CHAPTER

1
Ten Principles of Economics
Goals

Learn that economics is about the allocation of scarce resources

in this chapter you will

Examine some of the trade-offs that people face

Learn the meaning of opportunity cost
See how to use marginal reasoning when making decisions
Discuss how incentives affect peoples behavior
Consider why trade among people or nations can be good for
everyone
Discuss why markets are a good, but not perfect, way to allocate
resources
Learn what determines some trends in the overall economy

Outcomes

Define scarcity

after accomplishing
these goals, you
should be able to

Explain the classic trade-off between guns and butter

Add up your particular opportunity cost of attending college
Compare the marginal costs and marginal benefits of saving for
retirement
Explain why specialization and trade improve peoples choices
Give an example of an externality
Explain the source of large and persistent inflation

Chapter 1 Ten Principles of Economics

Strive for a Five

The principles discussed in this chapter are basic economic concepts. These principles are
an introduction to the book; Mankiw goes into these principles in more depth later in the
text. Basic concepts, such as these ten principles, have been asked on both the micro- and
macroeconomics exams.
Scarcity
Trade-offs
Thinking at the margin
Marginal cost versus Marginal Benefit

Key Terms

ScarcityLimited resources and unlimited wants

EconomicsStudy of how society manages its scarce resources
EfficiencyThe property of society getting the most from its scarce resources
EqualityThe property of distributing economic prosperity uniformly among
societys members
RationalSystematically and purposefully doing the best you can to achieve your
objectives
Opportunity costWhatever is given up to get something else
Marginal changesIncremental adjustments to an existing plan
IncentiveSomething that induces a person to act
Market economyAn economic system where interaction of households and firms in
markets determines the allocation of resources
Property rightsThe ability of an individual to own and exercise control over scarce
resources
Invisible handThe principle that self-interested market participants may
unknowingly maximize the welfare of society as a whole
Market failureA situation in which the market fails to allocate resources efficiently
ExternalityWhen one persons actions have an impact on a bystander
Market powerThe ability of an individual or group to substantially influence market
prices
MonopolyThe case in which there is only one seller in the market
ProductivityThe amount of goods and services produced from each unit of labor
input
InflationAn increase in the overall level of prices
Business cycleFluctuations in economic activity

Chapter Overview
Context and Purpose
Chapter 1 is the first chapter in a three-chapter section that serves as the introduction
to the text. Chapter 1 introduces ten fundamental principles on which the study of
economics is based. In a broad sense, the rest of the text is an elaboration on these ten
principles. Chapter 2 will develop how economists approach problems, while Chapter 3
will explain how individuals and countries gain from trade.

Chapter 1 Ten Principles of Economics

The purpose of Chapter 1 is to lay out ten economic principles that will serve as
building blocks for the rest of the text. The ten principles can be grouped into three
categories: how people make decisions, how people interact, and how the economy works
as a whole. Throughout the text, references will be made repeatedly to these ten principles.

Chapter Review
Introduction Households and society face decisions about how to allocate scarce resources.
Resources are scarce in that we have fewer resources than we wish. Economics is the
study of how society manages its scarce resources. Economists study how people make
decisions about buying and selling, and saving and investing. We study how people interact
with one another in markets where prices are determined and quantities are exchanged.
We also study the economy as a whole when we concern ourselves with total income,
unemployment, and inflation.
This chapter addresses ten principles of economics. The text will refer to these
principles throughout. The ten principles are grouped into three categories: how people
make decisions, how people interact, and how the economy works as a whole.

How People Make Decisions

People face trade-offs Economists often say, There aint no such thing as a free
lunch. This means that there are always trade-offsto 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 wont be able to spend it on new clothes. Socially, we face
trade-offs as a group. For example, there is the classic trade-off between guns and
butter. That is, if society spends more on national defense (guns), then it will have less
to spend on social programs (butter). There is also a social trade-off between efficiency
(getting the most from our scarce resources) and equality (benefits being distributed
uniformly across society). Policies such as taxes and welfare make incomes more equal,
but these policies reduce returns to hard work, and thus, the economy doesnt produce
as much. As a result, when the government tries to cut the pie into more equal pieces,
the pie gets smaller.

The cost of something is what you give up to get it The opportunity

cost of an item is what you give up to get that item. It is the true cost of the item.
The opportunity cost of going to college obviously includes your tuition payment. It
also includes the value of your time that you could have spent working, valued at your
potential earnings. It would exclude your room and board payment because you have
to eat and sleep whether you are in school or not.

Rational people think at the margin Rational people systematically do the

best they can to achieve their objectives. Marginal changes are incremental changes to
an existing plan. Rational decision makers only proceed with an action if the marginal
benefit exceeds the marginal cost. For example, you should only attend school for
another year if the benefits from that year of schooling exceed the cost of attending
that year. A farmer should produce another bushel of corn only if the benefit (price
received) exceeds the cost of producing it.

People respond to incentives An incentive is something that induces a

person to act. Because rational people weigh marginal costs and marginal benefits
of activities, they will respond when these costs or benefits change. For example,
when the price of automobiles rises, buyers have an incentive to buy fewer cars while
automobile producers have an incentive to hire more workers and produce more
autos. Public policy can alter the costs or benefits of activities. For example, a luxury
tax on expensive boats raises the price and discourages purchases. Some policies
have unintended consequences because they alter behavior in a manner that was not
predicted.

Chapter 1 Ten Principles of Economics

How People Interact

Trade can make everyone better off Trade is not a contest in which
one wins and one loses. Trade can make each trader better off. Trade allows each
trader to specialize in what he or she does best, whether it be farming, building, or
manufacturing, and trade their output for the output of other efficient producers. This
is as true for countries as it is for individuals.

Markets are usually a good way to organize economic activity In

a market economy, the decisions about what goods and services to produce, how
much to produce, and who gets to consume them are made by millions of firms and
households. Firms and households, guided by self-interest, interact in the marketplace
where prices and quantities are determined. Although this may appear to be chaos,
Adam Smith made the famous observation in the Wealth of Nations in 1776 that
self-interested households and firms interact in markets and generate desirable social
outcomes as if guided by an invisible hand. These optimal social outcomes were not
their original intent. The prices generated by their competitive activity signal the value
of costs and benefits to producers and consumers, whose activities usually maximize
the well-being of society. Alternatively, the prices dictated by central planners
contain no information on costs and benefits, and therefore, these prices fail to guide
economic activity efficiently. Prices also fail to guide economic activity efficiently
when governments distort prices with taxes or restrict price movements with price
controls.

Governments can sometimes improve market outcomes Government

must first protect property rights in order for markets to work. In addition,
government can sometimes intervene in the market to improve efficiency or equality.
When markets fail to allocate resources efficiently, there has been market failure.
There are many different sources of market failure. An externality is when the actions
of one person affect the well-being of a bystander. Pollution is a standard example.
Market power is when a single person or group can influence the price. In these
cases, the government may be able to intervene and improve economic efficiency. The
government may also intervene to improve equality with income taxes and welfare.
Sometimes well-intentioned policy intervention has unintended consequences.

How the Economy as a Whole Works

A countrys standard of living depends on its ability to produce

goods and services There is great variation in average incomes across countries
at a point in time and within the same country over time. These differences in
incomes and standards of living are largely attributable to differences in productivity.
Productivity is the amount of goods and services produced from each unit of labor
input. As a result, public policy intended to improve standards of living should improve
education, generate more and better tools, and improve access to current technology.

Prices rise when the government prints too much money Inflation is an
increase in the overall level of prices in the economy. High inflation is costly to the
economy. Large and persistent inflation is caused by rapid growth in the quantity of
money. Policymakers wishing to keep inflation low should maintain slow growth in
the quantity of money.

Society faces a short-run trade-off between inflation and

unemployment In the short run, an increase in the quantity of money stimulates
spending, which raises both prices and production. The increase in production
requires more hiring, which reduces unemployment. Thus, in the short run, an
increase in inflation tends to reduce unemployment, causing a trade-off between

Chapter 1 Ten Principles of Economics

inflation and unemployment. The trade-off is temporary but can last for a year or
two. Understanding this trade-off is important for understanding the fluctuations in
economic activity known as the business cycle. In the short run, policymakers may
be able to affect the mix of inflation and unemployment by changing government
spending, taxes, and the quantity of money.

Helpful Hints
1. Place yourself in the story. Throughout the text, most economic situations will be
composed of economic actorsbuyers and sellers, borrowers and lenders, firms and
workers, and so on. When you are asked to address how any economic actor would
respond to economic incentives, place yourself in the story as the buyer or the seller,
the borrower or the lender, the producer or the consumer. Dont think of yourself
always as the buyer (a natural tendency) or always as the seller.You will find that your
role-playing will usually produce the right response once you learn to think like an
economistwhich is the topic of the next chapter.
2. Trade is not a zero-sum game. Some people see an exchange in terms of winners
and losers. Their reaction to trade is that, after the sale, if the seller is happy, the buyer
must be sad because the seller must have taken something from the buyer. That is,
they view trade as a zero-sum game where what one gains the other must have lost.
They fail to see that both parties to a voluntary transaction gain because each party is
allowed to specialize in what it can produce most efficiently and then trade for items
that are produced more efficiently by others. Nobody loses, because trade is voluntary.
Therefore, a government policy that limits trade reduces the potential gains from trade.
3. An externality can be positive. Because the classic example of an externality is
pollution, it is easy to think of an externality as a cost that lands on a bystander.
However, an externality can be positive in that it can be a benefit that lands on a
bystander. For example, education is often cited as a product that emits a positive
externality because when your neighbor educates herself, she is likely to be more
reasonable, responsible, productive, and politically astute. In short, she is a better
neighbor. Positive externalities, just as much as negative externalities, may be a reason
for the government to intervene to promote efficiency.

Self-Test
Multiple-Choice Questions
1. Economics is the study of
a. production methods.
b. how society manages its scarce resources.
c. how households decide who performs which tasks.
d. the interaction of business and government.
e. the earning and spending of money.
2. In economics, the cost of something is
a. the dollar amount of obtaining it.
b. always measured in units of time given up to get it.
c. what you give up to get it.
d. often impossible to quantify, even in principle.
e. the dollar cost of producing it.

Chapter 1 Ten Principles of Economics

3. High school athletes who skip college to become highly paid professional athletes
a. obviously do not understand the value of a college education.
b. usually do so because they cannot get into college.
c. understand that the opportunity cost of attending college is very high.
d. are not making a rational decision because the marginal benefits of college
outweigh the marginal costs of college for high school athletes.
e. understand that the opportunity cost of becoming a professional athlete is very
high.
4. A rational decision maker takes an action only if the
a. marginal benefit is less than the marginal cost.
b. marginal benefit is greater than the marginal cost.
c. total benefit is maximized.
d. total cost is minimized.
e. the opportunity cost is less than the marginal cost.
5. Mike has spent $500 purchasing and repairing an old fishing boat, which he expects
to sell for $800 once the repairs are complete. Mike discovers that, in addition to the
$500 he has already spent, he needs to make one more repair, which will cost another
$400, in order to make the boat worth $800 to potential buyers. He can sell the boat
as it is now for $300. What should he do?
a. He should sell the boat as it is now for $300.
b. He should sell the boat for no less than the $900 he has spent on it.
c. He should complete the repairs and sell the boat for $800.
d. It does not matter which action he takes; the outcome is the same either way.
e. He should sell the boat for the $500 he has already spent.
6. Which is the most accurate statement about trade?
a. Trade can make every nation better off.
b. Trade makes some nations better off and others worse off.
c. Trading for a good can make a nation better off only if the nation cannot
produce that good itself.
d. Trade helps rich nations and hurts poor nations.
e. Trade helps poor nations and hurts rich nations.
7. One advantage market economies have over centrally planned economies is that
market economies
a. provide an equal distribution of goods and services to households.
b. establish a significant role for government in the allocation of resources.
c. solve the problem of scarcity.
d. are more efficient.
e. are better at directing resources toward achieving national goals.

8. Which of the following questions is not answered by the decisions that every
society must make?
a. What determines consumer preferences?
b. What goods will be produced?
c. How will goods be produced?
d. Who will consume the goods produced?
e. Who will produce the goods being consumed?
9. The term used to describe a situation in which markets do not allocate resources
efficiently is
a. economic meltdown.
b. market failure.
c. government failure.
d. equilibrium.
e. disequilibrium.

Chapter 1 Ten Principles of Economics

10. Laws that restrict smoking cigarettes in public places are examples of government
intervention that is intended to reduce
a. efficiency.
b. equality.
c. externalities.
d. productivity.
e. equity.
11. In the United States, incomes historically have grown about 2 percent per year. At this
rate, average income doubles every
a. fifteen years.
b. twenty-five years.
c. thirty-five years.
d. forty-five years.
e. fifty years.
12. Which of the following is the most correct statement about the relationship between
inflation and unemployment?
a. In the short run, falling inflation is associated with falling unemployment.
b. In the short run, falling inflation is associated with rising unemployment.
c. In the short run, falling inflation is unrelated to unemployment.
d. In the long run, falling inflation is associated with falling unemployment.
e. In the long run, falling inflation is associated with rising unemployment.

Free Response Questions

1. Greg is trying to make a decision about going on vacation. The following are costs
he is considering: transportation expenses ($750); lodging expenses ($600); recreation
expenses ($250); food expenses while on vacation ($500); and food expenses while at
home ($300). Greg also knows that while on vacation, he will not earn $1,500 from
work. Complete the following.
a. Calculate the total cost of Greg going on vacation.
b. List the name of each of the expenses you included and their dollar amount.
2. Define scarcity. Two ways that societies have used to deal with the economic problem
of scarcity are markets and government. List one economic advantage of each of those
systems of dealing with the problem of scarcity.

Chapter 1 Ten Principles of Economics

Solutions
Multiple-Choice Questions
1. b TOP: Economics/Scarcity
2. c TOP: Opportunity cost
3. c TOP: Opportunity cost
4. b TOP: Marginal changes
5. c TOP: Marginal cost
6. a TOP: Trade
7. d TOP: Market economy
8. a TOP: Market economy
9. b TOP: Market failure
10. c TOP: Externalities/Government
11. c TOP: Income
12. b TOP: Inflation/Unemployment/Trade-offs

Free Response Questions

1. Transportation
$750
lodging
$600
recreation
$250
food
$200

(food on vacation [$500]

minus food at home [$300])
forgone wages $1,500
Total Cost
$3,300
TOP: Market economy/Government

2. Definition: Unlimited wants with limited resources.
One advantage of market is economic efficiency
One advantage of government is the ability to deal with market failure (positive or negative externalities).
TOP: Economics/Scarcity