FYI: How to Read Your Textbook

1. Read before class.

You’ll get more out of class.
2. Summarize, don’t highlight.
Highlighting is a passive activity that won’t improve
your comprehension or retention.
Instead, summarize each section in your own
words. Then, compare your summary to the one
at the end of the chapter.
 FYI: How to Read Your Textbook
3. Practice, practice, practice.
Tutorial exercises.
4. Study in groups.
Get together with a few classmates to review each
chapter, quiz each other, and help each other
understand the material. You may even find a gf/bf
5. Teach someone.
The best way to learn something is to teach it to
someone else, such as a study partner or friend, or
gf/bf and make her/him love you more.
CHAPTER
1,2

Introduction

Microeonomics
PRINCIPLES OF

N. Gregory Mankiw

© 2009 South-Western, a part of Cengage Learning, all rights reserved

 Outline
1. Ten principles of economics
2. The circular-flow model
3. The production possibilities frontier/curve (PPF)
4. Microeconomics vs Macroeconomics
5. Positive vs Normative

THINKING LIKE AN ECONOMIST 3

 Ten Principles of Economics
• Economy – “oikonomos” (Greek)
– “One who manages a household”
• Household - many decisions
– Allocate scarce resources
• Ability, effort, and desire
• Society - many decisions
– Allocate resources
– Allocate output
• Resources are scarce
4
 Ten Principles of Economics
• Scarcity - limited nature of society’s resources
• Economics
– Study of how society manages its scarce
resources
• Economists study:
– How people make decisions
– How people interact with one another
– Analyze forces and trends that affect the
economy as a whole
5
Table 1
Ten principles of economics
How People Make Decisions
1: People Face Trade-offs
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
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
How the Economy as a Whole Works
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 Trade-off between Inflation and
Unemployment
6
 The principles of
HOW PEOPLE
MAKE DECISIONS
 HOW PEOPLE MAKE DECISIONS
Principle #1: People Face Tradeoffs

▪ 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.
▪ Society faces an important tradeoff:
efficiency vs. equality
 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.
“Value of the next-highest-valued alternative use of
that resource”
 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.
 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.
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 is $6500 if transmission works,
$5700 if it doesn’t
B. Blue book value is $6000 if transmission works,
$5500 if it doesn’t
13
ACTIVE LEARNING 1
Answers
Cost of fixing transmission = $600
A. Blue book value is $6500 if transmission works,
$5700 if it doesn’t
Benefit of fixing the transmission = $800
($6500 – 5700).
It’s worthwhile to have 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.
Paying $600 to fix transmission is not worthwhile.
14
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
 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 #7: Governments Can Sometimes
Improve Market Outcomes

▪ Important role for govt: enforce property rights

(with police, courts)
▪ Market failure: when the market fails to allocate
society’s resources efficiently
▪ 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)
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
▪ The most important determinant of living
standards: productivity, the amount of goods
and services produced per unit of labor.
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.
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.
Table 1
Ten principles of economics
How People Make Decisions
1: People Face Trade-offs
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
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
How the Economy as a Whole Works
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 Trade-off between Inflation and
Unemployment
24
 Outline
1. Ten principles of economics
2. The circular-flow model
3. The production possibilities frontier/curve (PPF)
4. Microeconomics vs Macroeconomics
5. Positive vs Normative

THINKING LIKE AN ECONOMIST 25

Models and assumptions

Don’t forget
to floss!
 Our First Model:
The Circular-Flow Diagram
▪ The Circular-Flow Diagram: a visual model of
the economy, shows how dollars flow through
markets among households and firms
▪ Two types of “actors”:
▪ households
▪ firms
▪ Two markets:
▪ the market for goods and services
▪ the market for “factors of production”

THINKING LIKE AN ECONOMIST 27

FIGURE 1: The Circular-Flow Diagram

Households:
▪ Own the factors of production,
sell/rent them to firms for income
▪ Buy and consume goods & services

Firms Households

Firms:
▪ Buy/hire factors of production,
use them to produce goods
and services
▪ Sell goods & services
THINKING LIKE AN ECONOMIST 28
Our First Model: The Circular-Flow Diagram
Revenue Spending
Markets for
G&S Goods &
G&S
sold Services bought

Firms Households

Factors of Labor, land,

production Markets for capital
Factors of
Wages, rent, Production Income
profit
THINKING LIKE AN ECONOMIST 29
 Outline
1. Ten principles of economics
2. The circular-flow model
3. The production possibilities frontier/curve (PPF)
4. Microeconomics vs Macroeconomics
5. Positive vs Normative

THINKING LIKE AN ECONOMIST 30

 Our Second Model:
The Production Possibilities Frontier
Quantity of
Computers The production possibilities
Produced frontier shows the
combinations of output - in
C this case, cars and
3,000 F
computers - that the
Production
economy can possibly
A Possibilities
2,200 produce.
B Frontier
2,000 The economy can produce
any combination on or
inside the frontier.
D Points outside the frontier
1,000
are not feasible given the
E
economy’s resources.

0 300 600 700 1,000 Quantity of

Cars
Produced
31
ATTENTION

A production possibilities frontier only shows the

choices available—not which point of production is
best

THINKING LIKE AN ECONOMIST 32

 The Economist as a Scientist
• Opportunity cost of one good
– Give up the other good
• Bowed out production possibilities frontier
– Opportunity cost of a car – highest
• Economy - producing many cars and fewer
computers
– Opportunity cost of a car – lower
• Economy - producing fewer cars and many
computers
– Resource specialization
33
 The Economist as a Scientist
• Technological advance
– Outward shift of the production possibilities
frontier
– Economic growth
– Produce more of both goods

34
 3
A shift in the production possibilities frontier
Quantity of
Computers
Produced A technological advance in
4,000 the computer industry
enables the economy to
produce more computers
3,000 for any given number of
2,300 G cars. As a result, the
2,200 production possibilities
A frontier shifts outward. If
the economy moves from
point A to point G, then the
production of both cars and
computers increases.

0 600 650 1,000 Quantity of

Cars Produced

35
 The Shape of the PPF
▪ The PPF could be a straight line, or bow-shaped
▪ Depends on what happens to opportunity cost
as economy shifts resources from one industry
to the other.
▪ If opp. cost remains constant,
PPF is a straight line.
▪ If opp. cost of a good rises as the economy
produces more of the good, PPF is bow-
shaped.

THINKING LIKE AN ECONOMIST 36

 Why the PPF Might Be Bow-Shaped

As the economy

Beer
shifts resources
from beer to
mountain bikes:
▪ PPF becomes
steeper
▪ opp. cost of
mountain bikes
increases
Mountain
Bikes
THINKING LIKE AN ECONOMIST 37
 Why the PPF Might Be Bow-Shaped

At point A, At A, opp. cost of

Beer
A mtn bikes is low.
most workers are
producing beer,
even those that
are better suited
to building bikes.
So, do not have to
give up much beer to
get more bikes.
Mountain
Bikes
THINKING LIKE AN ECONOMIST 38
 Why the PPF Might Be Bow-Shaped

At B, most workers

Beer
At B, opp. cost
are producing bikes.
of mtn bikes
The few left in beer is high.
are the best brewers.
Producing more B
bikes would require
shifting some of the
best brewers away
from beer production,
would cause a big
Mountain
drop in beer output.
Bikes
THINKING LIKE AN ECONOMIST 39
 Outline
1. Ten principles of economics
2. The circular-flow model
3. The production possibilities frontier/curve (PPF)
4. Microeconomics vs Macroeconomics
5. Positive vs Normative

THINKING LIKE AN ECONOMIST 40

 Microeconomics and Macroeconomics
▪ Microeconomics is the study of how households
and firms make decisions and how they interact
in markets.
▪ Macroeconomics is the study of economy-wide
phenomena, including inflation, unemployment,
and economic growth.
▪ These two branches of economics are closely
intertwined, yet distinct – they address different
questions.

THINKING LIKE AN ECONOMIST 41

THINKING LIKE AN ECONOMIST 42
 Outline
1. Ten principles of economics
2. The circular-flow model
3. The production possibilities frontier/curve (PPF)
4. Microeconomics vs Macroeconomics
5. Positive vs Normative

THINKING LIKE AN ECONOMIST 43

 The Economist
▪ As scientists → positive statements → to describe
the world as it is.
▪ As policy advisors → normative statements → to
prescribe how the world should be.
▪ Positive statements can be confirmed or refuted,
normative statements cannot.

44
 Why Economists Disagree
▪ Economists may have different
scientific judgments. That is,
economists may disagree about
the validity of alternative
positive theories regarding how
the world works.
▪ Economists may have different
values. That is, economists may
have different normative views
about what policy should try to
accomplish

THINKING LIKE AN ECONOMIST 45

ACTIVE LEARNING 3
Identifying positive vs. normative
Which of these statements are “positive” and which
are “normative”? How can you tell the difference?
a. Prices rise when the government increases the
quantity of money.
b. The government should print less money.
c. A tax cut is needed to stimulate the economy.
d. An increase in the price of burritos will cause an
increase in consumer demand for video rentals.

46
ACTIVE LEARNING 3
Answers
a. Prices rise when the government increases the
quantity of money.
Positive – describes a relationship, could use
data to confirm or refute.
b. The government should print less money.
Normative – this is a value judgment, cannot be
confirmed or refuted.

47
ACTIVE LEARNING 3
Answers
c. A tax cut is needed to stimulate the economy.
Normative – another value judgment.
d. An increase in the price of burritos will cause an
increase in consumer demand for video rentals.
Positive – describes a relationship.
Note that a statement need not be true to be
positive.

48
THINKING LIKE AN ECONOMIST 49
 What we did?
✓ Learn ten principles of economics (especially the first 7)
✓ Learn two simple models—the circular-flow diagram and the production
possibilities frontier (PPF)

✓ Understand the flow of income and goods

& services

✓ Compute opportunity cost by PPF

✓ Explain why PPF bowed outward
✓ Find and graph efficient/inefficient
production points on PPF

✓ Distinguish between microeconomics and macroeconomics

✓ Learn the difference between positive and normative statements (List two
reasons why economists disagree) 50