesare arehigh,
high,than
thanininthe
theUnited
UnitedStates,
States,where
where
gasoline
gasolinetaxes
taxesare arelow.
low.
•• AAgasoline
gasolinetax taxalso encourages
also encouragespeople peopleto totake
takepublic
public
transportation
transportationrather
ratherthanthandrive
driveand
andto tolive
livecloser
closertotowhere
wherethey
they
work.
work.
•• If the
If thetax
taxwere
werelarger,
larger,more
morepeople
peoplewould
wouldbe bedriving
drivinghybrid
hybridcars,
cars,
and
andififititwere
werelarge
largeenough,
enough,theytheywould switch
would switchto toelectric
electriccars.
cars.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 30
 •• When
Whenpolicymakers
policymakersfail
failto
toconsider
considerhow
howtheir
theirpolicies
policiesaffect
affect
incentives,
incentives,they
theyoften
oftenend
endup upwith
withresults they
results theydid
didnot
notintend.
intend.
•• For
Forexample,
example,consider
considerpublic
publicpolicy
policyregarding
regardingauto
autosafety.
safety.
•• Today
Todayall
allcars
carshave
haveseat belts.
seat belts.but
butthis
thiswas
wasnot
nottrue
true5050years
years
ago.
ago.In
Inthe
the1960s,
1960s,Ralph
RalphNader’s
Nader’sbook
bookunsafe
unsafeatatAny
AnySpeed
Speed
generated much
generated muchpublic
publicconcern
concernover
overauto
autosafety.”
safety.”
•• Congress
Congressresponded
respondedwith
withlaws
lawsrequiring
requiringseat
seatbelts
beltsasas
standard equipment
standard equipmenton onnew
newcars.
cars.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 31
 •• How
Howdoes doesaaseat
seatbelt
beltlaw
lawaffect
affectauto
autosafety?
safety?
•• The
Thedirect
directeffect
effectisisobvious.
obvious.
•• When
Whenaaperson personwears
wearsaaseat belt,
seat belt,the
theprobability
probabilityofofsurviving
survivingaamajor
major
auto
autoaccident
accidentrises.
rises.
•• But
Butthat’s
that’snot
notthe
theendendofofthe
thestory
storybecause
becausethe law
the lawalso
alsoaffects
affectsbehavior
behavior
bybyaltering
alteringincentives.
incentives.
•• The
Therelevant
relevantbehavior
behaviorherehereisisthe
thespeed
speedandandcare
carewith which
with whichdrivers
drivers
operate
operatetheir theircars.
cars.
•• Driving
Drivingslowly
slowlyandandcarefully
carefullyisiscostly
costlybecause
becauseitituses
usesthe
thedriver’s
driver’stime
time
and energy.
and energy.
•• When
Whendeciding
decidinghow howsafely
safelytotodrive,
drive,rational
rationalpeople
peoplecompare
comparethe the
marginal
marginalbenefit
benefitfrom
fromsafer driving
safer drivingtotothe
themarginal
marginalcost.
cost.
•• They
Theydrive drivemore
moreslowly
slowlyand
andcarefully
carefullywhen
whenthethebenefit
benefitofofincreased
increased
safety is high.
safety is high.
•• ItItisisno
nosurprise,
surprise,forforinstance,
instance,that
thatpeople
peopledrive
drivemore
moreslowly
slowlyand
and
carefully
carefullywhen whenroads
roadsareareicy
icythan when
than whenroads
roadsare
areclear.
clear.
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 1: Page 32
 •• At
Atfirst,
first,this
thisdiscussion
discussionof ofincentives
incentivesand andseat
seatbelts
beltsmight
mightseem
seem
like
likeidle
idlespeculation.
speculation.
•• Yet
Yetininaaclassic 1975
classic 1975study,
study,economist
economistSam SamPeltzman
Peltzmanshowed
showed
that
thatauto-safety
auto-safetylawslawshave
havehadhadmany
manyof ofthese
theseeffects. 
effects. 
•• According
Accordingto toPeltzrnan’s
Peltzrnan’sevidence,
evidence,thesetheselawslawsproduce
producebothboth
fewer
fewerdeaths
deathsper peraccident
accidentandandmore
moreaccidents. 
accidents. 
•• He
Heconcluded
concludedthat thatthe
thenet
netresult
resultisislittle
littlechange
changeininthe
thenumber
numberof of
driver
driverdeaths
deathsand andan anincrease
increaseininthe number
the numberof ofpedestrian
pedestrian
deaths.
deaths.
•• Addition
Additionof ofaasafety
safetydevice
deviceallows
allowspeoplepeopleto tofeel
feelso
somuch
much
safer
saferin inthe
theactivity
activitythey’re
they’reengaged
engagedin, in,and
andthus,
thus,the
the
participant
participantof ofsaid
saidactivity
activitytakes
takeson onmore
moreandandmore
morerisk
riskto
to
the
thepoint
pointwhere
wherethe thesafety
safetydevice
deviceproduces
producesan anopposite
opposite
effect,
effect,leading
leadingto toinjury
injuryand/or
and/orfatalities.
fatalities.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 33
 •• When
When analyzing
analyzing any any policy,
policy, we
we must
must consider
consider
not
not only
only the
the direct
direct effects
effects but
but also
also the
the
indirect and
indirect and sometimes
sometimes lessless obvious
obvious effects
effects
that
that work
work through
through incentives.
incentives.
•• IfIf the
the policy
policy changes
changes incentives,
incentives, itit will cause
will cause
people
people to to alter
alter their
their behavior.
behavior.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 34
 HOW PEOPLE INTERACT

•• The
The first
first four
four principles
principles discussed
discussed how
how
individuals
individuals make
make decisions.
decisions.
•• The
The next
next three
three principles
principles concern
concern how
how
people
people interact
interact with
with one
one another.
another.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 35
 Principle 5: Trade can Make Everyone
Better Off
•• People
Peoplegain
gainfrom
fromtheir
theirability
ability to
totrade
tradewith
withone
one
another.
another.
•• Competition
Competitionresults
resultsinin gains
gainsfrom
from trading.
trading.
•• Trade
Tradeallows
allowspeople
peopleto tospecialise
specialisein inwhat
whatthey
theydo
do
best.
best.
•• By
Bytrading,
trading,each
eachperson
personcancanthen
thenbuybuyaavariety
varietyof
of
goods
goodsor or services.
services.
•• For
For example,
example,you youmaymaybe be aaskilled
skilledmanagement
management
consultant.
consultant.
•• Money
Moneyyou you earn
earnthrough
through your
your consulting
consulting work
workmight
might
be
beused
usedto tobuild
buildaahouse
houseeven
eventhough
thoughyou
youmay
maynot
not
have
have the
theskills
skillsto
to build
buildthe
the house
house yourself.
yourself.
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 1: Page 36
 •• For
Forinstance
instance,,American
Americanand andJapanese
Japanesefirms
firmsproduce
producemany manyof
of
the
thesame
samegoods.
goods.
•• Ford
FordandandToyota compete
Toyota competefor forthe
thesame
samecustomers
customersininthethemarket
market
for
forautomobiles.
automobiles.
•• Apple
Appleand andSony
Sonycompete
competefor forthe
thesame customers
same customersininthe themarket
market
for
fordigital
digitalmusic
musicplayers.
players.
•• Yet
Yetititisiseasy
easyto
tobe
bemisled
misledwhenwhenthinking
thinkingabout
aboutcompetition
competition
among
amongcountries.
countries.
•• Trade
Tradebetween
betweenthe
theUnited States
United Statesand andJapan
Japanisisnot
notlike
likeaasports
sports
contest
contestininwhich
whichone
oneside
sidewins
winsandandthe
theother
otherside
sideloses.
loses.
•• In
Infact,
fact,the opposite
the oppositeisistrue:
true:Trade
Tradebetween
betweentwo
twocountries
countriescancan
make
makeeach eachcountry
countrybetter
betteroff.
off.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 37
 •• To
To see
see why,
why, consider
consider how how trade
trade affects
affects your
your
family.
family.
•• When
When aa member
member of of your
your family
family looks
looks for
for aa job,
job,
he
he or she
or she competes
competes against
against members
members of of other
other
families
families who
who are
are looking
looking forfor jobs.
jobs.
•• Families
Families also
also compete
compete against one
against one another
another
when
when they
they go
go shopping
shopping because
because each each family
family
wants
wants to to buy
buy the
the best
best goods
goods at at the
the lowest
lowest
price
price ..
•• So
So in
in aa sense,
sense, each
each family
family in
in the
the economy
economy is is
competing
competing withwith all
all other
other families.
families.
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 1: Page 38
 •• Despite
Despitethis thiscompetition,
competition, your
your family
familywould
wouldnot not bebe
better
better off offisolating
isolatingitself
itselffrom
from all
allother
other families.
families.
•• IfIfIt did,
It did, your
your family
familywould
wouldneed
needto togrow
growitsitsown
own food,
food,
make
make its itsown
ownclothes,
clothes, and
andbuild
build its
its own
ownhome.
home.
•• Clearly, your
Clearly, yourfamilyfamilygains
gainsmuch
muchfromfromitsitsability
ability to
to
trade
tradewithwithothers.
others.
•• Trade
Tradeallowsallowseach
eachperson
personto tospecialize
specialize in in
the activities
the activitieshe heororshe
shedoes
doesbest,
best,whether
whetherititisis
fanning,
fanning,sewing,
sewing,or or home
homebuilding.
building.
•• By Bytrading
tradingwith
withothers, people
others, peoplecan can buybuyaa greater
greater
variety
varietyof of goods
goods and
andservices
servicesat at lower
lowercost.
cost.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 39
 •• Countries
Countries as as well
well as
as families
families benefit
benefit from
from the
the
ability
ability to
to trade
trade with
with one
one another.
another.
•• Trade
Trade allows
allows countries to
countries to specialize
specialize inin what
what
they
they do
do best
best and
and toto enjoy
enjoy aa greater
greater variety
variety of
of
goods
goods and and services.
services.
•• The
The Japanese,
Japanese, as wellas well as
as the
the French
French andand the
the
Egyptians
Egyptians and and the
the Brazilians,
Brazilians, are
are as
as much
much
our
our partners
partners in in the
the world
world economy
economy as they
as they
are
are our
our competitors.
competitors.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 40
 Principle 6: Markets are Usually a
Good Way to Organize Economic
Activity
 Market
Market economy:
economy: An An economy
economy that that
allocates
allocates resources
resources through
through the the
decentralized
decentralized decisions
decisions of of many
many firms
firms and
and
households
households as as they
they interact
interact inin markets
markets for
for
goods
goods and
and services.
services.
 Firms
Firms decide
decide whom
whom to to hire
hire and
and what
what to
to
make.
make.
 Households
Households decide
decide which
which firms
firms toto work
work
for
for and
and what
what to
to buy
buy with
with their
their incomes.
incomes.
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 1: Page 41
 Principle 6: Markets are Usually a
Good Way to Organize Economic
Activity
 Market
Market economy:
economy: An An economy
economy that that
allocates
allocates resources
resources through
through the the
decentralized
decentralized decisions
decisions of of many
many firms
firms and
and
households
households as as they
they interact
interact inin markets
markets for
for
goods
goods and
and services.
services.
 Firms
Firms decide
decide whom
whom to to hire
hire and
and what
what to
to
make.
make.
 Households
Households decide
decide which
which firms
firms toto work
work
for
for and
and what
what to
to buy
buy with
with their
their incomes.
incomes.
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 1: Page 42
 •• Individuals
Individualsand
andfirms
firmsthat
that operate
operatein in aamarket
market
economy
economyrespond
respondto toprices
pricesand
andthereby
thereby act actas
asifif
guided
guidedby byan
an“invisible
“invisiblehand”
hand” which
whichleads
leadsthethemarket
market
to
toallocate
allocateresources
resourcesefficiently.
efficiently.
•• For
For example,
example,ifif there
thereisisananoversupply
oversupplyof of wheat
wheat on on
the
the world
worldmarket
market thenthenindividual
individualfarmers
farmerswillwilllower
lowerthe
the
price
price they
theycharge
chargeuntiluntilthey
theycan
can sell
sellall
allof
of their
their wheat. 
wheat. 
•• Lower
Lower wheat
wheat prices
priceswill willalso
alsolikely
likelyreduce
reducethe thetotal
total
quantity
quantityofof wheat
wheatthat thatfarmers
farmersdecide
decideto toproduce.
produce.
•• Market
Market prices
pricesare
areableableto
toadjust
adjusttotoequate
equatesupply and
supply and
demand
demand without
withoutthe theneed
needforforany
any central
centralplanning.
planning.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 43
 Invisible hand
•• The
Theunobservable
unobservablemarket marketforce
forcethat
thathelps
helpsthe
thedemand
demandand and
supply
supplyofofgoods
goodsininaafree freemarket
marketto toreach
reachequilibrium
equilibrium
automatically
automaticallyisisthe theinvisible
invisiblehand.
hand.
•• The
Thephrase
phraseinvisible
invisiblehand handwaswasintroduced
introducedby byAdam
AdamSmith
Smithininhis
his
book
book'The
'TheWealth
Wealthof ofNations'.
Nations'.HeHeassumed
assumedthat thatan
aneconomy
economycan can
work
workwell
wellininaafree
freemarket
marketscenario
scenariowhere
whereeveryone
everyonewill
willwork
workforfor
his/her
his/herown
owninterest.
interest.
•• He
Heexplained
explainedthat thatananeconomy
economywillwillcomparatively
comparativelyworkworkandand
function
functionwell
wellififthe
thegovernment
governmentwill willleave
leavepeople
peoplealone
alonetotobuy
buy
and
andsell
sellfreely
freelyamong
amongthemselves.
themselves.
•• He
Hesuggested
suggestedthat thatififpeople
peoplewere
wereallowed
allowedto totrade
tradefreely,
freely,self
self
interested
interestedtraders
traderspresent
presentininthethemarket
marketwould
wouldcompete
competewithwith
each
eachother,
other,leading
leadingmarkets
marketstowards
towardsthe thepositive
positiveoutput
outputwith
withthe
the
help
helpof
ofan
aninvisible
invisiblehand.
hand.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 44
 Invisible hand
•• In
Inaafree
freemarket
market scenario
scenariowhere
wherethere
thereare
areno no
regulations
regulationsor orrestrictions
restrictionsimposed
imposedby bythe
the
government,
government, ifif someone
someonecharges
charges less,
less,the
thecustomer
customer
will
willbuy
buyfrom
fromhim.
him.
•• Therefore,
Therefore, youyouhave
haveto tolower
loweryour
yourprice
priceoror offer
offer
something
somethingbetter
betterthan
thanyour
yourcompetitor.
competitor.
•• Whenever
Wheneverenoughenoughpeople
people demand
demandsomething,
something, itit will
will
be
besupplied
suppliedby by the
the market
marketand andeveryone
everyonewill willbe
be
happy.
happy.
•• The
Theseller
seller end
endup upgetting
gettingthetheprice
price and
andthethebuyer
buyerwill
will
get
get better
bettergoods
goodsat at the
thedesired
desiredprice.
price.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 45
 •• Communist
Communistcountries
countriesworked
workedon onthe
thepremise that
premise that
government
government officials
officialswere
wereinin the
thebest
best position
positionto to
determine
determinethe
theallocation
allocationofofscarce
scarceresources
resourcesin in
the economy.
the economy.
•• These
Thesecentral
centralplanners
plannersdecided
decidedwhat
whatgoods
goodsand and
services
serviceswere
wereproduced,
produced, how
howmuchmuch was produced,
was produced,
and
andwho
whoproduced
producedandand consumed
consumedthesethesegoods
goodsand and
services.
services.
•• The
Thetheory
theorybehind
behindcentral
centralplanning was
planning wasthatthat only
onlythe
the
government
government could
couldorganize
organizeeconomic
economicactivity
activityininaa
way
waythat
thatpromoted
promotedeconomic
economic wellbeing for
wellbeing for the
the
country
countryas
as aawhole.
whole.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 46
 •• Today,
Today,mostmostcountries
countriesthat
thatonce
oncehad
hadcentrally
centrallyplanned
planned
economies
economieshave haveabandoned
abandonedthisthissystem
systemand andare trying
are tryingto
to
develop
developmarket
marketeconomies.
economies.
•• In
Inaamarket
marketeconomy,
economy,thethedecisions
decisionsof ofaacentral
centralplanner
plannerare
are
replaced by
replaced bythe thedecisions
decisionsofofmillions
millionsofoffirms
firmsand
andhouseholds.
households.
•• Firms
Firmsdecide
decidewhom
whomto tohire
hireand
andwhat
whatto tomake. 
make. 
•• Households
Householdsdecidedecidewhich
whichfirms
firmstotowork
workforforand
andwhat
whattotobuy
buywith
with
their
theirincomes.
incomes.
•• These
Thesefirms
firmsand households
and householdsinteract
interactininthe
themarketplace,
marketplace,where
where
prices
pricesand
andself-interest
self-interestguide
guidetheir
theirdecisions.
decisions.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 47
 •• At
Atfirst
first glance,
glance, thethesuccess
successof of market
marketeconomies
economies isis
puzzling.
puzzling.
•• After
After all,
all, in
inaa market
marketeconomy,
economy, no noone
oneis looking
is lookingout
out
for
for the
theeconomic
economicwell-being
well-beingof ofsociety
societyasasaa whole.
whole.
•• Free
Freemarkets
marketscontain
containmanymanybuyers
buyersand sellers
and sellersofof
numerous
numerousgoods goodsandand services,
services, and
andall
all of
ofthem
themare
are
interested
interested primarily
primarilyin intheir
theirown
own well-being. 
well-being. 
•• Yet
Yetdespite
despitedecentralized
decentralizeddecision
decisionmaking
makingand andself-
self-
interested
interested decision
decisionmakers,
makers, market
market economies
economies
have proven
have provenremarkably
remarkablysuccessful
successfulin inorganizing
organizing
economic
economicactivityactivityin
in aaway
waythat
thatpromotes
promotesoverall
overall
economic well
economic wellbeing. being.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 48
 •• Prices
Pricesare
arethe
theinstrument
instrumentwithwithwhich the
which theinvisible
invisiblehand directs
hand directs
economic
economicactivity.
activity.
•• In
Inany
anymarket,
market,buyers
buyerslook
lookatatthe
theprice
pricewhen
whendetermining
determininghow how
much
muchto todemand, and
demand, andsellerssellerslook
lookatatthe
theprice
pricewhen
whendeciding
deciding
how
howmuch
muchto tosupply.
supply.
•• As
Asaaresult
resultofofthe
thedecisions
decisionsthat
thatbuyers and
buyers andsellers
sellersmake,
make,
market
marketprices
pricesreflect
reflectboth
boththe
thevalue
valueof ofaagood
goodtotosociety
societyandandthe
the
cost
costto
tosociety
societyof making
of makingthethegood.
good.
•• Smith’s
Smith’sgreat
greatinsight
insightwas
wasthat
thatprices
pricesadjust
adjustto
toguide
guidethese
these
individual
individualbuyers
buyersand andsellers
sellersto reach
to reachoutcomes
outcomesthat,
that,ininmany
many
cases,
cases,maximize
maximizethe thewelfare
welfareof ofsociety
societyas asaawhole.
whole.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 49
 •• There
Thereisisananimportant
importantcorollary
corollaryto tothe
theskill
skillof ofthe
theinvisible
invisiblehand
handin inguiding
guiding
economic
economicactivity:
activity:
•• When the
When thegovernment
governmentprevents
preventsprices
pricesfrom
fromadjusting
adjustingnaturally
naturallytotosupply
supplyand and
demand, it impedes the invisible hand’s ability to coordinate the
demand, it impedes the invisible hand’s ability to coordinate the millions of millions of
households
householdsand andfirms
firmsthat
thatmake
makeup upthe
theeconomy.
economy.
•• This corollary
This corollaryexplains
explainswhy whytaxes
taxesadversely
adverselyaffect
affectthe
theallocation
allocationof of
resources:
resources:
•• Taxes
Taxesdistort
distortprices
pricesandandthus the
thus thedecisions
decisionsofofhouseholds
householdsand andfirms.
firms.
•• ItItalso
alsoexplains
explainsthetheeven
evengreater
greaterharm
harmcaused
causedby bypolicies
policiesthat directly
that directlycontrol
control
prices.
prices.
•• And
Andititexplains
explainsthethefailure
failureofofcommunism.
communism.InIncommunist countries,
communist countries,prices priceswere
were
not
notdetermined
determinedininthe themarketplace
marketplacebut butwere
weredictated
dictatedby bycentral
centralplanners.
planners.
•• These planners
These plannerslackedlackedthe theinformation
informationthat
thatgets
getsreflected
reflectedininprices
pricesthat
thatare
arefree
free
totorespond
respond to market forces. Central planners failed because they tried to runthe
to market forces. Central planners failed because they tried to run the
economy with one hand tied behind their backs -the invisible
economy with one hand tied behind their backs -the invisible hand of the hand of the
marketplace.
marketplace.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 50
 Principle 7: Governments can
Sometimes Improve Market
Outcomes
 When
When the
the invisible
invisible hand
hand does
does not
not work.
work.
 Market
Market failure:
failure: AAsolution
solutionininwhich
whichaamarket
market
left
lefton
onits
itsown
ownfails
failsto
toallocate
allocateresources
resources
efficiently.
efficiently.
 Externality:
Externality:The Theimpact
impactof ofone
oneperson’s
person’s
actions
actionson onthe
thewell-being
well-beingof ofaabystander.
bystander.
 Market
Market power:
power:The Theability
ability of
of aasingle
single economic
economic
actor
actor(or
(orsmall
smallgroup
groupofofactors)
actors) to
tohave
haveaa
substantial
substantialinfluence
influenceon onmarket
marketprices.
prices.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 51
 •• Sometimes
Sometimes aa market
market may
may fail
fail to
to allocate
allocate
resources
resources efficiently,
efficiently, and
and government
government
regulation
regulation can
can be
be used
used toto improve
improve the the
outcome.
outcome.
•• Market
Market failures
failures can
can occur
occur due
due to to the
the
existence
existence of public
of public goods, monopolies
goods, monopolies
and externalities.
and externalities. For
For example,
example, an an electricity
electricity
supplier
supplier might
might have
have aa monopoly.
monopoly.
•• Government
Government regulation may
regulation may be be required
required toto
ensure
ensure that
that the
the supplier
supplier does
does not not abuse
abuse its
its
market
market power.
power.
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 1: Page 52
 •• If the
If theinvisible
invisiblehand of
hand ofthethemarket
marketisisso sogreat,
great,why
whydo doweweneed
need
government?
government?
•• One
Onepurpose
purposeofofstudying economics
studying economicsisisto torefine
refineyour
yourview
viewabout
aboutthe
the
proper
properrole
roleand
andscope
scopeofofgovernment
governmentpolicy.
policy.
•• One
Onereason
reasonwe weneed
needgovernment
governmentisisthat thatthe
theinvisible
invisiblehand
handcancanwork
workits its
magic
magiconlyonlyififthe
thegovernment enforces
government enforcesthe therules
rulesand
andmaintains
maintainsthe
the
institutions
institutionsthat
thatare
arekey
keytotoaamarket
marketeconomy.
economy.
•• Most
Mostimportant, markets
important, marketswork workonly
onlyififproperty
propertyrights
rightsare
areenforced.
enforced.
•• AAfarmer
farmerwon’t
won’tgrow
growfood
foodififhe
heexpects
expectshis hiscrop
croptotobe stolen;
be stolen;aa
restaurant
restaurantwon’t
won’tserveservemeals
mealsunless
unlessititisisassured
assuredthatthatcustomers
customerswillwill
pay
paybefore
beforetheytheyleave;
leave;and
anda music
a musiccompany
companywon’t won’tproduce
produceCDsCDsififtoo
too
many
manypotential
potentialcustomers
customersavoid
avoidpaying
payingby bymaking
makingillegal
illegalcopies. 
copies. 
•• We
Weallallrely
relyon
ongovernment-provided
government-providedpolice policeandandcourts
courtstotoenforce
enforceour
our
rights
rightsover
overthe
thethings
thingsweweproduce
produceand the
and theinvisible
invisiblehand
handcounts
countson
onourour
ability
abilityto
toenforce
enforceour ourrights.
rights.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 53
 •• Yet
Yetthere
thereisisanother,
another,more
moreprofound
profoundreason
reasonwe weneed
need
government:
government:
•• The
Theinvisible
invisiblehand
handisispowerful,
powerful,but it
but itisisnot
notomnipotent.
omnipotent.
•• Although
Althoughmarkets
marketsareareoften
oftenaagood
goodwaywayto toorganize
organizeeconomic
economic
activity,
activity,this
thisrule has
rule hassome
someimportant
importantexceptions.
exceptions.
•• There
Therearearetwo
twobroad
broadreasons
reasonsfor foraagovernment
governmentto tointervene
interveneinin
the economy
the economyand andchange
changethe theallocation
allocationof ofresources
resourcesthatthatpeople
people
would
wouldchoose
chooseon ontheir
theirown
ownto topromote efficiency
promote efficiencyand andtotopromote
promote
equity.
equity.
•• That
Thatis,
is,most
mostpolicies
policiesaim
aimeither
eitherto
toenlarge
enlargethe theeconomic
economicpie pieor
or
to
tochange
changehow howthethepie
pieisisdivided.
divided.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 54
 •• Consider
Considerfirstfirstthe
thegoal
goalofofefficiency.
efficiency.
•• Although
Althoughthe theinvisible
invisiblehand
handusually
usuallyleads
leadsmarkets
marketstotoallocate resources
allocate resources
efficiently,
efficiently,this
thisisisnot
notalways
alwaysthe thecase.
case.
•• Economists
Economistsuse usethetheterm
termmarket
marketfailure
failuretotorefer
refertotoa situation
a situationininwhich
which
the
themarket
marketon onits
itsown
ownfails
failstotoproduce
producean efficient
an efficientallocation
allocationofofresources.
resources.
•• One possible
One possiblecause causeofofmarket
marketfailure
failureisisan
anexternality,
externality,which
whichisisthe
the
impact of one person’s actions on the well-being
impact of one person’s actions on the well-being of a bystander. of a bystander.
•• The
Theclassic
classicexample
exampleofofan anexternality
externalityisispollution.
pollution.
•• Another
Anotherpossible
possiblecausecauseof market
of marketfailure
failureisismarket
marketpower,
power,which
whichrefers
referstoto
the
theability
abilityofofaasingle
singleperson
person(or (orsmall
smallgroup)
group)totounduly influence
unduly influencemarketmarket
prices.
prices.For
Forexample,
example,ififeveryone
everyoneinintown townneeds
needswater
waterbut butthere
thereisisonly
only
one
onewell,
well,the owner
the ownerofofthe thewell
wellisisnot
notsubject
subjecttotothe
therigorous
rigorouscompetition
competition
with
withwhich
whichthe theinvisible
invisiblehand
handnormally keeps
normally keepsself-interest
self-interestinincheck.
check.
•• InInthe
thepresence
presenceof externalities or
of externalities ormarket
marketpower,
power,well-designed
well-designed
public policy
public policycan canenhance
enhanceeconomic
economicefficiency.-
efficiency.- govt.
govt.has
hastotointervene
intervene

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 55
 •• The
Theinvisible
invisiblehand
handmaymayalso
alsofail
failto
toensure
ensurethat
thateconomic
economic
prosperity
prosperityisisdistributed
distributedequitably.
equitably.
•• AAmarket economy
market economyrewardsrewardspeople
peopleaccording
accordingto totheir
theirability
abilityto
to
produce
producethings
thingsthat
thatother
otherpeople
peopleare arewilling
willingtotopay for.
pay for.
•• The
Theworld’s
world’sbest
bestbasketball
basketballplayer
playerearns
earnsmore
morethan
thanthe
theworld’s
world’s
best
bestchess
chessplayer
playersimply
simplybecause
becausepeople are
people arewilling
willingto
topay
pay
more
moreto towatch
watchbasketball
basketballthan
thanchess.
chess.
•• The
Theinvisible
invisiblehand
handdoes
doesnot
notensure
ensurethatthateveryone has
everyone hassufficient
sufficient
food,
food,decent
decentclothing,
clothing,and
andadequate
adequatehealthcare.
healthcare.
•• Many
Manypublic
publicpolicies,
policies,such
suchasasthe
theincome
incometax and
tax andthethewelfare
welfare
system,
system,aimaimtotoachieve
achieveaamore
moreequitable
equitabledistribution
distributionofof
economic
economicwell-being.
well-being.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 56
 •• ToTo say
saythat
thatthe
thegovernment
government cancanimprove
improveon onmarket
market
outcomes
outcomesat attimes
timesdoes
doesnot
notmean
meanthatthat ititalways
alwayswill. 
will. 
•• Public
Public policy
policyisismade
madenot notbybyangels
angelsbut butby byaa political
political
process
processthatthatisisfar
farfrom
fromperfect.
perfect.
•• Sometimes
Sometimespolicies are
policies aredesigned
designedsimply
simplyto toreward
reward
the
the politically
politically powerful.
powerful.
•• Sometimes
Sometimesthey theyarearemade
madeby bywell
wellintentioned leaders
intentioned leaders
who
whoare
arenotnotfully
fullyinformed.
informed.
•• AsAsyou
youstudy
studyeconomics,
economics,you youwill
willbecome
becomeaabetter better
judge
judge of
of when
when a government
a government policy
policyisisjustifiable
justifiable
because
becauseititpromotes
promotesefficiency
efficiencyor
or equity
equity and and when
whenitit
isisnot.
not.
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 1: Page 57
 HOW THE ECONOMY AS A
WHOLE WORKS
 The
Thelast
lastthree
threeprinciples
principlesconcern
concernthe
theworkings
workingsof
of
the
theeconomy
economy as asaa whole.
whole.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 58
 Principle 8: A Country’s Standard
of Living Depends on its Ability to
Produce Goods and Services
 Standard
Standard ofof Living
Living may
may be
be measured
measured inin
different
different ways
ways (e.g.
(e.g. personal
personalincome
incomeor
ortotal
total
market
marketvalue
valueof
of aanation’s
nation’sproduction.)
production.)
–– Differences in standard of living between
Differences in standard of living between
countries
countriesor
oreven
evenprovinces
provincesis
isattributable
attributableto
to
the
theproductivity
productivity of
of the
thecountry
countryor
orprovince.
province.
 Productivity:
Productivity: The
The amount
amount of
of goods
goods and
and
services
services produced
produced from
from each
each hour
hour of
of aa
worker’s
worker’s time.
time.
Productivity => Standard of Living
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 1: Page 59
 •• AA country
country whose
whose workers
workers produce
produce aa large
large
number
number of of goods
goods andand services
services per per unit
unit of
of time
time
will
will enjoy
enjoy aa high
high standard
standard of of living.
living.
•• Citizens
Citizens ofof high-income
high-income countries
countries have have more
more
TV
TV sets,
sets, more
more cars,
cars, better
better nutrition,
nutrition,
better healthcare,
better healthcare, and and aa longer
longer life
life
expectancy
expectancy than than citizens
citizens ofof low-income
low-income
countries.
countries.
•• Changes
Changes in in living
living standards
standards over over time
time are
are
also
also large.
large.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 60
 •• What
Whatexplains
explainsthesetheselarge
largedifferences
differencesininliving
livingstandards
standardsamong
among
countries
countriesand andover overtime?
time?
•• The
Theanswer
answeris surprisingly
is surprisinglysimple.
simple.
•• Almost
Almostall allvariation
variationininliving
livingstandards
standardsisisattributable
attributabletoto
differences
differences‘in ‘incountries’ productivity-that
countries’ productivity-thatis, is,the
theamount
amountof of
goods
goodsand andservices
servicesproduced
producedfrom fromeach
eachhour
hourof ofaaworker’s
worker’s
time.
time.
•• In nations
In nationswhere
whereworkers
workerscan canproduce
produceaalarge
largequantity
quantityof
ofgoods
goods
and
andservices
servicesper perunit
unitof oftime,
time,most
mostpeople enjoy
people enjoyaahighhighstandard
standard
of
ofliving;
living;ininnations
nationswherewhereworkers
workersare areless
lessproductive,
productive,most
most
people
peopleendure
endureaamore meagre
more meagreexistence.
existence.
•• Similarly,
Similarly,thethegrowth
growthraterateofofaanation’s
nation’sproductivity
productivitydetermines
determines
the
thegrowth
growthraterateof ofits average
its averageincome.
income.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 61
 •• The
Thefundamental
fundamentalrelationship
relationshipbetween
betweenproductivity
productivityand andliving
living
standards
standardsisissimple,
simple,butbutits
itsimplications are
implications arefar-reaching.
far-reaching.
•• IfIfproductivity
productivityisisthe
theprimary
primarydeterminant
determinantof ofliving
livingstandards,
standards,
other
otherexplanations
explanationsmustmustbe of
be ofsecondary
secondaryimportance.
importance.
•• For
Forexample,
example,ititmight
mightbebetempting
temptingto tocredit
creditlabor
laborunions
unionsor or
minimum-wage
minimum-wagelaws forlaws forthetherise
riseininliving
livingstandards
standardsof ofAmerican
American
workers
workersoveroverthe
thepast
pastcentury.
century.
•• Yet
Yetthe
thereal
realhero
heroof ofAmerican workers
American workersisistheir theirrising
risingproductivity.
productivity.
•• AsAsanother
anotherexample,
example,some somecommentators
commentatorshave haveclaimed
claimedthat
that
increased competition
increased competitionfrom fromJapan
Japanand andother
othercountries
countriesexplained
explained
the
theslow
slowgrowth
growthininU.S.
U.S.incomes
incomesduring duringthe
the1970s and
1970s and1980s.
1980s.
•• Yet
Yetthe
thereal
realvillain
villainwas
wasnotnotcompetition
competitionfrom fromabroad
abroadbutbutflagging
flagging
productivity
productivitygrowth
growthininthe United
the UnitedStates.States.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 62
 •• The
Therelationship
relationshipbetween
betweenproductivity
productivityandand living
living
standards
standardsalso alsohas-profound
has-profoundimplications
implications forfor
public policy.
public policy.
•• When
Whenthinking
thinkingabout
abouthow howany
anypolicy
policywill
willaffect
affectliving
living
standards,
standards,the the key
keyquestion
questionisishow
howitit will affect
will affectourour
ability
abilityto
to produce
producegoodsgoodsandandservices.
services.
•• To
To boost
boost living
livingstandards,
standards, policymakers
policymakersneed needto to
raise productivity
raise productivityby byensuring
ensuringthat
thatworkers
workersare arewell
well
educated,
educated, havehavethethetools
toolsneeded
neededto toproduce
producegoods goods
and services,
and services, and andhave
haveaccess
accessto tothe
thebest
bestavailable
available
technology.
technology.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 63
 Principle 9: Prices Rise when the
Government Prints Too Much
Money
 In
InGermany…
Germany…

In
InJanuary
January1921,
1921,aadaily
dailynewspaper
newspapercost cost0.30
0.30marks.
marks.

In
InNovember
November1922,1922,the
thesame
samepaper
papercost
cost70
70000
000000
000marks.
marks.

Inflation:
Inflation:An
Anincrease
increasein inthe
theoverall
overalllevel
levelof
ofprices
pricesin
inthe
the
economy.
economy.
•• One
Onecause
causeof ofinflation
inflationis
isthe
thegrowth
growthininthe
thequantity
quantityofofmoney.
money.
•• When
Whenthe thegovernment
governmentcreates
createslarge
largequantities
quantitiesofofmoney,
money,thethevalue
value
of the money falls.
of the money falls.
•• Printing
Printingmoney
moneycauses
causesinflation.
inflation.When
Whenaagovernment
governmentprints
prints
money,
money,the
thequantity
quantityof
ofmoney
moneyincreases
increasesand
andeach
eachunit
unitof
ofmoney
money
therefore
thereforebecomes
becomesless
lessvaluable.
valuable.AsAsaaresult,
result,more
moremoney
moneyisis
required
requiredto
tobuy
buygoods
goodsand
andservices.
services.----quantitative
----quantitativeeasing.
easing.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 64
 Principle 10: Society Faces a Short-Run Tradeoff
Between Inflation and Unemployment.
•• InInGermany
GermanyininJanuary January1921,
1921,a·daily
a·dailynewspaper
newspapercost cost0.30
0.30marks.
marks.Less Lessthan
than22
years
yearslater,
later,ininNovember 1922,
November 1922,the thesame
samenewspaper
newspapercost cost70,000,000
70,000,000marks. marks.AllAll
other prices in the economy rose by similar amounts. This
other prices in the economy rose by similar amounts. This episode is one of episode is one of
history’s
history’smostmostspectacular
spectacularexamples
examplesofofinflation,
inflation,an anincrease
increaseininthe theoverall level
overall level
ofofprices in the economy.
prices in the economy.
•• IfIf inflation
 inflationwas
wasabout about33percent
percentperperyear;
year;atatthis
thisrate,
rate,ititwould
wouldtake
takemore
morethan
than20 20
years
yearsfor forprices to
prices todouble.
double.
•• Because
Becausehigh highinflation
inflationimposes
imposesvarious
variouscosts
costson onsociety,
society,keeping
keepinginflation
inflationatataa
low
lowlevel
levelisisa goal
a goalofofeconomic
economicpolicymakers
policymakersaroundaroundthe theworld.
world.
•• What
Whatcauses
causesinflation?
inflation?
•• InInalmost
almostall allcases
casesofoflarge
largeor
orpersistent
persistentinflation,
inflation,the
theculprit
culpritisisgrowth
growthinin
the quantity
the quantityofofmoney. money.
•• When
Whenaagovernment
governmentcreates createslarge
largequantities
quantitiesofofthethenation’s
nation’smoney,
money,the thevalue
valueofof
the money
the moneyfalls. falls.
•• InInGermany
Germanyininthe theearly
early1920″
1920″when
whenprices
priceswerewereon onaverage
averagetripling
triplingevery
every
month,
month,the quantity
the quantityofofmoneymoneywaswasalso
alsotripling
triplingevery
everymonth.
month.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 65
 •• Phillips
Phillipscurve:
curve:AAcurvecurvethatthatshows
showsthe theshort-run
short-runtradeoff
tradeoff
between
betweeninflation
inflationandandunemployment.
unemployment.
•• Reducing
Reducinginflation
inflationoften
oftencauses
causesaatemporary
temporaryrise riseinin
unemployment.
unemployment.
•• This
Thistradeoff
tradeoffisisthethekey
keytotounderstanding
understandingthe theshort-run
short-runeffects
effectsof
of
changes
changesinintaxes,
taxes,government
governmentspending
spendingand andmonetary
monetarypolicy.
policy.––
•• The Phillips
The Phillipscurve is
curve isaasingle-equation
single-equationempirical
empiricalmodel,model,named
named
after William
after WilliamPhillips,
Phillips,describing
describingaahistorical
historicalinverse
inverserelationship
relationship
between
betweenratesratesof unemployment and
of unemployment andcorresponding
correspondingrates rates
of inflation that
of inflation thatresult
resultwithin
withinan aneconomy.
economy.
•• Stated
Statedsimply,
simply,decreased
decreasedunemployment,
unemployment,(i.e., (i.e.,increased
increasedlevels
levels
of
ofemployment)
employment)ininan aneconomy
economywill willcorrelate
correlatewithwithhigher
higherrates
rates
of inflation.
of inflation.
•• While
Whilethere
thereisisaashort
shortrun
runtradeoff
tradeoffbetween
betweenunemployment
unemploymentand and
inflation,
inflation,itithas
hasnot
notbeen
beenobserved
observedininthethelong
longrun.run.
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 1: Page 66
 •• Although
Althoughaahigher
higherlevel
levelofofprices
pricesis,is,ininthe
thelong
longrun,
run,the
theprimary
primary
effect
effectofofincreasing
increasingthe thequantity
quantityof money,
of money,the theshort-run
short-runstory
storyisis
more
morecomplex
complexand andmore
morecontroversial,
controversial,
•• Most
Mosteconomists
economistsdescribe
describethe theshortrun effects
shortrun effectsof ofmonetary
monetary
injections
injectionsas asfollows:
follows:
•• Increasing
Increasingthe theamount
amountof ofmoney
moneyininthe theeconomy
economystimulates
stimulatesthethe
overall
overalllevel
levelofofspending
spendingand andthus
thusthe demand
the demandfor forgoods
goodsand and
services
services
•• Higher
Higherdemand
demandmay mayoverovertime
timecause
causefirmsfirmstotoraise
raisetheir
theirprices,
prices,
but
butininthe
themeantime,
meantime,ititalso encourages
also encouragesthem themto toincrease
increasethe the
quantity
quantityof ofgoods
goodsand andservices
servicestheytheyproduce
produceandandtotohire
hire
more workers
more workersto toproduce
producethose
thosegoods
goodsand andservices.
services.
•• More
Morehiring
hiringmeans
meanslowerlowerunemployment.
unemployment.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 67
 •• This
Thisline
lineof
ofreasoning
reasoningleadsleadstotoone
onefinal
finaleconomy-wide
economy-widetrade-off:
trade-off:
aashort-run
short-runtrade-off
trade-offbetween
betweeninflation and
inflation andunemployment.
unemployment.
•• Although
Althoughsome
someeconomists
economistsstillstillquestion
questionthese
theseideas,
ideas,mostmost
accept
acceptthat
thatsociety
societyfaces
facesaashort
shortrunruntrade
tradeoff
offbetween
betweeninflation
inflation
and
andunemployment.
unemployment.
•• This
Thissimply
simplymeans
meansthat,
that,over
overaaperiod
periodof ofaayear
yearorortwo,
two,many
many
economic
economicpolicies
policiespush
pushinflation
inflationandandunemployment
unemploymentIn Inopposite
opposite
directions.
directions.
•• Policymakers
Policymakersface facethis
thistrade-off
trade-offregardless
regardlessof ofwhether
whetherinflation
inflation
and
andunemployment
unemploymentboth bothstart
startout
outat athigh
highlevels
levelsatatlow
lowlevels,
levels,or or
someplace
someplaceininbetween.
between.
•• This
Thisshort
shortrun
runtradeoff
tradeoffplays
playsaakeykeyrole
roleininthe
theanalysis
analysisof ofthe
the
business
businesscycle
cycle-the
-theirregular
irregularand
andlargely
largelyunpredictable
unpredictable
fluctuations
fluctuationsinineconomic
economicactivity,
activity,asasmeasured
measuredby bythe
theproduction
production
of
ofgoods
goodsand
andservices
servicesor orthe
thenumber
numberof ofpeople
peopleemployed.
employed.
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.
Chapter 1: Page 68
 •• Policymakers
Policymakerscan canexploit the
exploit theshort
shortrun
runtrade
tradeoffoffbetween
between
inflation
inflationand
andunemployment using
unemployment usingvarious variouspolicy instruments.
policy instruments.
•• By
Bychanging
changingthe theamount
amountthat
thatthethegovernment
governmentspends,
spends,the the
amount
amountitittaxes,
taxes,and
andthetheamount
amountof money
of moneyititprints,
prints,
policymakers
policymakerscan caninfluence
influencethethecombination
combinationof ofinflation
inflationand
and
unemployment
unemploymentthat thatthe economy
the economyexperiences.
experiences.
•• Because
Becausethese
theseinstruments
instrumentsof ofeconomic
economicpolicy
policyarearepotentially
potentiallyso
so
powerful,
powerful,how policymakers
how policymakersshould shoulduse usethese
theseinstruments
instrumentsto to
control
controlthe
theeconomy,
economy,ififatatall,
all,isisaasubject
subjectof ofcontinuing
continuingdebate
debate

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 69
 Summary

•• When
When individuals
individuals make
make decisions,
decisions, they
they
face
face tradeoffs
tradeoffs among
among alternative
alternative goals.
goals.
•• The
The cost
cost ofof any
any action
action is
is measured
measured inin
terms
terms of of foregone
foregone opportunities.
opportunities.
•• Rational
Rational people
people make
make decisions
decisions byby
comparing
comparing marginal
marginal costs
costs and
and marginal
marginal
benefits.
benefits.
•• People
People change
change their
their behavior
behavior in
in response
response
to
to the
the incentives
incentives they
they face.
face.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 70
 Summary

•• Trade
Trade can
can be be mutually
mutually beneficial.
beneficial.
•• Markets
Markets are
are usually
usually aa good
good wayway of
of
coordinating
coordinating trade trade among
among people.
people.
•• Government
Government can can potentially
potentially improve
improve
market
market outcomes
outcomes ifif there there is
is some
some market
market
failure
failure or
or ifif the
the market
market outcome
outcome is is
inequitable.
inequitable.
•• Productivity
Productivity is is the
the ultimate
ultimate source
source of
of
living
living standards.
standards.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 71
 Summary

•• Money
Money growth
growth isis the
the ultimate
ultimate source
source of
of
inflation.
inflation.
•• Society
Society faces
faces aa short-run
short-run tradeoff
tradeoff between
between
inflation
inflation and
and unemployment.
unemployment.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 72
 The End

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition.

Chapter 1: Page 73