MECO- Chapter 1: Ten Principles

of Economics
Core principles of economics Mankiw Chp 1
Understand with examples the ten principles of economics.

The management of society’s resources is important because resources are

scarce.
Scarcity means that society has limited resources and therefore cannot produce all the
goods and services people wish to have.
Economics is the study of how society manages its scarce resources. In most societies,
resources are allocated not by an all-powerful dictator but through the combined
choices of millions of households and firms.

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 Economists, therefore, study how people make decisions: how much they work, what
they buy, how much they save, and how they invest their savings. Economists also
study how people interact with one another.
For instance, they examine how the multitude of buyers and sellers of a good together
determine the price at which the good is sold and the quantity that is sold.
Finally, economists analyze the forces and trends that affect the economy as a whole,
including the growth in average income, the fraction of the population that cannot find
work, and the rate at which prices are rising.

1-1 How People Make Decisions

Individual decision making:

1-1a Principle 1: People Face Trade-offs

Making decisions requires trading off one goal against another.
guns vs butter
clean environment vs high level of income
Another trade-off society faces is between efficiency and equality.
Efficiency means that society is getting the maximum benefits from its scarce resources.

Equality means that those benefits are distributed uniformly among society’s members.
In
other words, efficiency refers to the size of the economic pie, and equality refers to
how the pie is divided into individual slices.

efficiency: the property of society getting the most it can from its scarce resources
equality: the property of distributing economic prosperity uniformly among the members
of society

Nonetheless, people are likely to make good decisions only if they understand the
options that are available to them.

Our study of economics, therefore, starts by acknowledging life’s trade-offs.

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 1-1b Principle 2: The Cost of Something Is What You
Give Up to Get It
Because people face trade-offs, making decisions requires comparing the costs and
benefits of alternative courses of action.

The opportunity cost of an item is what you give up to get that item.

1-1c Principle 3: Rational People Think at the Margin

rational people: people who systematically and purposefully do the best they can to
achieve
their objective, given the available opportunities.

Economists use the term marginal change to describe a small incremental adjustment
to an existing
plan of action.
Keep in mind that margin means “edge,” so marginal changes are adjustments around
the edges of what you are doing. Rational people often make decisions by comparing
marginal benefits and marginal costs.
The reason is that a person’s willingness to pay for a good is based on the marginal
benefit that an extra unit of the good would yield. The marginal benefit, in turn, depends
on how many units a person already has.

Water is essential, but the marginal benefit of an extra cup is small because water is
plentiful. By
contrast, no one needs diamonds to survive, but because diamonds are so rare, people
consider the marginal benefit of an extra diamond to be large

A rational decision maker takes an action if and only if the marginal benefit of the action
exceeds the marginal cost.

1-1d Principle 4: People Respond to Incentives

incentive: something that induces a person to act

Incentives are key to analyzing how markets work

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 the influence of prices on the behavior of consumers and producers is crucial to how a
market economy allocates scarce resources.
Public policymakers should never forget about incentives: Many policies change the
costs or benefits that people face and, as a result, alter their behavior.

When policymakers fail to consider how their policies affect incentives, they often end
up facing unintended consequences.
e.g. of taxes on fuel and car safety

If the policy changes incentives, it will cause people to alter their behavior.

1-2 How People Interact

The next three principles concern how people interact with one another.

1-2a Principle 5: Trade Can Make Everyone Better Off

By trading with others, people can buy a greater variety of goods and services at lower
cost.
Like families, countries also benefit from the ability to trade with one another.

Trade allows countries to specialize in what they do best and to enjoy a greater variety
of goods and services. The Chinese, as well as the French, Egyptians, and Brazilians,
are as much our partners in the world economy as they are our competitors.

1-2b Principle 6: Markets Are Usually a Good Way to

Organize Economic Activity
market economy: an economy that allocates resources through the decentralized
decisions
of many firms and households as they interact in markets for goods and services

These central planners decided what goods and services were produced, how much
was produced,
and who produced and consumed these goods and services. The theory behind central

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 planning was that only the government could organize economic activity in a way that
promoted economic well-being for the country as a whole.

In a market economy, the decisions of a central planner are replaced by the decisions of
millions 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 marketplace, where prices and self-interest guide
their decisions.

At first glance, the success of market economies is puzzling. In a market economy, no

one is looking out for the economic well-being of society as a whole. Free markets
contain many buyers and sellers of numerous goods and services, and all of them are
interested primarily in their own well-being. Yet despite decentralized decision making
and self-interested decision makers, market economies have proven remarkably
successful in organizing economic activity to promote overall
economic well-being.

In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations,
economist Adam Smith made the most famous observation in all of economics:
Households and firms interacting in markets act as if they are guided by an “invisible
hand” that leads them to desirable market outcomes. One of our goals in this book is to
understand how this invisible hand works its magic.
prices are the instrument with which the invisible hand directs economic activity.

Individuals are usually best left to their own devices, without the heavy hand of
government
guiding their actions.

In any market, buyers look at the price when determining how much to demand, and
sellers look at the price when deciding how much to supply.
As a result of the decisions that buyers and sellers make, market prices reflect both the
value of a good to society and the cost to society of making the good. Smith’s great
insight was that prices adjust to guide these individual buyers and sellers to reach
outcomes that, in many cases,
maximize the well-being of society as a whole.

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 Smith is saying that participants in the economy are motivated by self-interest and that
the “invisible hand” of the marketplace guides this self-interest into promoting general
economic well-being.

Smith’s insight has an important corollary: When a government prevents prices from
adjusting naturally to supply and demand, it impedes the invisible hand’s ability to
coordinate the decisions of the households and firms that make up an economy. This
corollary explains why taxes adversely affect the allocation of resources: They distort
prices and thus the decisions of households and firms. It also explains the great harm
caused by policies that directly control prices, such as
rent control. And it explains the failure of communism. In communist countries, prices
were not determined in the marketplace but were dictated by central planners. These
planners lacked the necessary information about consumers’ tastes and producers’
costs, which in a market economy is reflected in prices. Central planners failed because
they tried to run the economy with one hand tied behind their backs—the invisible hand
of the marketplace.

The vigorous competition among producers makes a market work well for consumers.
That is why economists love Uber. A 2014 survey of several dozen prominent
economists asked whether car services such as Uber increased consumer wellbeing.
Yes, said every single economist. The economists were also asked whether surge
pricing increased consumer well-being. Yes, said 85 percent of them.

Surge pricing makes consumers pay more at times, but because Uber drivers respond
to incentives, it also increases the quantity of car services supplied when they are most
needed. Surge pricing also helps allocate the services to those consumers who value
them most highly and reduces the costs of searching and waiting for a car.

1-2c Principle 7: Governments Can Sometimes Improve

Market Outcomes
One reason we need government is that the invisible hand can work its magic only if the
government enforces the rules and maintains the institutions that are key to a market
economy.
Most important, market economies need institutions to enforce property rights so
individuals can own and control scarce resources.

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 property rights: the ability of an individual to own and exercise control over scarce
resources

We all rely on government-provided police and courts to enforce our rights over the
things we produce—and the invisible hand counts on our ability to enforce those rights.
Another reason we need government is that, although the invisible hand is powerful, it is
not omnipotent. There are two broad rationales for a government to intervene in the
economy and change the allocation of resources that people would choose on their
own: to promote efficiency or to promote equality.

That is, most policies aim either to enlarge the economic pie or to change how the pie is
divided.

Consider first the goal of efficiency. Although the invisible hand usually leads markets to
allocate resources to maximize the size of the economic pie, this is not always the case.
Economists use the term market failure to refer to a situation in which the market on its
own fails to produce an efficient allocation of resources.

As we will see, one possible cause of market failure is an externality, which is the impact
of one person’s actions on the well-being of a bystander. The classic example of an
externality is pollution. When the production of a good pollutes the air and creates
health problems for those who live near the factories, the market left to its own devices
may fail to take this cost into account.
Another possible cause of market failure is market power, which refers to the ability of a
single person or firm (or a small group) to unduly influence market prices. For example,
if everyone in town needs water but there is only one well, the owner of the well is not
subject to the rigorous competition with which the invisible hand normally keeps self-
interest in check; she may take advantage of this opportunity by restricting the output of
water so she can charge a higher
price. In the presence of externalities or market power, well-designed public policy can
enhance economic efficiency.

Now consider the goal of equality. Even when the invisible hand yields efficient
outcomes, it can nonetheless leave sizable disparities in economic well-being.
A market economy rewards people according to their ability to produce things that other
people are willing to pay for. The world’s best basketball player earns more than the

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 world’s best chess player simply because people are willing to pay more to watch
basketball than chess. The invisible hand does not ensure that everyone has sufficient
food, decent clothing, and adequate healthcare.
This inequality may, depending on one’s political philosophy, call for government
intervention. In practice, many public policies, such as the income tax and the welfare
system, aim to achieve a more equal distribution of economic well-being.

To say that the government can improve on market outcomes does not mean that it
always will. Public policy is made not by angels but by a political process that is far from
perfect.
Sometimes policies are designed simply to reward the politically powerful. Sometimes
they are made by well-intentioned leaders who are not fully informed. As you study
economics, you will become a better judge of when a government policy is justifiable
because it promotes efficiency or equality and when it is not.

1-3 How the Economy as a Whole Works

Working of the economy as a whole

1-3a Principle 8: A Country’s Standard of Living

Depends on Its Ability to Produce Goods and Services
Large variation in average income is reflected in various measures of quality of life.
Citizens of high-income countries have more TV sets, more cars, better nutrition, better
healthcare, and a longer
life expectancy than citizens of low-income countries.

What explains these large differences in living standards among countries and
over time?
The answer is surprisingly simple. Almost all variation in living standards is attributable
to differences in countries’ productivity—that is, 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 people enjoy a high standard of living; in
nations where workers are less productive, most people endure a more meager

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 existence. Similarly, the growth rate of a nation’s productivity determines the growth rate
of its average income.
productivity: the quantity of goods and services produced from each unit of labor input
The fundamental relationship between productivity and living standards is simple, but its
implications are far-reaching. If productivity is the primary determinant of living
standards, other explanations must be of secondary importance.
The relationship between productivity and living standards also has profound
implications for public policy. When thinking about how any policy will affect living
standards, the key question is how it will affect our ability to produce goods and
services.

To boost living standards, policymakers need to raise productivity by ensuring that

workers are well educated, have the tools they need to produce goods and services,
and have access to the best available technology.
Living standard…productivity…equipment, labour

1-3b Principle 9: Prices Rise When the Government prints too much
money
inflation: an increase in the overall level of prices in the economy

Because high inflation imposes various costs on society, keeping inflation at a low level
is a goal of economic policymakers around the world.
What causes inflation?

In almost all cases of large or persistent inflation, the culprit is growth in the quantity of
money. When a government creates large quantities of the nation’s money, the value of
the money falls. In Germany in the early 1920s, when prices were on average tripling
every month, the quantity of money was also tripling every month. Although less
dramatic, the economic history of the United States points to a similar conclusion: The
high inflation of the 1970s was associated with rapid growth in the quantity of money,
and the return of low inflation in the 1980s was associated with slower growth in the
quantity of money.

1-3c Principle 10: Society Faces a Short-Run Trade-off

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 between Inflation and Unemployment
Although a higher level of prices is, in the long run, the primary effect of increasing the
quantity of money, the short-run story is more complex and controversial.

Most economists describe the short-run effects of monetary injections as follows:

1. Increasing the amount of money in the economy stimulates the overall level of
spending and thus the demand for goods and services.
2. Higher demand may over time cause firms to raise their prices, but in the meantime,
it also encourages them to hire more workers and produce a larger quantity of goods
and services.
3. More hiring means lower unemployment.
business cycle: fluctuations in economic activity, such as employment and production

This line of reasoning leads to one final economy-wide trade-off: a short-run trade-off
between inflation and unemployment.
Although some economists still question these ideas, most accept that society faces a
short-run trade-off between inflation and unemployment. This simply means that, over a
period of a year or two, many economic policies push inflation and unemployment in
opposite directions.

Policymakers face this trade-off regardless of whether inflation and unemployment both
start out at high levels (as they did in the early 1980s), at low levels (as they did in the
late 1990s), or someplace in between.

This short-run trade-off plays a key role in the analysis of the business cycle—the
irregular and largely unpredictable fluctuations in economic activity, as measured by the
production of goods and services or the number of people employed.

Policymakers can exploit the short-run trade-off between inflation and unemployment
using various policy instruments. By changing the amount that the government spends,
the amount it taxes, and the amount of money it prints, policymakers can influence the
overall demand for goods and services.
Changes in demand in turn influence the combination of inflation and unemployment
that the economy experiences in the short run. Because these instruments of economic

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 policy are potentially so powerful, how policymakers should use them to control the
economy, if at all, is a subject of continuing debate.

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