N.

Gregory Mankiw

Principles of
Economics Sixth Edition

1
Ten Principles of
Premium
Economics PowerPoint
Slides by
Ron Cronovich
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2012 UPDATE
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 In this chapter,
look for the answers to these questions:
• What kinds of questions does economics
address?
• What are the principles of how people make
decisions?
• What are the principles of how people interact?
• What are the principles of how the economy as
a whole works?

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 What Economics Is All About
▪ Scarcity: the limited nature of society’s
resources (How we manage this scarce
resources)
▪ Economics: the study of how society manages
its scarce resources, e.g.
▪ how people decide what to buy,
how much to work, save, and spend
▪ 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
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 The principles of
HOW PEOPLE
MAKE DECISIONS
 PRINCIPLE #1:
People Face Tradeoffs
All decisions involve tradeoffs. Examples:
▪ 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.

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 PRINCIPLE #1:
People Face Tradeoffs
▪ Society faces an important tradeoff:
efficiency vs. equality
▪ Efficiency: when society gets the most from its
scarce resources
▪ Equality: when prosperity is distributed
uniformly among society’s members
▪ Tradeoff: To achieve greater equality,
could redistribute income from wealthy to poor.
But this reduces incentive to work and produce,
shrinks the size of the economic “pie.”
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 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.

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 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.

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 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.

▪ It is the benefit you get when you change

something.

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 PRINCIPLE #3:
Rational People Think at the Margin
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.

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 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.

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The principles of
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 and
specialization:
▪ Get a better price abroad for goods they
produce
▪ Buy other goods more cheaply from abroad
than could be produced at home

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 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/Buy
▪ how to produce them/ Buy
▪ how much of each to produce /Buy
▪ who gets them
* Each of many households decides who to work for and what goods to buy.
* Each of many firms decides whom to hire and what goods to produce.
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 PRINCIPLE #6:
Markets Are Usually A Good Way to
Organize Economic Activity
▪ A market economy allocates resources through the
decentralized decisions of many households and firms as
they interact in markets.
▪ This is to say, the market is guided by invisible hand
(the interaction between buyers and sellers)
▪ Famous insight by Adam Smith in
The Wealth of Nations (1776):
Each of these households and firms
acts as if “led by an invisible hand”
to promote general economic well-being.

***Invisible hand works without Government

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 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.

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 PRINCIPLE #7:
Governments Can Sometimes
Improve Market Outcomes
If the invisible hand of the market is so great, why do we
need government?
▪ Important role for government: enforce 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 our rights.
▪ People are less inclined to work, produce, invest, or
purchase if large risk of their property being stolen. Thus,
we need government to help us to protect our right.

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 PRINCIPLE #7:
Governments Can Sometimes
Improve Market Outcomes
▪ Market failure: when the market fails to allocate
society’s resources efficiently
▪ Causes of market failure:
▪ Externalities, when the production or consumption
of a good affects by standers (e.g. pollution)
▪ Market power, a single buyer or seller has
substantial influence on market price
(e.g. monopoly)
▪ Public policy provided by Government may
promote efficiency. 17
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 PRINCIPLE #7:
Governments Can Sometimes
Improve Market Outcomes
▪ Government may alter market outcome to
promote equity.
▪ If the market’s distribution of economic well-being
is not desirable, tax or welfare policies can
change how the economic “pie” is divided.
(reducing inequality)

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The principles of
HOW THE
ECONOMY
AS A WHOLE
WORKS
 PRINCIPLE #8:
A Country’s Standard of Living Depends on
Its Ability to Produce Goods & Services
▪ Living standards are different in both time and
countries
▪ 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.

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 PRINCIPLE #8:
A Country’s 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.

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 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.

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 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.

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