Economics

Principles of

N. Gregory Mankiw

CHAPTER Ten Principles

1 of Economics
What Economics Is All About
▪ Scarcity: the limited nature of society’s
resources (land, capital, labour)
▪ 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

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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.

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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

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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
▪ how to produce them
▪ how much of each to produce
▪ who gets them

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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.
▪ 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.

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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 6
Markets Are Usually A Good Way to
Organize Economic Activity

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PRINCIPLE 7
Governments Can Sometimes
Improve Market Outcomes
▪ Important role for govt: enforce property rights
(with police, courts)
▪ People are less inclined to work, produce,
invest, or purchase if large risk of their property
being stolen.

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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 bystanders (e.g. pollution)
▪ Market power, a single buyer or seller has
substantial influence on market price
(e.g. monopoly)
▪ Public policy may promote efficiency.
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PRINCIPLE 7
Governments Can Sometimes
Improve Market Outcomes
▪ Govt 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.

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The principles of
HOW THE
ECONOMY
AS A WHOLE
WORKS

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PRINCIPLE 8
A Country’s 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.

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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 government 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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CONCLUSION