1.1.

Ten Principles of Economics

The word economy comes from the Greek word, “oikonomos” which means
“One who manages a household”. Come to think about it, households and
economies have much in common.
A household faces many decisions, allocates scarce resources taking into
account: ability, effort, desire. Decision‐making is at the heart of
economics. The individual must decide how much to save for retirement,
how much to spend on different goods and services, how many hours a
week to work. The firm must decide how much to produce, what kind of
labor to hire. Society as a whole must decide how much to spend on
national defense (“guns”) versus how much to spend on consumer goods
(“butter”).
Economics - The study of how society manages its scarce resources.
In most societies, resources are allocated by a powerful dictator but
through the combined choices of millions of households and firms.
Economists study how people make decisions, how much they work, what
they buy, how much they save, and how they invest their savings.
Economist also study how people interact with one another
Scarcity is the limited nature of society’s resources society has limited
resources and therefore cannot produce all the goods and services people
wish to have.
1.1.2. How People Interact
The fifth principle is "Trade can make everyone better off".

You may have heard on the news that the Chinese and American firms are
competitors in the world economy. This is true because American and
Chinese firms produce many of the same goods. They basically compete
for the same markets for clothing, toys, automobile tires, rubber shoes,
gadgets, and many other items. While it is easy to be misled when thinking
about competition among countries, but in reality trade between these
United States and China can make each country better off. Trade allows
each country to specialize in the activities it does best, whether it is
farming, sewing, or home building. As a result, we as consumers can buy a
greater variety of goods and services at a lower cost.
The sixth principle is "Markets are usually a good way to organize
economic activity".

In a market economy, unlike the command economy, the decisions lie in

the hands of firms and households. Firms decide whom to hire and what to
make. Households decide which firms to work for and what to buy with their
incomes. These firms and households interact in the market place, where
prices and self-interest guide their decisions. Market economies despite
decentralized decision making, have proven remarkably successful in
organizing economic activity to promote overall economic well-being

In Adam Smith’s 1776 book "An Inquiry into the Nature and Causes of the
Wealth of Nations he made the most famous observation on households
and firms. He noted that these two are interacting in markets and acting as
if they are guided by an “invisible hand” which leads them to desirable
market outcomes
The seventh principle is "Governments can sometimes improve
market outcomes".

We need the government to enforce rules and maintain institutions that are
key to a market economy. Market economies need institutions to enforce
property rights, promote efficiency, avoid market failure promote equality,
avoid disparities in economic well-being.
Property rights refer to the ability of an individual to own and exercise
control over scarce resources.
Market failure refers to a situation in which the market left on its own fails
to allocate resources efficiently.
1.1.3. How the Economy Works
The first two topics that you have learned focused on how individuals make
decisions and how people interact with one another. All these interactions
together make up the "economy". The principles that will be introduced to
you in this module is more focused on how the economy works as a whole.

The eighth principle is "A Country’s Standard of Living Depends on

Its Ability to Produce Goods and Services"
The differences in standard of living are prevalent among nations. Citizens
of high-income countries enjoy a better standard of living than low-income
countries. These citizens live in better homes, they drive more cars, they
have better health care and they have a longer life expectancy. What
explains the differences in the living standards among countries is
productivity. Productivity refers to the amount of goods and services
produced by each unit of labor input. In nations where workers can produce
a large quantity of goods and services per hour, most citizens enjoy a high
standard of living; in nations where workers are less productive, most
people endure a more meager existence. The video below exemplifies the
eight countries in the world with the highest quality of life according to the
Organization for Economic Cooperation and Development.
The ninth principle is "Prices Rise When the Government Prints Too
Much Money"
In almost all cases of large or persistent inflation, the culprit is growth in the
quantity of money. Inflation is defined as an increase in the overall level of
prices in the economy. So when a government creates large quantities of a
nation's money, the value of money falls. High inflation imposes various
costs on society hence keeping inflation at a low level is a goal of economic
policymakers around the world.

The tenth principle is "Society Faces a Short-Run Trade-off between

Inflation and Unemployment"
Although some economists still question the idea, most accept that society
faces a short-run trade-off between inflation and unemployment. This
simply means that, in a year or two, many economic policies push inflation
and unemployment in different directions. This short-run trade-off plays a
key role in the analysis of the business cycle the irregular demand and
largely unpredictable fluctuations in economic activity, as measured by the
production of goods and services or the number of people employed. In the
video below, Gregory Mankiw - the author of our book in this course,
Caroline Hoxby, and Todd Buchholz explain the concept of the short-run
trade-off between inflation and employment.
1.2. The Circular Flow Model
Every field of study has its own language. The same can be said in the field
of Economics. Supply, demand, elasticity, comparative advantage,
consumer surplus, deadweight loss are just some of the terms that are
common in an economist's language. In this part of the module, you will
encounter many new terms and some familiar words that economists used
in specialized ways. These terms will provide you with a new and useful
way of thinking about the world in which you live.

The Economist as Scientist

Economists are known to approach the subject matter with the objectivity of
a scientist. They conduct scientific method in the study of the economy in
the same way as biologist does in the study of life. Economists devise
theories, collect data, and analyze the collected data in order to verify or
refute their theories.

A. Economists Follow the Scientific Method.

 Observations help us to develop theory.
 Data can be collected and analyzed to evaluate theories.
 Using data to evaluate theories is more difficult in economics than in
physical science because economists are unable to generate their
own data and must make do with whatever data are available.
 Thus, economists pay close attention to the natural experiments
offered by history.

B. Assumptions Make the World Easier to Understand.

1. One important role of a scientist is to understand which assumptions
one should make.
2. Economists often use assumptions that are somewhat unrealistic but
will have small effects on the actual outcome of the answer.
C. Economists Use Economic Models to Explain the World around Us.
1. Most economic models are composed of diagrams and equations.
2. The goal of a model is to simplify reality to increase our understanding.
Assumptions help to simplify reality.
D. Microeconomics and Macroeconomics
Microeconomics - the study of how households and firms make decisions
and how they interact in markets.
Macroeconomics - the study of economy-wide phenomena, including
inflation, unemployment, and economic growth.

1.2.1. Role of Household and Business Firms

Household and business firms are the two basic units of the economy.
Household are the one who owns the economics resource or also known
as the factors of production and sells to business firms. On the other hand,
business firms use these factors of production in producing goods and
services that the household buys.

This diagram is a schematic representation of the organization of the economy.

1.2.2. Products and Resource Markets
Market is defined as the place where buyers and sellers execute an
exchange. There are two always 2 sides of the market the buyer (demand)
side and the seller (supply) side. Who plays as the buyer or seller depends
on the type of market that exists. The first type of market is the Resources
Market (Market for factors of Production), it is a market where the factors of
production; land, labor, capital, and entrepreneurial skill are being sold. The
other type of market, which is common to us is the Product Market (Market
for Goods and Services), here is where the goods and services are being
sold.
-market for factors of production (such as labour or capital), where firms
purchase factors of production from households in exchange for money.
-market for goods and services, where households purchase goods and
services from firms in exchange for money.
In the resource market, the household takes the role of a seller and
business firms take the role of a buyer, while in the product market, the
business firm takes the role of a seller and household take the role of a
buyer.
1.2.3. Income and Expense
An income of one represents and expense of the other, firms
cannot use the factors of production without [saying for them first,
same thing household cannot consume goods and services if they
will not pay for it. Each of the factors of production has a
corresponding payment, rent for the use of land, interest in the
use of capital, salaries and wages for labor, and profit for the
entrepreneur. These four represent income for the household and
expense (cost) on the part of the business firm. The price paid in
buying goods and services, on the other hand, represents
revenue for the firms and expenses (spending) on the part of the
household.
1.3. Production Possibility Curve and the Law of Comparative
Advantage
Production possibilities frontier is a graph that shows the combinations of
output that the economy can possibly produce, given the available factors
of production and production technology.

 The Production Possibility Curve

The production possibilities frontier shows the combinations of output—in

this case, cars and computers—that the economy can possibly produce.
The economy can produce any combination on or inside the frontier. Points
outside the frontier are not feasible given the economy’s resources. The
slope of the production possibilities frontier measures the opportunity cost
of a car in terms of computers. This opportunity cost varies, depending on
how much of the two goods the economy is producing.
1.3.1. Production Possibility Curve

The PPF shows the tradeoff between the outputs of different goods at a
given time, but the tradeoff can change over time. For example, over time,
the economy might get more workers (or more factories or more land). Or,
a more efficient technology might be invented. Both events—an increase in
the economy’s resources or an improvement in technology—cause an
expansion in the set of opportunities. That is, both allow the economy to
produce more of one or both goods.
1.3.2. Absolute and Comparative Advantage
Absolute Advantage
A nation or company is said to have an absolute advantage if it requires
fewer resources—generally raw materials, manpower, or time—to produce
a given item. For example, assume France and the United States both
produce airplanes. In one month, France can produce 14 planes while the
U.S can churn out 45 of comparable quality. This means it takes France
2.14 days to manufacture each plane versus the U.S. rate of 0.67 days.
Solution:
30 days / 14 Planes =(1 Plane) in a 2.14 day .
30 days / 45 Planes =(1 Plane) in a 0.67 day.
In the above example, the U.S. has the absolute advantage because its
ability to produce high-quality products at a quicker rate than its competition
indicates a more efficient production model or more available and more
talented labor.
While absolute advantage can be used to compare similar production, it
does not take into account the opportunity cost of choosing one product
over another, possibly more beneficial one.

Comparative Advantage
Comparative advantage is all about reducing the opportunity cost of a
given production strategy. The opportunity cost of producing a particular
item is equal to the potential benefit that could have been gained by
choosing an alternative. It is also what a business or country misses out on
when choosing one option over another.
Assume that, utilizing the same amount of time and resources, China
can produce either 30 computers or 45 cellphones. The opportunity cost of
manufacturing one computer is 45/30, or 1.5 cellphones. Conversely, the
opportunity cost of producing one cellphone is 30/45, or 0.67 of a computer.
 The comparative advantage comes into play when neighboring Thailand
decides it can also produce computers or cellphones, but not both. If
Thailand's opportunity cost for producing cellphones is lower than 0.67 of a
computer, then it has a comparative advantage for the production of
cellphones. In this case, it is mutually beneficial for Thailand to produce
phones and China to produce computers.
Even if China is more efficient at producing both items, giving it the
absolute advantage, establishing specialized production and arranging an
international trade agreement allows both countries to benefit.