1

Ten Principles of Economics

PRINCIPLES OF

MICROECONOMICS
FOURTH EDITION

N. G R E G O R Y M A N K I W
PowerPoint Slides by Ron Cronovich
2007 Thomson South-Western, all rights reserved

Topics

What kinds of questions does economics

address?

What are the principles on which people make

decisions?

What are the principles on which how people

interact?

What are the principles on which how the

economy as a whole works?
1

CHAPTER 1

TEN PRINCIPLES OF ECONOMICS

What Economics Is All About

Scarcity refers to the limited nature of societys
resources.

Economics is the study of how society manages

its scarce resources, including how people decide how much to work, save, and spend, and what to buy how firms decide how much to produce, how many workers to hire how society decides how to divide its resources between national defense, consumer goods, protecting the environment, and other needs
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS
2

HOW PEOPLE MAKE DECISIONS

Decision making is at the heart of economics. The first four principles deal with how people
make decisions.

CHAPTER 1

TEN PRINCIPLES OF ECONOMICS

HOW PEOPLE MAKE DECISIONS

Principle #1: People Face Tradeoffs

There is no such thing as free lunch All decisions involve tradeoffs. Examples:

Having more money to buy stuff requires working

longer hours, which leaves less time for leisure.

Protecting the environment requires resources

that might otherwise be used to produce consumer goods.

Guns v/s Butter

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS
4

HOW PEOPLE MAKE DECISIONS

Principle #1: People Face Tradeoffs

Society faces an important tradeoff:

efficiency vs. equity

efficiency: getting the most out of scarce

resources

equity: distributing prosperity fairly among

societys members

Tradeoff: To increase equity, can redistribute

income from the well-off to the poor. But this reduces the incentive to work and produce, and shrinks the size of the economic pie.
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS
5

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.

It is the relevant cost for decision making.

CHAPTER 1

TEN PRINCIPLES OF ECONOMICS

HOW PEOPLE MAKE DECISIONS

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.

CHAPTER 1

TEN PRINCIPLES OF ECONOMICS

HOW PEOPLE MAKE DECISIONS

Principle #3: Rational People Think at the Margin

A person is rational if she systematically and

purposefully does the best she can to achieve her objectives.

Many decisions are not all or nothing,

but involve marginal changes incremental adjustments to an existing plan.

Evaluating the costs and benefits of marginal

changes is an important part of decision making.
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS
8

HOW PEOPLE MAKE DECISIONS

Principle #3: Rational People Think at the Margin

Examples:

A student considers whether to go to college

for an additional year, comparing the fees & foregone wages to the extra income he could earn with an extra year of education.

A firm considers whether to increase output,

comparing the cost of the needed labor and materials to the extra revenue.
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS
9

HOW PEOPLE MAKE DECISIONS

Principle #3: Rational People Think at the Margin

Water- Diamond Paradox

Persons willingness to pay for a good is based

on marginal benefit that an extra unit of the good would yield

Marginal benefit depends on how many units a

person already has.

Marginal benefit from extra unit of water is

negligible but people consider the marginal benefit of an extra diamond to be large. CHAPTER 1 TEN PRINCIPLES OF ECONOMICS
10

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 because

they make decisions by comparing costs and benefits. Examples: In response to higher cigarette taxes, smoking falls. Indian oil prices

CHAPTER 1

TEN PRINCIPLES OF ECONOMICS

11

Exercise
You are selling your 1996 Maruti 800. 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?
A. Blue book value is 6500 if transmission works, 5700 if it doesnt
B. Blue book value is 6000 if transmission works, 5500 if it doesnt
12

Answers
Cost of fixing transmission = 600
A. Blue book value is 6500 if transmission works, 5700 if it doesnt

Benefit of fixing the transmission = 800 (6500 5700).

Its worthwhile to have the transmission fixed.
B. Blue book value is 6000 if transmission works, 5500 if it doesnt

Benefit of fixing the transmission is only 500. Paying 600 to fix transmission is not worthwhile.
13

Answers
Observations:

The 1000 you previously spent on repairs is

irrelevant. What matters is the cost and benefit of the marginal repair (the transmission).

The change in incentives from scenario A

to scenario B caused your decision to change.

14

HOW PEOPLE INTERACT

An economy is just
a group of people interacting with each other.

The next
three principles deal with how people interact.

CHAPTER 1

TEN PRINCIPLES OF ECONOMICS

15

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
TEN PRINCIPLES OF ECONOMICS
16

CHAPTER 1

Absolute Advantage
Adam Smith: The Wealth of Nations, 1776

A country Should specialize in production of and export products

for which it has absolute advantage; import other products Has absolute advantage when it is more productive than another country in producing a particular product

17

Comparative Advantage
David Ricardo: Principles of Political
Economy, 1817

Country should specialize in the production of

those goods in which it is relatively more productive... even if it has absolute advantage in all goods it produces

18

HOW PEOPLE INTERACT

Principle #6: Markets Are Usually A Good Way to Organize Economic Activity

A market is a group of buyers and sellers.

(They 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
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS
19

HOW PEOPLE INTERACT

Principle #6: Markets Are Usually A Good Way to Organize Economic Activity

In a market economy, these decisions result from

the interactions of many households and firms.

Famous insight by Adam Smith in

An Inquiry into the Nature and Causes of the Wealth of Nations (1776):

Each of these households and firms acts in the market economy as if led by an invisible hand to promote general economic wellbeing.
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS
20

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 of goods and services.

Each price reflects the goods value to buyers

and the cost of producing the good.

Prices are the instrument with which the invisible

hand directs economic activity
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS
21

HOW PEOPLE INTERACT

Principle #7: Governments Can Sometimes Improve Market Outcomes

Important role for government enforce property rights

(with police, courts)

People are less inclined to work, produce, invest, or

purchase if large risk of their property being stolen.

A restaurant wont serve meals if customers do not pay before they leave. A music company wont produce CDs if too many people avoid paying by making illegal copies.
TEN PRINCIPLES OF ECONOMICS
22

CHAPTER 1

HOW PEOPLE INTERACT

Principle #7: Governments Can Sometimes Improve Market Outcomes

Governement may alter market outcome to promote

efficiency

market failure, when the market fails to allocate

societys resources efficiently. Causes: 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)

In such cases, public policy may increase efficiency.

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS
23

HOW PEOPLE INTERACT

Principle #7: Governments Can Sometimes Improve Market Outcomes

Government may alter market outcome to promote

equity

If the markets distribution of economic well-being

is not desirable, tax or welfare policies can change how the economic pie is divided.

CHAPTER 1

TEN PRINCIPLES OF ECONOMICS

24

HOW THE ECONOMY AS A WHOLE WORKS

The last three

principles deal with the economy as a whole.

CHAPTER 1

TEN PRINCIPLES OF ECONOMICS

25

HOW THE ECONOMY AS A WHOLE WORKS

Principle #8: A countrys standard of living depends on its ability to produce goods & services.

Huge variation in living standards across

countries and 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.

CHAPTER 1

TEN PRINCIPLES OF ECONOMICS

26

HOW THE ECONOMY AS A WHOLE WORKS

Principle #8: A countrys standard of living depends on its ability to produce goods & services.

The most important determinant of living standards:

productivity, the amount of goods and services produced per unit of labor.

Productivity depends on the equipment, skills, and

technology available to workers.

Other factors (e.g., labor unions, competition from

abroad) have far less impact on living standards.
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS
27

HOW THE ECONOMY AS A WHOLE WORKS

Principle #9: Prices rise when the government prints too much money.

Inflation: increase 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 government creates money,

the greater the inflation rate.

CHAPTER 1

TEN PRINCIPLES OF ECONOMICS

28

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.

Money increases- Demand increases- Price

increases- Producers produce more employment increases

Other factors can make this tradeoff more or less

favorable, but the tradeoff is always present.
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS
29

CONCLUSION
Economics offers many insights about the
behavior of people, markets, and economies.

It is based on a few ideas that can be applied

in many situations.

CHAPTER 1

TEN PRINCIPLES OF ECONOMICS

30

CHAPTER SUMMARY The principles of decision making are:

People face tradeoffs. The cost of any action is measured in terms of

foregone opportunities.

Rational people make decisions by comparing

marginal costs and marginal benefits.

People respond to incentives.

CHAPTER 1

TEN PRINCIPLES OF ECONOMICS

31

CHAPTER SUMMARY The principles of interactions among people are:

Trade can be mutually beneficial. Markets are usually a good way of

coordinating trade.

Govt can potentially improve market

outcomes if there is a market failure or if the market outcome is inequitable.

CHAPTER 1

TEN PRINCIPLES OF ECONOMICS

32

CHAPTER SUMMARY The principles of the economy as a whole are:

Productivity is the ultimate source of living

standards.

Money growth is the ultimate source of

inflation.

Society faces a short-run tradeoff between

inflation and unemployment.

CHAPTER 1

TEN PRINCIPLES OF ECONOMICS

33