PRINCIPLES OF

Economics
By N. Gregory Mankiw
 A brief Recap
Economics: How households and societies
manage their scarce resources.

Scarcity: Means the limited nature of

resources

Resource Allocation: Is done not by force but

by the interaction or combined actions of
millions of households and firms.
 What Economists study?
How people make decisions:
how much they work, what they buy, how much they save,
and how they invest their savings.
How people interact with one another:
For instance, they examine how the multitude of buyers and
sellers of a good together determine the price at which the
good is sold and the quantity that is sold.
What forces and trends that affect the
economy as a whole:
The growth in average income, the fraction of the population
that cannot find work, and the rate at which prices are rising.
Ten Principles of Economics

1
Ten principles of economics
How People Make Decisions
1: People Face Trade-offs
2: The Cost of Something Is What You Give Up to Get It
3: Rational People Think at the Margin
4: People Respond to Incentives
How People Interact
5: Trade Can Make Everyone Better Off
6: Markets Are Usually a Good Way to Organize Economic Activity
7: Governments Can Sometimes Improve Market Outcomes
How the Economy as a Whole Works
8: A Country’s Standard of Living Depends on Its Ability to Produce
Goods and Services
9: Prices Rise When the Government Prints Too Much Money
10: Society Faces a Short-Run Trade-off between Inflation and
Unemployment
5
 How People Make Decisions
Principle 1: People face trade-offs
• Making decisions
 Trade off one goal against another
 Student – time
 Parents – income
 Society
• National defense vs. consumer goods
• Clean environment vs. high level of income
• Efficiency(Size of Pie) vs. equality (How pie is
divided)
6
 How People Make Decisions
Principle 1: People face trade-offs
• Efficiency
– Society - maximum benefits from its scarce
resources
– Size of the economic pie
• Equality
– Benefits - uniformly distributed among
society’s members
– How the pie is divided into individual slices
7
 How People Make Decisions
Principle 2: The cost of something is what you
give up to get it
• People face trade-offs
– Make decisions
• Compare cost with benefits of alternatives
– Opportunity cost
• Whatever most be given up to obtain one item

8
 How People Make Decisions
Principle 3: Rational people think at the margin
• Rational people
– Systematically & purposefully do the best
they can to achieve their objectives
• Marginal changes
– Small incremental adjustments to a plan of
action
• Rational decision maker – take action only if
– Marginal benefits > Marginal costs
9
 How People Make Decisions
Principle 4: People respond to incentives
• Incentive
– Something that induces a person to act
– Higher price
• Buyers - consume less
• Sellers - produce more
– Public policy
• Change costs or benefits
• Change people’s behavior

10
 How People Make Decisions
Principle 4: People respond to incentives
– Gasoline tax
• Car size & fuel efficiency; carpool; public
transportation
– Unintended consequences
• Policymakers fail to consider how their policies
affect incentives

11
 How People Interact
Principle 5: Trade can make everyone better off
• Trade
– Specialization
• Allows each person/country to specialize in the
activities he/she does best
– People/countries can buy a greater variety of
goods and services at lower cost

12
 How People Interact
Principle 6: Markets are usually a good way to
organize economic activity
• Communist countries – central planning
– Government officials (central planners)
• Allocate economy’s scarce resources
– Decided
» What goods & services were produced
» How much was produced
» Who produced & consumed these goods & services
• Theory: only the government could organize economic
activity to promote economic well-being for the
country as a whole
13
 How People Interact
Principle 6: Markets are usually a good way to
organize economic activity
• Market economy - allocates resources
– Decentralized decisions of many firms and
households
– As they interact in markets for goods and
services
– Guided by prices and self interest
– Adam Smith’s “invisible hand”
14
 How People Interact
Principle 7: Governments can sometimes
improve market outcomes
• We need government
– Enforce the rules
– Maintain institutions - key to market economy
• Enforce property rights
• Property rights
– Ability of an individual to own and exercise
control over scarce resources
15
 How People Interact
Principle 7: Governments can sometimes
improve market outcomes
• Government intervention
– Change allocation of resources
– To promote efficiency
• Avoid market failure
– To promote equality
• Avoid disparities in economic wellbeing

16
 How People Interact
• Market failure
– Situation in which the market on its own fails
to produce an efficient allocation of resources
• Causes for market failure
– Externality
• Impact of one person’s actions on the well-being
of a bystander
– Market power
• Ability of a single person (or small group) to
unduly influence market prices
17
 How People Interact
• Disparities in economic wellbeing
– Market economy
• Rewards people - ability to produce things that
other people are willing to pay for
– Government intervention
• Public policies
– May diminish inequality
– Process far from perfect

18
 How the Economy as a Whole Works
Principle 8: A country’s standard of living
depends on its ability to produce goods and
services
• Large differences in living standards
– Among countries
– Over time
• Explanation: differences in productivity

19
 How the Economy as a Whole Works
• Productivity
– Quantity of goods & services produced from
each unit of labor input
• Higher productivity
– Higher standard of living
• Growth rate of nation’s productivity
– Determines growth rate of its average income

20
 How the Economy as a Whole Works
Principle 9: Prices rise when the government
prints too much money
• Inflation
– An increase in the overall level of prices in the
economy
• Causes for large / persistent inflation
– Growth in quantity of money
• Value of money falls

21
 How the Economy as a Whole Works
Principle 10: Society faces a short-run trade-off
between inflation and unemployment
• Short-run effects of monetary injections:
– Stimulates - overall level of spending
– Higher demand for goods and services
– Firms – raise prices; hire more workers; produce
more goods and services
– Lower unemployment
• Short-run tradeoff between inflation and
unemployment
22
 How the Economy as a Whole Works
Principle 10: Society faces a short-run trade-off
between inflation and unemployment
• Short-run trade-off between unemployment
and inflation
– Key role – analysis of business cycle
• Business cycle
– Fluctuations in economic activity
• Employment
• Production

23