Chapter 2

Economic PrinciPles
economic theory. economic techliques or
the rules
Dcfinition: Econotr.ric principles are dcfined as
of the people in a society' to interact the people in
a
which are applied to *ut . ,pp'opttutJ-Jttision
;i-.;;Ji;l;"* how the icontmv works as a whole in a societv'
Ten Economic PrinciPles
Princinle l: Peop)e Face Trade-offs
;;i;;t;i; ;' ih;'c*t of Somerhing is what You Give up 10 GeL It
iri""ii,i. :' Ralional People Thirrl< at tlte 14argin' Nalure)
giir.iii" +, People Respond to lncenli!es {Human
ff
iii""iirr. s' trate Can Make E\er) one Bettertoo organize Economic ActiYitv
;;i;;i;i; ;, Market are Usuallv a Good Wav
t.ir"iii" l, c"".r.*ent Can Sornelimes Improve Mdrket ourcomes -
;I;;til ;, ;;;;;t s,*a*a tepends on its Abilitv to Produce Goods and services
"i:ii'ine
irrir.iiri. st Pri..t fu.e when the Government Prins too N'4uch Money
;1il.i,pi; io, il;;ii u sr'o*-*n Trade-off betueen Inflation Unemplovment
nu".'
people.rnake decision in a society' how
Here ue discuss ten economic principles to understand how principles
il;;;;];;'""i..v *a n"* irl" t"o"o,,,v *o'k' u' u *iole Thus these ten economic
three categorles:
are grouPed into
irr a cocicty'
t l) iiow people rna'ke decjsion
(2) how DcoDIe interact and
1].1 how ilre economy
works as a whole

of Thinking
How Peopte Make Decision: The EconomicWay

PeoDleofasocielymakedecisionbasedo0thelollowinglourprinciplesofeconomics.
Princinle 1: Peonte Face Trade-olfs
;;i;;;i; ;' i h;'Ast o[ Someihing is uhat You Give up 10 Get It
p.irr.iot" S, Ralional People'l hink al the Margin
i'.ir"iir" a, People Respond to Inccnlives (Human Nature)
How People Int€ract:
people interact with one another'
il f;ffiil tlr; principles concern how
prin"ipl" St irade ian Make Everyone Belter Off
to organize Economic Activitv
;1il:il;;; rti,n.i"r. ,t*nv ' Good wav[mprove Market outcomes
i'.i""iii" l, Gorernment Can Sornetimes

How the EconomY as a Whole Works

economv as a whole'
Th. f;iil;; ,hree principles concem the working of the

on itsAbjlity to Produce Goods and Services

Principte 8: A Country's Standard ofLiving depends
i'.i".iii" s, p;.i
tuse when the Gor emment Prints
(oo Much Money
Inflation unemplovment
;;i;ili; io; 3;;i"iy a shod-run rrade-off
Faces between

peonle ofa societY make decision based on the following

four principles ofeconomics'
Uu[" Decision: The Economic Way ot Thinking
Uoi f"opt"

Principle 1: People Face Trade-offs

Youcanthinkabouteverychoiccasatrade-off.Trade-offmeanstogetmoleofsomethingwelikewe
hare to sive up else rhar we like For effitt
iiyo' tp"na *oney on dinner and movie you will not be
;;;; "";;;ii ;*.M.tott't' sotiiuf ont as a $oup For example there is a classic
i,h;iffiii: ;;n, uno itaoi rt'ut irto'ittv 'p*dt t*t *o"v on national defense
urn.i'. il" "i"-i*"i'uat of
(suns) then tess to tp"J;;;;f;;;;s
it wilt have Gutt"') to-in"t"u"e the standard of living
ih" neoole ol this sociery. There is
such
t;""1 ;;;-;ff between efficiencv and equality Policies nork
"l;;;
;"',il#Hr*i"];i*"r,nrr. i"."i.,.r "-*.qr^tu but these policies reduce retums to hard
*h"n th" government tdes to cut the pie
and thus the economy does not p'"d;-;;;;;';t '"s'lt
1
into morc equal pieces the pie gets smaller. llie questions what, how, and for whom become
sharper
when ue think in terms oftradeoffs
govemments choose
Ilhat?" Trctdeolrt arise u'hen people choose how to spend their incomes, when
what to produce'
how to spend their tax revenues, atrd when businesses choose

How?" Tradeoffs arise when businesses choose among altemative production technologies'

individuals-
Forllhom?" Trqdeoff arise when choices change the.distribution of buying powef acloss kadeoff
bo.,".r-"nt redistribution of incomc lrom the rich to the poor creates the big tradeo{I-the
between equality and efficiencY.

from its scarce

Efficieucy: Efficiency of a society is defined as getting rbe maximurn benefits
.n'q,"rr.y.Equalityofasocietyisdefinedasbenelrtswillbedistributedtothepeopleofthatsociety
resources.

unilormly.

Principle 2: The Cost of Something is What You Give Up to Get It

The opportunity cost
Thinking about a choice as a trade-offemphasizes cost as an opportunily forgone'
of an iteim is what you give up to get thai item lt is the true cost of the ilem' The opportunity cost of
io oi'tuin MBA d"gr"e ftom BUp includes your tuition fees, value ofyour time that
co;g to "niu".rity your room and board
!o, iorfa ftuua tp"nt working, valued at your potential eamilgs Itorwould not'
exclude
payments because you have to eat afld sleep whether are in school

Opportunity Cost
get that item' It is the
The opportunity cost ofan item is defined as the highest value that you give up to
true cost of the item.

with weekly
Example: Suppose you run a sandwich shop and make total weekly- revenues of 52000'
profit? what.if, instead of ruming the shop, you
ruuor, iooa, uno ,."t totaling $1500. Are youmaking a
ard gotten paid $800? This forgone payment is pq
ftuu" worked for someon" else -of ihi
"o"fi y cost of running the shop, and it should be added to the $1500 to get a total cost of$2300'
"pp""*i
Sirr." tt iri, greater than lour $20{i0 in revenue, you are making an economic loss, not an
economic
profit.

Example:Goingtoamovie.Isthecostjustthe$9.00togetin?No-it,salsothecostofgettingthere
(url"ri, yout o-*n gas) and the time taken. To find the true cost, we'd have to consider what
"u.',
could trave been done with both the money and the time - say, buying a CD and studyirg some more'

PriDciple 3; Rational People Think at lhe Margin.

Rational people make choices at the margin which means that they evaluate the consequences
of
rnuti"g ir"r"a"ntul changes in the use of th"i, ,"ao""""' The word "marginal" means "next"'
i
uJaitl'onul," o,
,,itr"t" Fo, when we talk about the marginal cost of a good, we mean
"nLl.,,
oiproar"ing one more "*ur,rple,
unit of ihe good lf we talk about marginal benefit we mean benefrt
tfr"
trorn"ori
pursuing an inJremental increase in an activity. Rational decision makels only proceed with an
,"tiorr;ttf," ,irtgi.rd benefit is exceeding the marginal cost' For example you will altend university for
,a;iti""a year ii the benefits from thaf year of schooling exceed the,cost of attending that year. A
farmer should produce one more unit of a commodity only if the benefils
( price received) exceed the
cost olproducing it.

Marginal Benefit: The benefit from pursuing an incremental increase in an activity is its marginal
U"r"it. fh" ,u.gl*l benefit indicatei, in dollar terms, what the consumer is willing to pay to acquire
curve. If a
one more unit oithe good; it can also be related to the height of an individ,al's demand
.onrr*"rlrwillingto-pay$5.00foragallonofgasoline,andtheactualpdceis$3'00'thenthereisa
consumer surplus of $2.0b with ttre purchase of that gallon of gasoline. The value
to the consumer, or
maximum price that consumers are willing
*.gina U"nJnt, it S5.00. Value is calculated by getting the
to pay.

Youcandothatbyincreasingthelevelofanactivitywhenevertheaddedbenefitofdoingsoexceeds
the added cost. That is. do more rvhen MB > MC. Stop whor MB < MC'

2
 N1arqinal

a
economics exam'
get lhe highest grade you can on tomo ow's
Example: Suppose your only goal is to studv or to sleep Now' each hour 1ou
There are twelve hours untrl then, -i"';;;";;;?;";h"hourio

*Tf; J1i-:,}1* .:*'il':l'#*i6+'1"

il*.l:l*}thus, ru'r:':$i"1"$'y*"'i::'91'H;
ao*"iuu'a graph) Meanwhile' isee each
less-material. the marginal 'Np"i nn exam' because 1 ou
""li;t'trt'"'it'*t
hour of studv is a lost hour oI sleep i"ti'U
tf ttp **es you to lose '"'
And the more sleep you lose' the wots" it is (Having 8
'olltt
can't concentrale and aren't tf''inting cfeariy j has a large effect') Thus' the
ei;; il* g"''i'g rt""tt i':'*o
hours of slcep instead ot t has liltle "." (see graph)'
marcinal cost (MC) ol studying *ruj'it''f" ti'-t rhe MB ol'sleep) is unward sloping from the
"!
.' t*ly r"' a rhircl? You'il qain l0 points
suoiose vou'ue studied for Z 1l", "]'drl"riO-' -so do it The same goes for hours
studving, but lose 4 f,o* lo" of "lttp'iot
t'*li*'""J"rO poins.
losc more
yo'''" tiiJing oitt'aying a seventh hour' MB MC' 6You'll
<
a s and 6. But bv the decide to studv for hours and sleep
'i^t
ooinrs from lack of sleep ,,,un yor'rr'pur-'f*
;;;;ii;; i" v*
#t";;i;;t;;early universal rule for economic decision
ihe rest of rhe night. the rule ol MC -8il;
making

MC
Points

10
l
,l

MB

36 8
Study Hours

(Human Nature)
Principle 4: People Respond to Incentives
on the incentives we
Because we face scarcity, we must
make choices' The choices we make deDend
enloi"gt';" p*atV that discourages an action' Rational people
face. An incentive is a re*a'd rhat F-or the price o[
example when
resoond when marginal cosls td;;ii?;t;'t-"T;iitits ".*gt automobile producers have an
buyers
"'tt"tt iittt"ti"t t Uty f"*t'.tal'whjle
automobiles cars rises, of
incentive to hire more workers "rd
p;J;;;;;;";;s Public policy can alter the costs or benefits
discourage purchases'
ffiil.;";;;ple tax on luxury cars raise the price and

How PeoPle Interact:

how people interact with one another

The following tkee principles concem

Better Off
Principle 5: Trade Can Make Everyone

3
People of a society or people between tu,o countdes iltelact by trading. 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 thei output for
the output ofother efficient products. This is as true for countries as it is for individuals.

Principle 6: Market are Usually a Good Way to Organize Economic Activity

ln a market econ0my, the decision about what goods and services to produce, how much to produce
and for whom the gopds are services to produce, are made by millions of firms and households. Firms
decide whom to hire what to make. Households decide which firms to work and what to buy with their
incomes. Firms are households guided by self-intercst; intenct in the marketplace where prices and
quantities are detennined. Adam Smith made the famous observation h the Wealth oJ Nations in 1776
that self interested households and fiIms interact in markets and generate desirable social outcomes as
if guided by an invisible hand. Prices are the instruments with which the invisible hand directs
economic activity. In any market buyers look at the prices when determining how much to demand and
seller look at the price when decided how much to supply. Thus their competitive activities signal the
value of costs aad benefits to producers and consumers whose activities usually maximize the
well-being society

Market Ecotromy: An economy that allocates resources through the decentralized decisions of many
firms and households as they interact in markets for goods and services is called market economy.

Principle 7: Government Can Sometimes Improye Market Outcomes

Govemment must fimt protect property fights in order lbr markets to work. In addition, government
can sometimes intervene in the market to improve efflciency or equality. When markets fail to allocate
resources efficiently, there has been market failure. 'I here are many different sources of market failure.
Extemality and market power cause the market failure. In these situations the govemment may be able
to intewene and improve economic efficiency. The govemment may also intervene to improve equality
with income taxes and welfare

Property Rights: Property right is defined as the ability of an individual to own and exercise contuol
over scarce resources

Market Failure: Market failure is defined as the situalion in which market Ieft on i1s own fails to
allocate resources effi ciently.

Externality: Extomality is defined as the impact of one person's action on the well being of a
bystander

How the Eco[oDly as a Whole Works

The following three principles concem the working ofthe economy as a whole.

Principle 8: A Country's Standard of Living depends on its Ability to Produce Goods and
Servic€s

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

Principle 9: Prices Rise when the Government Prints too Much Money

By inllation we mean a process ofdsing prices. Inflation is an increase in the overall level ofprices in
the economy. High inJlation is costly to the economy. President G. Ford called inflation "putrlic enemy
number one". Diferent names have beert given to inflation depending upon the rate ofrise in prices. (i)
Creeping Inflation, (ii) Chronic or Secular Inflation: (iii) Walking In{Iation, (iv) Moderate Inflation,
(v) Running Inflation, (vi) Jumping Inflation, (vii) Hlperinflation
Creeping Inllation: \\&en the rise in prices is very slow like &at of a snail or creepeq it is called
creeping inflation If the rise in price is less than 3% per annum, then the inllation is called creeping
inflation.
4 (
Chronic or Secular Inflation: If creeping intlation existing fbl a long peliod of time, then the inflation
is called chronic or secula inflation.
watking Inflation: whetr price rises moderately and the annual inllation rate is a single unit then the
inflation is called rvalking inflation. Ifthe rate of rise in price lies belween 3%o to 107o per anmrm or
lcss than l0% then the inflation is ca1led walking int.lation. Inflation at this rate is a waming signal {'or
the government to controlit before it runs into running inflation.
Moierate Inflation: If the inflationary rate is Iess thao 9o/o per anilum, that is single digit inflation,
stable inflation not serious problem in economy.
Running Inflation: When the price rise rapidly like as the runaing of a horse at the Iate of speed of X0
to 20 pircent per annum, it is called the nuLning inflation- This. inflation has negative impact on
economy especially such inflation affects the poor class and middle classes. Running inflation means
inflationary rate is in doubie digit per amum.
Jumping Inflation: When the price rises at a faster rate at double or triple digits pel annum like as the
jumping ofu hott", at the rate of speed 20 to 100% per annum it is called the jumping inllation. For
Lxampli, in India during l9?3 and 1974 the inflationary situation could be characterized as being one
ofthe jumping inflation because prices rose by 26 per cent in 1973.
Hypeiinflation : When prices rise very fast at triple digit Iates from more than 100% per annum, it is
catied the hyperinflation. Hyperinflation is extremely rare. Recent examples include Yugoslavia
Arqentina , Brazil , Georgia and Turkev (where inflation reached 7070 in 1999) The classic example of
hlperinflation was ofcourse the rampant inflation in Weim . When
hyperinllation occurs, the value ofmoney becomes worthless and People lose all confidence in money
both as a store of value and also as a medium of exchange. The current hypctiE0ali9!-i!.Ziqbablyq is
a good example of the havoc that can be caused when price inflation spirals out of control. Oilen
drastic action is required to stabilize an economy suffering from high and volatile inflation and tllis
leads to political and social instability. The Intemational Monetary Fund is often brought into the
process of implementing economic reforms to reduce inflation and achieve greater hnancial stability-

Large and persistent inflation is caused by rapid growth in the quantity of money- Policy makers
wishing to keep inflation low should maintain slow growth in the quantity ofmoney.

Principle l0: Society Faces a Short-run Trade'Off between Inflation Unemploymetrt

In the short-run an increue in the quantity of money stimulates spending which raises both prices ar:rd
production. The iflcrcase in production requites more hiring labors as a result in the short-run
pnemplol.rnent reduces. Thus in the short-run an increase in inflations tends to reduce unemploymerlt,
causing trade-off between inflation and unemployment. In the short-run policy makers may be able to
affect the mix ofinflationand unemployment by changing governrnent spending, taxes and the quantity
oI money.