CHAPTER

Ten Principles of Economics

Economics
PRINCIPLES OF

N. Gregory Mankiw

2011
© 2011 South-Western, a part of Cengage Learning, all rights reserved update
A hospital in a town has one dialysis machine that can run for 30 hours per week. As the boss of the hospital,
you must decide who gets the treatment. There are a number of patients who require treatment and their
needs are given below.
Patient A: 6 year old child who needs 10 hrs per week. They are awaiting a kidney transplant which is expected to
occur in one year.
Patient B: A 55 year old man who needs 5 hrs per week. He is married with adult kids.
Patient C: A 3 year old child who will need dialysis indefinitely. 4 hrs per week.
Patient D: 78 year old female, 4 hrs per week.
Patient E : 7 year old child, has three brothers and sisters, 4 hours per week.
Patient F: 8 year old child, no brothers and sisters, 5 hours per week.
Patient G: 30 year old female, two young children, 6 hours per week.
Patient H: 30 year old male, two young children, 5 hours per week.
Patient I: 30 year old male, no children, 4 hours per week.
Patient J: 45 year old man with no children. Needs 6 hours per week but has a brother who will donate a kidney. This
will take place in six month’s time.
Patient K: A 65 year old man who requires 10 hours per week. As he is quite wealthy, he has promised to buy another
dialysis machine for the hospital if he is still alive in one year’s time. Decide how you will allocate the 30 hours, in
order of preference.

2
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?

3
 What Economics Is All About
 Scarcity: the limited nature of society’s
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
TEN PRINCIPLES OF ECONOMICS 4
 HOW PEOPLE MAKE DECISIONS
Principle
Principle #1:
#1: People
People Face
Face Tradeoffs
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 things requires working
longer hours, which leaves less time for family.
 Protecting the environment requires resources
that could otherwise be used to produce
consumer goods.

TEN PRINCIPLES OF ECONOMICS 5

 HOW PEOPLE MAKE DECISIONS
Principle
Principle #1:
#1: People
People Face
Face Tradeoffs
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.”
TEN PRINCIPLES OF ECONOMICS 6
 HOW PEOPLE MAKE DECISIONS
Principle
Principle #2:
#2: The
The Cost
Cost of
of Something
Something Is
Is
What
What You
You Give
Give Up
Up to
to Get
Get ItIt
 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.

TEN PRINCIPLES OF ECONOMICS 7

 HOW PEOPLE MAKE DECISIONS
Principle
Principle #2:
#2: The
The Cost
Cost of
of Something
Something Is
Is
What
What You
You Give
Give Up
Up to
to Get
Get ItIt
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.

TEN PRINCIPLES OF ECONOMICS 8

 HOW PEOPLE MAKE DECISIONS
Principle
Principle #3:
#3: Rational
Rational People
People Think
Think at
at the
the
Margin
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.

TEN PRINCIPLES OF ECONOMICS 9

 HOW PEOPLE MAKE DECISIONS
Principle
Principle #3:
#3: Rational
Rational People
People Think
Think at
at the
the
Margin
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 sell more
inventory, she compares the cost of the needed
labor and materials to the extra revenue.

TEN PRINCIPLES OF ECONOMICS 10

 HOW PEOPLE MAKE DECISIONS
Principle
Principle #4:
#4: People
People Respond
Respond to
to Incentives
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 petrol prices rise, consumers buy more
cars that use less petrol and stop buying cars
that use a lot of petrol.
 When cigarette taxes increase,
teen smoking falls.
TEN PRINCIPLES OF ECONOMICS 11
 ACTIVE LEARNING 1
Applying the principles

TEN PRINCIPLES OF ECONOMICS 12

ACTIVE LEARNING 1
Applying the principles

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 ACTIVE LEARNING 1
Answers

TEN PRINCIPLES OF ECONOMICS 14

 HOW PEOPLE INTERACT
Principle
Principle #5:
#5: Trade
Trade Can
Can Make
Make Everyone
Everyone
Better
Better Off
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 & specialization:
 Get a better price abroad for goods they produce
 Buy other goods more cheaply from abroad than
could be produced at home

TEN PRINCIPLES OF ECONOMICS 15

 HOW PEOPLE INTERACT
Principle
Principle #6:
#6: Markets
Markets Are
Are Usually
Usually A
A Good
Good
Way
Way to
to Organize
Organize Economic
Economic Activity
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
TEN PRINCIPLES OF ECONOMICS 16
 HOW PEOPLE INTERACT
Principle
Principle #6:
#6: Markets
Markets Are
Are Usually
Usually A
A Good
Good
Way
Way to
to Organize
Organize Economic
Economic Activity
Activity

TEN PRINCIPLES OF ECONOMICS 17

 HOW PEOPLE INTERACT
Principle
Principle #6:
#6: Markets
Markets Are
Are Usually
Usually A
A Good
Good
Way
Way to
to Organize
Organize Economic
Economic Activity
Activity

TEN PRINCIPLES OF ECONOMICS 18

 HOW PEOPLE INTERACT
Principle
Principle #7:
#7: Governments
Governments Can
Can Sometimes
Sometimes
Improve
Improve Market
Market Outcomes
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.

TEN PRINCIPLES OF ECONOMICS 19

 HOW PEOPLE INTERACT
Principle
Principle #7:
#7: Governments
Governments Can
Can Sometimes
Sometimes
Improve
Improve Market
Market Outcomes
Outcomes
 Market failure: when the market fails to allocate
society’s resources efficiently
 Causes:
 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)
 In such cases, public policy may promote efficiency.
TEN PRINCIPLES OF ECONOMICS 20
 HOW PEOPLE INTERACT
Principle
Principle #7:
#7: Governments
Governments Can
Can Sometimes
Sometimes
Improve
Improve Market
Market Outcomes
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.

TEN PRINCIPLES OF ECONOMICS 21

ACTIVE LEARNING 2
Discussion Questions
In each of the following situations, what is the
government’s role? Does the government’s
intervention improve the outcome?
a. Public schools for K-12
b. Workplace safety regulations
c. Public highways
d. Patent laws, which allow drug companies to
charge high prices for life-saving drugs

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The principles of
HOW THE
ECONOMY
AS A WHOLE
WORKS
HOW THE ECONOMY AS A WHOLE WORKS
Principle
Principle #8:
#8: A A country’s
country’s standard
standard of
of living
living
depends
depends onon its
its ability
ability to
to produce
produce goods
goods & &
services.
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.

TEN PRINCIPLES OF ECONOMICS 24

HOW THE ECONOMY AS A WHOLE WORKS
Principle
Principle #8:
#8: A A country’s
country’s standard
standard of
of living
living
depends
depends onon its
its ability
ability to
to produce
produce goods
goods & &
services.
services.

TEN PRINCIPLES OF ECONOMICS 25

HOW THE ECONOMY AS A WHOLE WORKS
Principle
Principle #9:
#9: Prices
Prices rise
rise when
when the
the government
government
prints
prints too
too much
much money.
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.

TEN PRINCIPLES OF ECONOMICS 26

HOW THE ECONOMY AS A WHOLE WORKS
Principle
Principle #10:
#10: Society
Society faces
faces aa short-run
short-run
tradeoff
tradeoff between
between inflation
inflation and
and unemployment
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.

TEN PRINCIPLES OF ECONOMICS 27

CHAPTER SUMMARY

The principles of decision making are:

 People face tradeoffs.
 The cost of any action is measured in terms of
foregone opportunities.
 Rational people make decisions by comparing
marginal costs and marginal benefits.
 People respond to incentives.
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CHAPTER SUMMARY

The principles of interactions among people are:

 Trade can be mutually beneficial.
 Markets are usually a good way of coordinating
trade.
 Govt can potentially improve market outcomes if
there is a market failure or if the market outcome
is inequitable.

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CHAPTER SUMMARY

The principles of the economy as a whole are:

 Productivity is the ultimate source of living
standards.
 Money growth is the ultimate source of inflation.
 Society faces a short-run tradeoff between
inflation and unemployment.

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