Introduction to

(HSS– 2023)

Ten Principles of
Economics
(Lecture No -2, 3, 4)
Copyright © 2004 South-Western/Thomson Learning
Decision-making is at the heart of economics.
• The individual must decide
• how much to spend on different goods and
services, how many hours a week to work,
• how much to save for retirement.
• 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”).
How people make
decisions
1. People face tradeoffs.
2. The cost of something is
what you give up to get it.
3. Rational people think at
the margin.
4. People respond to
incentives.
How people interact
with each other
5. Trade can make
everyone better off.
6. Markets are usually
a good way to
organize economic
activity.
7. Governments can
sometimes improve
market outcomes.
The forces and trends
that affect how the
economy works as a
whole
8. A country’s standard of living
depends on its ability to
produce goods and services.
9. Prices rise when the
government prints too much
money.
10. Society faces a short-run
tradeoff between inflation
and unemployment.
This means that there are
always trade-offs -- to get
more of something we like, we
have to give up something
else that we like.
For example, if you spend
money on dinner and a movie,
you won't be able to spend it
on new clothes.
This is because resources to
satisfy the wants are limited.
To get one thing, we usually have to give up another
thing since resources to satisfy the unlimited wants
are scarce.
Trade-offs are all the alternatives that we give up
whenever we choose one course of action over
others.
ü Guns vs. butter
ü Food vs. clothing
ü Leisure time vs. work
ü Clean environment vs. national income
ü Efficiency vs. equity
Making decisions requires trading off
one goal against another.
• Efficiency v. Equity
• Efficiency means
• society gets the most that it can from its scarce resources
and avoiding waste.
• Equity means the benefits of those scarce resources are
distributed fairly among the members of society.
Efficiency refers to the size of the economic pie, and
equality refers to how the pie is divided into
individual slices.
The aim is to ensure that people who would have little or
no income in a market economy, and cannot secure
enough of essential goods and services, such as food,
shelter, health care, and so on, will be able to survive.
• Tradeoff between Efficiency and Equity
This idea is developed by Arthur Okun in 1970, who
argued that ‘the conflict between equality and
economic efficiency is inescapable’
To achieve greater equality, Government could
redistribute income from wealthy to poor.
When the government redistributes income from the
rich to the poor, it reduces the reward for working
hard; as a result, people work less and produce fewer
goods and services, which shrinks the size of the
economic “pie.”
• Decisions require comparing costs and benefits of
alternatives.
• Whether to go to college or to work?
• Whether to study or go out on a visit to a place?
• Whether to go to class or sleep in?
• The opportunity cost of an item is what you
give up to obtain that item.
• Going to college for a year is not just the tuition fees, books,
and other 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.
• The opportunity cost of an item is the cost of
next best alternative sacrificed or foregone.
• The opportunity cost of a choice is the value of the
next best opportunities lost.
• The opportunity cost is a cost because in choosing
one thing, you are precluding an alternative choice.
• The opportunity cost results from scarcity of
resources that forces choices to be made.
• If resources were unlimited, no sacrifices would be
necessary, and the opportunity cost of consuming or
producing anything would be zero.
A machine can produce either X or Y. The
opportunity cost of producing a given quantity of X
is, therefore, the quantity of Y which it would have
produced. If that machine can produce 10 units of X
or 20 units of Y, then opportunity cost of producing
10X is 20Y or opportunity cost of producing one
unit of X is 2Y.
College athletes often decide to drop college
education, because the opportunity cost of their
attending college is very high.
• Rational people
• systematically and purposefully do the best they
can to achieve their objectives given the available
opportunities.
• Marginal changes are small, incremental
adjustments to an existing plan of action.
• This principle provide answer to the questions
• why people use their cell phones as much as they do
• why airlines are willing to sell tickets below average cost,
• why people are willing to pay more for diamonds than for
water.
• Rational economic decision making means that
individuals are assumed to act in their best self-interest,
trying to maximise (make as large as possible) the
satisfaction they expect to receive from their economic
decisions.
• It is assumed that consumers spend their money on
purchases to maximise the satisfaction they get from
buying different goods and services.
• Rational decision makers only proceed with an
action if the marginal benefit exceeds or
equal to the marginal sacrifice.
• You should only attend college for another year if
the benefits from that year of study in college
exceed the cost of attending the college for that
year.
• A farmer should cultivate an extra acre of land for
rice only if the benefit (price received in selling rice)
exceeds the cost of producing rice in that extra acre
of land.
• Cell phone users with a package of unlimited talk
time are often prone to make long and frivolous calls
because in unlimited talk time package an additional
minute call is free or carries zero price.
 • Rational decision maker – take action only if
Marginal benefits ≥ Marginal sacrifice
• You like the movie KGF2 and want to visit the movie as
many times as possible. The cost of visiting movie each
time (round) is Rs. 50/-. The total satisfaction derived
form visiting movie is given in the following table.
1st Time 2nd Time 3rd Time 4th Time 5th Time
Total Satisfaction (Rs) 100 180 250 290 310

Please note- You will get less and less satisfaction each time,
the more you visit the movie
• How many times (rounds) you will visit KGF2?
In determining how many time one will visit movie KGF2, one will
utilize the economic principle, i.e., ‘Rational People think at
margin’.
This principle implies that a consumer always goes on consuming
a commodity till marginal benefit (marginal satisfaction in this
case) is greater than or equal to marginal sacrifice (price per unit
of movie ticket in this case). The moment the consumer feels that
the marginal benefit is less than marginal sacrifice, he stopped
his consumption.
Given total satisfaction from different rounds of visit of the movie
KGF2, it is required to calculate marginal satisfaction from
various rounds of visit of movie which is given below. Marginal
satisfaction is the addition to the total satisfaction when one visit
movie by one additional round.
 1st Time 2nd Time 3rd Time 4th Time 5th Time

Total Satisfaction (Rs) 100 180 250 290 310

Marginal Satisfaction (Rs) 100 80 70 40 20
Decision Rule at P = Rs.50 MU>P MU>P MU>P MU<P MU<P
Visit Visit Visit No Visit No Visit
Decision Rule at P = Rs.40 MU>P MU>P MU>P MU=P MU<P
Visit Visit Visit Visit No Visit

It is given that price of per round visit of movie KGF2 is Rs. 50. Now it is
observed from the above table that the marginal satisfaction from the visit of
3rd round of movie (Rs.70) is greater than the ticket price (Rs.50). But the
marginal satisfaction from the fourth round visit of movie (Rs. 40) is less
than the price (Rs. 50). So one will visit KGF2 for three times (rounds).
If price of visit of movie decreases to Rs.40, one will visit KGF2 for 4 times.
• 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, he compares the cost of the
needed labor and materials to the extra
revenue.
• In his book, The Armchair Economist, Steven
Landsburg states that “most of economics can be
summarized in four words: ’people respond to incentives.’
The rest is commentary.”
• An incentive is something (such as the prospect of a
punishment or a reward) that induces a person to act.
• A change in marginal sacrifice (cost) or a change in
marginal benefit changes the incentives that we face and
leads us to change our choice.
• More of an activity is undertaken when its marginal
sacrifice (cost) falls or its marginal benefit rises; less of an
activity is undertaken when its marginal sacrifice (cost)
rises or its marginal benefit falls.
• Examples
• Incentive: Higher price
Response : Buyers consume less & Sellers produce more
• Incentive: Public policy (Increase in tax on alcohol)
Response
• Change costs or benefits (Increase in price of alcohol)
• Change people’s behavior (Reduction in consumption )
• When petrol prices rise (Incentive), consumers buy more
hybrid cars and fewer petrol SUVs (Response).
• When tax on cigarette increases (Incentive), teen
smoking falls (Response)
v People gain from their ability to trade with one another.
v Trade allows individuals to specialize in producing goods
and services in which they are efficient in comparison to
others.
v This leads to increased productivity and increased
production, as resources are allocated more effectively.
v Through trade, individuals can access a wider variety of
goods and services at lower prices, improving their overall
well-being.
v Ultimately, trade benefits all parties involved by creating
opportunities for mutually beneficial exchanges and
promoting overall prosperity
vCountries also benefit from trade and
specialization:
•Competition results in gains from trading
•Get a better price abroad for goods they
produce
•Buy other goods more cheaply from abroad
than could be produced at home
Exercise
• Jogesh can produce 40 kg of wheat or 20 kg of fish in 6
hours. Debesh can produce 20 kg of wheat or 40 kg of fish
in 6 hours. Jogesh and Debesh were to work in the
production of wheat and fish. Who would produce wheat,
who would produce fish and why? Explain with the help of
the relevant basic principles of economics.
ANSWER:
• Basic Principles utilised- Trade can make everyone better
off
• Jogesh will produce wheat since he is more efficient or
productive in production of wheat.
• Debesh will produce fish since he is more efficient or productive
in the production of fish.
Before trade :
Let both will spend 6 hours for production of both commodities, i.e., 3
hours for each activity before trade.
Therefore, Jogesh can produce 20 kg of wheat and 10 kg of fish in 6 hours.
Debesh can produce 10 kg of wheat and 20 kg of fish in 6 hours
After Trade:
Each will specialise and spend six hours in the activity where he is more
efficient and exchange 1 kg of wheat against 1 kg. of fish.
Therefore, Jogesh will produce wheat only (40 kg) and Debesh will
produce Fish only (40 kg) in 6 hours.
Now Jogesh will give 10kg of wheat to Debesh in exchange of 10 kg of fish
which they produce earlier before trade.
Gain from Trade:
After exchange of 10 kg of wheat against 10 kg of fish, Jogesh will consume 30 kg of
wheat and 10 kg of fish and Debesh will consume 10 kg of wheat and 30 kg of fish.
Therefore, Jogesh will gain 10kg of wheat, Debesh will gain 10 kg of fish and whole
economy will gain 10 kg of wheat and 10 kg of fish when trade takes place
Person Production and Production Production Gain from
consumption after trade in and Trade
before trade in 6 hours consumption
6 hours after trade
Wheat Fish Wheat Fish Wheat Fish Wheat Fish
Jogesh 20 10 40 - 30 10 10 -
Debesh 10 20 - 40 10 30 - 10
Total 30 30 40 40 40 40 10 10
vMarket can be defines as a system where
buyers and sellers meet together, negotiate a
price at which transaction takes place.
v“Market organize economic activity” means
determining
v what goods and services to produce
v how to produce these goods and services
v how much of each good and service to
produce
v who gets these goods and services
A market economy allocates resources
through the decentralized decisions of many
firms and households as they interact in
markets for goods and services.
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.
The invisible hand works through the price
system:
v The interaction of buyers and sellers
determines prices.
v Each price reflects the good’s value to buyers
and the cost of producing the good.
v Prices guide self-interested households and
firms to make decisions that, in many cases,
maximize society’s economic well-being.
vIn a competitive market we need government to
• enforce the rules
• enforce property rights (Ability of an individual to own
and exercise control over scarce resources)
vMarket failure occurs when the market fails to
allocate resources efficiently.
vMarket failure may be caused by
• an externality, which is the impact of one person or
firm’s actions on the well-being of a bystander.
• market power, which is the ability of a single person or
firm to unduly influence market prices.
v In such cases, public policy can promote efficiency.
vWhen the market fails (breaks down)
government can intervene to promote
efficiency and equity.
• To promote efficiency : Avoid market failure
and solve the problem of externality.
• To promote equality : Avoid disparities in
economic wellbeing
• If the market’s distribution of economic well-
being is not desirable, tax or welfare policies
can change how the economic “pie” is divided.
vPrinciple #8: A country’s standard of
living depends on its ability to produce
goods and services.
vPrinciple #9: Prices rise when the
Government prints too much money.
vPrinciple #10: Society faces a short-run
tradeoff between inflation and
unemployment.