Chapter 1. Ten Principles of Economics

Questions to answer
1 What kinds of questions does economics address?
2 What are the principles of how people make decisions?
3 What are the principles of how people interact?
4 What are the principles of how the economy as a whole works?

WHAT IS ECONOMICS ALL ABOUT?
Scarcity: the limited nature of society’s resources
Economics
The existence of The scarcity of

unlimited human available
wants resources
TEN PRINCIPLES OF ECONOMICS
How people make decisions
How people interact
How the economy as a whole works

The principles of
HOW PEOPLE MAKE DECISIONS
Principle 1. People face trade-offs
All decisions involve tradeoffs.

✓ Going to a party the night before your midterm leaves
less time for studying.
Efficiency
✓ Having more money to buy stuff requires working long
er hours, which leaves less time for leisure.
✓ Protecting the environment requires resources that
could otherwise be used to produce consumer goods.
Principle 1. People face trade-offs
There ain’t no such thing as a free lunch.

→ trade-off = Give up sth to get sth else
Efficiency
Getting maximum benefits
from scare resources
Equality
Benefits are distributed uniformly
among society’s members
Principle 2. The cost of something is what you give up to get it
Opportunity cost = Value of the best alternative sacrificed
Scare resources >< unlimited wants

→ Trade-off
→ compare costs & benefits of ALL options
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.
Principle 3. Rational people think at the margin
People are rational.

→Do the best to achieve the objectives
Marginal change = a small incremental adjustment

to an existing plan of action
→ Pay more marginal cost = more profitable selling
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.
Why is water so cheap while diamonds
are expensive?
Principle 4. People respond to incentives
Incentives = something that induces a pers

on to act (punishment/ reward)
Higher price
= incentive for buyers to consume less
= incentive for sellers to produce more
Principle 4. 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.

ACTIVE LEARNING 1
Applying the principles
You are selling your 1996 Mustang. You have already spent $1000 on repairs.
At the last minute, the transmission dies. You can pay $600 to have it repaired,
or sell the car “as is.”
In each of the following scenarios, should you have the transmission repaired?
Explain.
A. Blue book value (what you could get for the car) is $6500 if transmission
works, $5700 if it doesn’t
B. Blue book value is $6000 if transmission works, $5500 if it doesn’t
ACTIVE LEARNING 1
Answer
Cost of fixing transmission = $600

A. Blue book value is $6500 if transmission works, $5700 if it doesn’t
Benefit of fixing transmission = $800
($6500 – 5700).
Get the transmission fixed.
B. Blue book value is $6000 if transmission works, $5500 if it doesn’t

Benefit of fixing the transmission is only $500.
Do not pay $600 to fix it.
The principles of
HOW PEOPLE INTERACT
HOW PEOPLE INTERACT
Principle 5. Trade can make everyone better off
• Trade allows each person to specialize in the activities he/ she does best.
• By trading with others, people can buy a greater variety of goods/ services.
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

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.
HOW PEOPLE INTERACT
Principle 7. Government can sometimes improve market outcome
✓ 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.
HOW PEOPLE INTERACT
Principle 7. Government can sometimes improve market outcome
When the invisible hand does not work, …

✓ Market failure: a solution in which a market left on its own fails to allocate
resources efficiently
✓ Externality: the impact of one person’s actions on the well-being of a
bystander
✓ Market power: The ability of a single economic actor to have substantial
influence on market prices
ACTIVE LEARNING 2
Discussion
In each of the following situations, what is the government’s role?

Does the government’s intervention improve the outcome?
a. Public schools for K-12
b. Workplace safety regulations
c. Public highways
d. Patent laws, which allow drug companies to charge high prices for life-saving drugs
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 and services
Huge variation in living standards across countries an

d 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.
Principle 8. A country’s standard of living depends on its ability to
produce goods and services
Productivity = amount of goods & services produced per unit of labor

• Productivity depends on equipment, skills & technology AVAILABLE to workers
• Other factors (labor unions, competition from abroad) have far less impact on living standards
Principle 9. Prices rise when the government prints too much $$$
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.
Principle 10. Society faces a short-run trade-off between inflation & unemployment
• In the short-run (1-2 years), many economic

policies push inflation and unemployment in
opposite directions
• Other factors can make this trade-off more or
less favorable, but the trade-off is always
present
SUMMARY
KEY TERMS AND CONCEPTS
Economics Organize economic activity
Tradeoffs Invisible hand
Opportunity cost Government
Marginal change Market outcome
Incentives Market failure
Specialization Externality
International trade Market power
Market Productivity
Inflation
CONTENT FOR CHAPTER REVIEW
1. Define economics
2. List and explain 10 principles of economics
3. For each principle, take 1 example for illustration

Chapter 1. Ten Principles of Economics

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Questions to answer

1 What kinds of questions does economics address?

2 What are the principles of how people make decisions?

3 What are the principles of how people interact?

4 What are the principles of how the economy as a whole works?

The existence of The scarcity of

How people interact

How the economy as a whole works

All decisions involve tradeoffs.

There ain’t no such thing as a free lunch.

Opportunity cost = Value of the best alternative sacrificed

Scare resources >< unlimited wants

…going to college for a year is not just the tuition, books

…seeing a movie is not just the price of the ticket,

People are rational.

Marginal change = a small incremental adjustment

✓ When a student considers whether to go to college for an additional

✓ When a manager considers whether to increase output, she

Why is water so cheap while diamonds

Incentives = something that induces a pers

✓ When gas prices rise, consumers buy more hybrid

✓ When cigarette taxes increase, teen smoking falls.

Cost of fixing transmission = $600

B. Blue book value is $6000 if transmission works, $5500 if it doesn’t

• Market: a group of buyers and sellers

• “Organize economic activity” means determining

– what goods to produce

– how to produce them

– how much of each to produce

– who gets them

The invisible hand works through the price system:

✓ The interaction of buyers and sellers determines prices.

✓ Prices guide self-interested households and firms to make decisions

✓ Important role for govt: enforce property

✓ People are less inclined to work, produce,

When the invisible hand does not work, …

In each of the following situations, what is the government’s role?

a. Public schools for K-12

b. Workplace safety regulations

Huge variation in living standards across countries an

✓ Average income in rich countries is more than

✓ The U.S. standard of living today is about eight

Productivity = amount of goods & services produced per unit of labor

Inflation: increases in the general level

✓ In the long run, inflation is almost

✓ The faster the govt creates money, the

• In the short-run (1-2 years), many economic

Tradeoffs Invisible hand

Opportunity cost Government

Marginal change Market outcome

Incentives Market failure

International trade Market power

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