CHAPTER

Ten Principles of Economics

Economics
PRINCIPLES OF

N. Gregory Mankiw

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by Ron Cronovich
© 2009 South-Western, a part of Cengage Learning, all rights reserved
In this chapter,
look for the answers to these questions:

 What kinds of questions does economics address?

 What are the principles of how people make
decisions?
 What are the principles of how people interact?
 What are the principles of how the economy as a
whole works?

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 What Economics Is All About
 Scarcity: the limited nature of society’s
resources
 Economics: the study of how society manages
its scarce resources, e.g.
 how people decide what to buy,
how much to work, save, and spend
 how firms decide how much to produce,
how many workers to hire
 how society decides how to divide its resources
between national defense, consumer goods,
protecting the environment, and other needs

TEN PRINCIPLES OF ECONOMICS 2

 The principles of
HOW PEOPLE
MAKE DECISIONS
 HOW PEOPLE MAKE DECISIONS
Principle #1: People Face Tradeoffs

All decisions involve tradeoffs. Examples:

 Going to a party the night before your midterm
leaves less time for studying.
 Having more money to buy stuff requires working
longer hours, which leaves less time for leisure.
 Protecting the environment requires resources
that could otherwise be used to produce
consumer goods.

TEN PRINCIPLES OF ECONOMICS 4

 HOW PEOPLE MAKE DECISIONS
Principle #1: People Face Tradeoffs
 Society faces an important tradeoff:
efficiency vs. equality
 Efficiency: when society gets the most from its
scarce resources
 Equality: when prosperity is distributed uniformly
among society’s members
 Tradeoff: To achieve greater equality,
could redistribute income from wealthy to poor.
But this reduces incentive to work and produce,
shrinks the size of the economic “pie.”
TEN PRINCIPLES OF ECONOMICS 5
 HOW PEOPLE MAKE DECISIONS
Principle #2: The Cost of Something Is
What You Give Up to Get It
 Making decisions requires comparing the costs
and benefits of alternative choices.
 The opportunity cost of any item is
whatever must be given up to obtain it.
 It is the relevant cost for decision making.

TEN PRINCIPLES OF ECONOMICS 6

 HOW PEOPLE MAKE DECISIONS
Principle #2: The Cost of Something Is
What You Give Up to Get It
Examples:
The opportunity cost of…
…going to college for a year is not just the tuition,
books, and fees, but also the foregone wages.
…seeing a movie is not just the price of the ticket,
but the value of the time you spend in the theater.

TEN PRINCIPLES OF ECONOMICS 7

 HOW PEOPLE MAKE DECISIONS
Principle #3: Rational People Think at the
Margin

Rational people
 systematically and purposefully do the best they
can to achieve their objectives.
 make decisions by evaluating costs and benefits
of marginal changes – incremental adjustments
to an existing plan.

TEN PRINCIPLES OF ECONOMICS 8

 HOW PEOPLE MAKE DECISIONS
Principle #3: Rational People Think at the
Margin
Examples:
 When a student considers whether to go to
college for an additional year, he compares the
fees & foregone wages to the extra income
he could earn with the extra year of education.
 When a manager considers whether to increase
output, she compares the cost of the needed
labor and materials to the extra revenue.

TEN PRINCIPLES OF ECONOMICS 9

 HOW PEOPLE MAKE DECISIONS
Principle #4: People Respond to Incentives
 Incentive: something that induces a person to
act, i.e. the prospect of a reward or punishment.
 Rational people respond to incentives.
Examples:
 When gas prices rise, consumers buy more
hybrid cars and fewer gas guzzling SUVs.
 When cigarette taxes increase,
teen smoking falls.

TEN PRINCIPLES OF ECONOMICS 10

The principles of
HOW PEOPLE
INTERACT
 HOW PEOPLE INTERACT
Principle #5: Trade Can Make Everyone
Better Off
 Rather than being self-sufficient,
people can specialize in producing one good or
service and exchange it for other goods.
 Countries also benefit from trade & specialization:
 Get a better price abroad for goods they produce
 Buy other goods more cheaply from abroad than
could be produced at home

TEN PRINCIPLES OF ECONOMICS 12

 HOW PEOPLE INTERACT
Principle #6: Markets Are Usually A Good Way
to Organize Economic Activity

 Market: a group of buyers and sellers

(need not be in a single location)
 “Organize economic activity” means determining
 what goods to produce
 how to produce them
 how much of each to produce
 who gets them

TEN PRINCIPLES OF ECONOMICS 13

 HOW PEOPLE INTERACT
Principle #6: Markets Are Usually A Good Way
to Organize Economic Activity

 A market economy allocates resources through

the decentralized decisions of many households
and firms as they interact in markets.
 Famous insight by Adam Smith in
The Wealth of Nations (1776):
Each of these households and firms
acts as if “led by an invisible hand”
to promote general economic well-being.

TEN PRINCIPLES OF ECONOMICS 14

 HOW PEOPLE INTERACT
Principle #6: Markets Are Usually A Good Way
to Organize Economic Activity
 The invisible hand works through the price system:
 The interaction of buyers and sellers
determines prices.
 Each price reflects the good’s value to buyers
and the cost of producing the good.
 Prices guide self-interested households and
firms to make decisions that, in many cases,
maximize society’s economic well-being.

TEN PRINCIPLES OF ECONOMICS 15

 HOW PEOPLE INTERACT
Principle #7: Governments Can Sometimes
Improve Market Outcomes

 Important role for govt: enforce property rights

(with police, courts)
 People are less inclined to work, produce, invest,
or purchase if large risk of their property being
stolen.

TEN PRINCIPLES OF ECONOMICS 16

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

 Govt may alter market outcome to promote equity

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

TEN PRINCIPLES OF ECONOMICS 18

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

 Huge variation in living standards across

countries and over time:
 Average income in rich countries is more than
ten times average income in poor countries.
 The U.S. standard of living today is about
eight times larger than 100 years ago.

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HOW THE ECONOMY AS A WHOLE WORKS
Principle #8: A country’s standard of living
depends on its ability to produce goods &
services.
 The most important determinant of living standards:
productivity, the amount of goods and services
produced per unit of labor.
 Productivity depends on the equipment, skills, and
technology available to workers.
 Other factors (e.g., labor unions, competition from
abroad) have far less impact on living standards.
TEN PRINCIPLES OF ECONOMICS 21
HOW THE ECONOMY AS A WHOLE WORKS
Principle #9: Prices rise when the
government prints too much money.

 Inflation: increases in the general level of prices.

 In the long run, inflation is almost always caused by
excessive growth in the quantity of money, which
causes the value of money to fall.
 The faster the govt creates money,
the greater the inflation rate.

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

TEN PRINCIPLES OF ECONOMICS 23

CHAPTER SUMMARY

The principles of decision making are:

 People face tradeoffs.
 The cost of any action is measured in terms of
foregone opportunities.
 Rational people make decisions by comparing
marginal costs and marginal benefits.
 People respond to incentives.

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CHAPTER SUMMARY

The principles of interactions among people are:

 Trade can be mutually beneficial.
 Markets are usually a good way of coordinating
trade.
 Govt can potentially improve market outcomes if
there is a market failure or if the market outcome
is inequitable.

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CHAPTER SUMMARY

The principles of the economy as a whole are:

 Productivity is the ultimate source of living
standards.
 Money growth is the ultimate source of inflation.
 Society faces a short-run tradeoff between
inflation and unemployment.

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