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Ten Principles of Economics

Chapter 1
Economics by Mankiw
Ten Principles of Economics

 Economy, “oikonomos” (Greek)

– “One who manages a household”
– Households and economies have much in
common
 A household faces many decisions
– Allocate scarce resources
• Taking into account: ability, effort, desire
 Society faces many decisions
– Allocate resources and output

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Scarcity, Goods, and Bads
 A good is called scarce if there is not
enough of it freely available (zero
price) to satisfy human wants.
 An economic good is any good (or
service) that is scarce.
 An economic bad is any good for
which we would pay to have less.

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Definitions of Economics
 Economics is a way of analyzing and
understanding the ways individuals
and groups of people behave in
terms of their choices regarding the
things they want but can’t get
enough of for free (scarce goods).
 Economics is a social science and a
form of applied logic (reasoning).
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Terms that are often confused:
Scarcity, Shortage, Poverty
 Scarcity means that not enough is
available for free.
 A shortage occurs when not enough is
available at the current price. It is a
problem of price.
 Poverty occurs when the goods are
scarce, and those who need them do not
have the resources to obtain them. It is a
problem of income.
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Scarcity and Choice
 Scarcity necessitates making choices.
 Economics is the study of how people make
choices regarding economic goods.
– As a society:
• Which goods do we create? (Which goods do we allocate our
scarce resources to the production of?)
• How do we produce them at the lowest cost (efficiency)?
• How do we decide who gets the goods once they are produced?
(distribution)
– As individuals:
• Which goods do I purchase?
• In exchange for what?
• How much labor do I sell? (Labor-leisure decision.)

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What Economists Study
 How people make decisions
 How people interact with one another
 Analyze forces and trends that affect
the economy as a whole
– Growth in average income
– Fraction of the population without jobs
– Rate at which prices are rising

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Ten Principles of Economics

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Principle 1:
People face trade-offs
 “There is no such thing as a free
lunch”
– To get something that we like, we
usually have to give up something else
that we also like
 Making decisions
– Trade off one goal against another

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Efficiency vs. Equality
 Efficiency
– Society getting the maximum benefits
from its scarce resources
– Size of the economic pie
 Equality
– Distributing economic prosperity
uniformly among the members of
society
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Opportunity Cost
Principle 2: The cost of something is what
you give up to get it
 People face trade-offs
– Make decisions, comparing the cost and
benefits of alternatives (on the margin)
 Opportunity cost
– Whatever must be given up to obtain some
item

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Opportunity Cost (2)
 Examples
– What does it cost to attend school?
– Society
• National defense vs. consumer goods (guns
vs. butter)
• Capital goods vs. Consumer goods
• Clean environment vs. higher income
• Efficiency vs. equality

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How People Make Decisions
Principle 3: People are rational, and make
decisions at the margin
 Marginal changes
– Small incremental adjustments: one more or
one less (delta or differential)
 Rational people
– Systematically and purposefully do the best
they can to achieve their objectives
– Make decisions by comparing marginal
benefits and marginal costs (Is MB>MC)
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Principle 4:
People Respond to Incentives
 Incentives Matter
– Higher price
• Buyers - consume less
• Sellers - produce more
– Public policy
• Change costs or benefits
• Change people’s behavior

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 Direct and Secondary Effects
 At one time, higher oil prices caused
increased incentives to conserve fuel
– Smaller cars, scooters, bicycles, mass transit
– New, more fuel-efficient aircraft
• Airbus A320 and Boeing 737
– Moved nearer to mass transit stations
– Online courses
– Sean “Diddy” Combs said he started flying on
commercial airlines
– Increased oil exploration
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 Principle 5:
Trade Can Make People Better Off

 Trade
– Note: You can’t trade what you don’t
own. Property rights are critical.
– Uncoerced trade must create gains.
– Allows each person to specialize in the
activities he or she does best
– Enjoy a greater variety of goods and
services at lower cost
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Markets
Principle 6: Markets are usually a good
way to organize economic activity
 Communist countries organize their
economies through central planning
– Government officials (central planners)
allocate economy’s scarce resources.

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Markets (2)
 Market economy, allocation of
resources
– Through decentralized decisions of
many firms and households
– As they interact in markets for goods
and services
– Guided by prices and self-interest

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Markets (3)
 Adam Smith’s “invisible hand”
– Households and firms interacting in
markets
• Act as if they are guided by an “invisible
hand”
• Leads them to desirable market outcomes
– Corollary: Government intervention
• Prevents the invisible hand’s ability to
coordinate the decisions of the households
and firms that make up the economy
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Which goods do we produce?
 In a market economy, there is
consumer sovereignty. Consumers
determine by their demand (backed
by dollars) what will be produced.
 In a command economy (centrally
planned economy) the government
determines what will be produced.

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Distribution Decisions
 Because scarce goods are not plentiful
enough to go around, people compete for
them.
 Ownership is allocated via rationing.
 Rationing may take many forms:
– In a centrally planned economy, government
rations the goods.
– In a market economy, ownership of scarce
goods is rationed in markets according to
price.

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Production Decisions
 In a market economy, firms have a profit
incentive to
– respond to consumer demand and
– build products at the lowest possible cost.
 Producing the most output with the least
resources is called efficiency. Firms have
a profit incentive to be efficient.
 In centrally-planned economies, it has
proved difficult to ensure efficiency
without introducing market-type
incentives. 22
Principle 7:
Governments can sometimes improve
market outcomes
 We need government
– Enforce rules and maintain institutions
that are key to a market economy
– Enforce property rights
– Promote efficiency, avoid market failure
– Promote equality, avoid disparities in
economic well-being

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Why Markets Fail
 Imperfect Property Rights
 Externalities
– Impact of one person’s actions on the well-
being of a bystander
– Pollution
 Market power
– Ability of a single economic actor (or small
group of actors) to have a substantial
influence on market prices

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Distribution Issues
 Market economy rewards people
according to their ability to produce things
that other people are willing to pay for.
 Government intervention, public policies
may:
– Aim to achieve a more equal distribution of
economic well-being
– Diminish inequality
– But creates other issues.

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The Wealth of Nations
Principle 8: A country’s standard of living
depends on its ability to produce goods and
services
 Large differences in living standards
– Among countries
– Over time
 Average annual income, 2011
– $48,000 (U.S.); $9,000 (Mexico)
– $5,000 (China); $1,200 (Nigeria)
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Wealth of Nations (2)
 Explanation: differences in
productivity
 Productivity
– Quantity of goods and services produced
from each unit of labor input
– Higher productivity
• Higher standard of living
– Growth rate of nation’s productivity
• Determines growth rate of its average income
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 Principle 9:
Prices rise when the government prints too
much money

 Inflation results when too many

dollars chase too few goods and
services
 Inflation
 An increase in the overall
level of prices in the economy “Well it may have been 68 cents
when you got in line, but it’s 74
 Causes for large or persistent inflation cents now!”

 Growth in quantity of money

– Value of money falls

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There is a short-run trade-off between
inflation and unemployment

Principle 10: Society faces a short-run trade-

off between inflation and unemployment
 Short-run effects of monetary injections:
– Stimulates the overall level of spending
• Higher demand for goods and services
– Firms – raise prices; hire more workers;
produce more goods and services
– Lower unemployment
– Business cycles

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