Ten Principles of Economics

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Questions to be discussed

 Why do we have economic problems?

 What are the three categories of economic
principles?
 What is the opportunity cost?
 What is a production possibility frontier?

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Economics
 Economics is the study of how society manages
its scarce resources.

 Economics is a study of mankind in the ordinary

business. – Alfred Marshall, 19th century
economist.
 Economics is about people:
 how they make decision;
 how they interact with one another; and
 how their interaction influence the course of society overall.

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Society and Scarce Resources

 The management of society’s resources is

important because resources are scarce.
 Scarcity. . . means that society has limited
resources and therefore cannot produce all
the goods and services people wish to have.

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Ten Principles of Economics

 Economics is the study of how society

manages its scarce resources.

 Ten Principles of Economics:

 How People Make Decisions
 How people interact with each other.
 How the economy as a whole works.

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Ten Principles of Economics
 How People Make Decisions
 People face tradeoffs.
 The cost of something is what you give up to get it.
 Rational people think at the margin.
 People respond to incentives.
 How people interact with each other.
 Trade can make everyone better off.
 Markets are usually a good way to organize economic activity.
 Governments can sometimes improve economic outcomes.
 How the economy as a whole works.
 The standard of living depends on a country’s production.
 Prices rise when the government prints too much money.
 Society faces a short-run tradeoff between inflation and
unemployment.
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Principle #1: People Face Tradeoffs.

To get one thing, we usually have to give up

another thing.
 Leisure time v. work
 Food v. clothing
 Guns v. butter
 Efficiency v. equity

Making decisions requires trading

off one goal against another.
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Principle #1: People Face Tradeoffs.

 Efficiency v. Equity
 Efficiency means society gets the most that it can
from its scarce resources.
 Equity means the benefits of those resources are
distributed fairly among the members of society.

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Principle #2: The Cost of Something Is What
You Give Up to Get It.

 Decisions require comparing costs and

benefits of alternatives.
 Whether to go to college or to work?
 Whether to study or go out on a date?
 Whether to go to class or sleep in?

 The opportunity cost of an item is what you

give up to obtain that item.

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What is the Cost of Attending College?
 Add up the money you spend on tuition,
books, room, and board?

 Yet this total does not truly represent what

you give up to spend a year in college.
 It includes some things that are not really costs of
going to college.
 It ignores the largest cost of going to college—
your time.

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Principle #2: The Cost of Something Is What
You Give Up to Get It.

LA Laker basketball
star Kobe Bryant chose
to skip college and go
straight from high
school to the pros
where he has earned
millions of dollars.

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Principle #3: People Make Decision on the
Margin

 Marginal changes are small, incremental

adjustments to an existing plan of action.

People make decisions by comparing

costs and benefits at the margin.

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Principle #3: People Make Decision on the
Margin - Example
 Consider an airline deciding how much to
charge passengers who fly standby.
 Suppose that flying a 200-seat plane across the
country costs the airline $100,000. In this case, the
average cost of each seat is $100,000/200, which is
$500.
 Should the airline sell a ticket for less than $500 to
standby-flyer?
 Marginal cost may be merely the cost of the bag of
peanuts and can of soda that the extra passenger will
consume.

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Principle #4: People Respond to Incentives.

 Marginal changes in costs or benefits

motivate people to respond.

 Public policymakers should never forget

about incentives, for many policies change
the costs or benefits that people face and,
therefore, alter behavior.

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Example: How does a seat belt law affect
auto safety?
 The direct effect is obvious.
 More people wear seat belts, and the probability of
surviving a major auto accident rises.

 But that’s not the end of the story.

 Seat belts make accidents less costly for a driver. Thus, a
seat belt law reduces the benefits to slow and careful
driving.
 In a 1975 study, economist Sam Peltzman showed that the
auto-safety laws have resulted is little change in the
number of driver deaths and an increase in the number of
pedestrian deaths.

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Principle #5: Trade can Make Everyone Better
off.
 People gain from their ability to trade with
one another. Because
 Trade allows people to specialize in what they do
best.
 People enjoy a greater variety of goods and
services when trading with each other.

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Principle #6: Markets Are Usually a Good Way
to Organize Economic Activity.
 A market economy is an economy that
allocates resources through the decentralized
decisions of many firms and households as
they interact in markets for goods and
services.
 Households decide what to buy and who to work
for.
 Firms decide who to hire and what to produce.

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Principle #6: Markets Are Usually a Good Way
to Organize Economic Activity.
 Adam Smith made the observation that
households and firms interacting in markets
act as if guided by an “invisible hand.”
 Because households and firms look at prices
when deciding what to buy and sell, they
unknowingly take into account the social costs of
their actions.
 As a result, prices guide decision makers to reach
outcomes that tend to maximize the welfare of
society as a whole.

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Principle #7: Governments Can Sometimes
Improve Market Outcomes.
 Market failure occurs when the market fails to
allocate resources efficiently.

 When the market fails (breaks down)

government can intervene to promote
efficiency and equity.

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Principle #7: Governments Can Sometimes
Improve Market Outcomes.
 Protecting the invisible hand by enforcing the
property rights.

 Market failure may be caused by

 an externality, which is the impact of one person
or firm’s actions on the well-being of a bystander.
 market power, which is the ability of a single
person or firm to unduly influence market prices.

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Principle #7: Governments Can Sometimes
Improve Market Outcomes.
 To say that the government can improve on markets
outcomes at times does not mean that it always will.
 Public policy is made by a political process that is far from
perfect.
 Sometimes policies are designed simply to reward the
politically powerful.
 Sometimes they are made by well-intentioned leaders who
are not fully informed.
 One goal of the study of economics is to help you judge
when a government policy is justifiable to promote
efficiency or equity and when it is not.

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Principle #8: The Standard of Living Depends
on a Country’s Production.
 Living standards around the world differ a lot
 In 2000 the average American had an income of
about $34,000.
 In the same year, the average Mexican earned
$8,790, and the average Nigerian earned $800.

 Citizens of high-income countries have more

TV sets, more cars, better nutrition, better
health care, and longer life expectancy than
citizens of low-income countries.

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Principle #8: The Standard of Living Depends
on a Country’s Production.
 Almost all variations in living standards are
explained by differences in countries’
productivities.
 Productivity is the amount of goods and services
produced from each hour of a worker’s time.

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Principle #9: Prices Rise When the
Government Prints Too Much Money.
 One of history’s most spectacular examples of
inflation, an increase in the overall level of prices in
the economy.
 In Germany in January 1921, a daily newspaper cost 0.30
marks.
 Less than two years later, in November 1922, the same
newspaper cost 70,000,000 marks.
 All other prices in the economy rose by similar amounts.

 When prices were on average tripling every month,

the quantity of money was also tripling every month.

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Principle #9: Prices Rise When the
Government Prints Too Much Money.
 Inflation is an increase in the overall level of
prices in the economy.

 One cause of inflation is the growth in the

quantity of money.

 When the government creates large

quantities of money, the value of the money
falls.

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Principle #10: Society Faces a Short-run
Tradeoff between Inflation & Unemployment.
 The Phillips Curve illustrates the tradeoff
between inflation and unemployment:
Inflation  Unemployment
It’s a short-run tradeoff!

 The tradeoff between inflation and

unemployment is only temporary, but it can
last for several years.

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Principle #10: Society Faces a Short-run
Tradeoff between Inflation & Unemployment.
 The Phillips curve is, therefore, crucial for
understanding many developments in the
economy.
 In particular, policymakers can exploit this
tradeoff using various policy instruments.
 By changing the amount that the government
spends, the amount it taxes, and the amount of
money it prints, policymakers can, in the short run,
influence the combination of inflation and
unemployment that the economy experiences.
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Our Second Model: The Production
Possibilities Frontier
 The production possibilities frontier is a graph
that shows the combinations of output that
the economy can possibly produce given the
available factors of production and the
available production technology.

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The Production Possibilities Frontier
Quantity of
Computers
Produced

3,000 D

C
2,200
2,000 A
Production
possibilities
frontier
1,000 B

0 300 600 700 1,000 Quantity of

Cars Produced
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Thinking like an Economist: The Production
Possibilities Frontier
 Concepts Illustrated by the Production
Possibilities Frontier
 Scarcity.
 Efficiency
 Tradeoffs
 Opportunity Cost
 Economic Growth

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A Shift in the Production Possibilities Frontier
Quantity of
Computers
Produced

4,000

3,000

2,100 E
2,000
A

700 750 1,000 Quantity of Cars Produced

0

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Microeconomics and Macroeconomics
 Microeconomics focuses on the individual parts
of the economy.
 How households and firms make decisions and
how they interact in specific markets

 Macroeconomics looks at the economy as a

whole.
 Economy-wide phenomena, including output,
inflation, unemployment, and economic growth.

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Outside Reading (not to be lectured)

 Read Chapter 2: Thinking like an Economist.

2022/09/13 Ten Principles of Economics