Chapter one:

Ten Principles of Economics

PRINCIPLES OF
MICROECONOMICS

ALI ASHUR
SENIOR LECTURER
UNIVERSITY OF BURAO
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?
What Economics Is All About
• Scarcity refers to the limited nature of society’s resources.
• Economics is the study of how society manages its scarce resources,
including
• how people decide how much to work, save,
and spend, and what to buy
• 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
HOW PEOPLE MAKE DECISIONS
• Decision making is at the heart of economics.
• The first four principles deal with how people
make decisions.
Note:
“Decision-making is at the heart of economics. The individual must decide how
much to save for retirement, how much to spend on different goods and services,
how many hours a week to work. The firm must decide how much to produce,
what kind of labor to hire. Society as a whole must decide how much to spend on
national defense (“guns”) versus how much to spend on consumer goods
(“butter”)”.
HOW PEOPLE MAKE DECISIONS
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 might otherwise
be used to produce consumer goods.
…Cont…
• Society faces an important tradeoff:
efficiency vs. equity
• efficiency: getting the most out of scarce resources
• equity: distributing prosperity fairly among society’s members
• Tradeoff: To increase equity, can redistribute income from the well-off to the
poor.
But this reduces the incentive to work and produce, and shrinks the size of the
economic “pie.”
Note: “Redistribute income from the rich to the poor” is accomplished through the
progressive tax system, as well as social programs like food stamps and
unemployment insurance that try to provide a safety net for people at the low end of
the income distribution.
“But this reduces the incentive to work hard” – the reward for working hard is a high
income. Taxes reduce this reward, and therefore reduce the incentive to work hard.
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.
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.
Principle #3: Rational People Think at the Margin

• A person is rational if she systematically and purposefully does the best she
can to achieve her objectives.
• Many decisions are not “all or nothing,”
but involve marginal changes – incremental adjustments to an existing plan.
• Evaluating the costs and benefits of marginal changes is an important part of
decision making.
Note:
“In economics, a rational consumer makes decisions about the goods she buys
(which ones and how much of each) with the goal of maximizing her well-
being, subject to her income, the prices of the goods, and her preferences.”.
“Another rational economic actor – the firm – decides how much output to
produce, what price to charge, and how many workers to hire in order to
maximize its profits”.
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 because they make
decisions by comparing costs and benefits. Examples:
• In response to higher gas prices,
sales of “hybrid” cars (e.g., Toyota Prius) rise.
• In response to higher cigarette taxes,
teen smoking falls.
HOW PEOPLE INTERACT
• An “economy” is just a group of people interacting with
each other.
• The next
three principles
deal with how people interact.
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 & specialization:
• get a better price abroad for goods they produce
• buy other goods more cheaply from abroad than could be
produced at home.
Eg: “If each person had to grow his own food, make his own
clothes, cut his own hair, we would have a world full of skinny,
unfashionable poor people having bad hair days every day of
the week”.
Principle #6: Markets Are Usually A Good Way to
Organize Economic Activity
• A market is a group of buyers and sellers.
(They 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
Note:
• A market economy is “decentralized,” meaning that there is no government committee that makes the decisions
about what goods to produce and so forth. Instead, many households and firms make their own decisions:

• Each of many households decides who to work for and what goods to buy.

• Each of many firms decides whom to hire and what goods to produce.
…Cont…
• In a market economy, these decisions result from the
interactions of many households and firms.
• 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.
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.
• A restaurant won’t serve meals if customers
do not pay before they leave.
• A music company won’t produce CDs if too many people
avoid paying by making illegal copies.
…Cont…
• Govt may alter market outcome to promote efficiency
• 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 increase efficiency.
HOW THE ECONOMY AS A WHOLE WORKS
• The last three principles deal with the economy as a whole.
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.

In this passage:
• “Average income in rich countries is more than ten times average
income in poor countries.”
• “Rich countries” refers to countries like the U.S., Japan, and Germany.
“Poor countries” refers to countries like India, Indonesia, and Nigeria”.
…Cont…
• 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.
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 govt creates money,
the greater the inflation rate.
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.
…Cont…

While the long-run effect of increasing the quantity of money is inflation, the short-run effects
are more complicated - and controversial. However, what most mainstream economists believe
is the following: An increase in the quantity of money causes spending to rise, which causes
prices to rise, which induces firms to produce more goods and services, which requires that they
hire more workers. Hence, in the short-run, increasing the quantity of money causes inflation to
rise, but unemployment to fall.
Of course, REDUCING the quantity of money would have the opposite effects (inflation would
fall, while unemployment would rise) in the short run.
Keep in mind, though, the lesson from Principle #9: In the long run, changing the quantity of
money only affects inflation. We will learn in a later chapter what determines the rate of
unemployment in the long run, and we will see that it has nothing to do with the quantity of
money.

The second point on this slide – “Other factors can make this tradeoff more or less favorable, but
the tradeoff is always present” – addresses the following point: In some decades, due to factors
outside of the control of policymakers, inflation and unemployment are both high (e.g. 1970s) –
or low (e.g. 1990s). Yet, given these other factors, policymakers can always reduce
unemployment temporarily by creating more inflation, or vice versa.
FYI: How to Read Your Textbook
1. Summarize, don’t highlight.
Highlighting is a passive activity that won’t improve your comprehension
or retention. Instead, summarize each section in a few sentences of
your own words. When you finish, compare your summary to the one at
the end of the chapter.
2. Test yourself.
Try the “QuickQuiz” that follows each section before moving on to the
next section. Write your answers down, and compare them to the
answers in the back of the book. If your answers are incorrect, review
the section before moving on.
3. Practice, practice, practice.
Work through the end-of-chapter review questions and problems. They
are often good practice for the exams. And the more you use your new
knowledge, the more solid it will become.
…Cont…
4. Go online.
The book comes with excellent web resources, including practice
quizzes, tools to strengthen your graphing skills, helpful video clips, and
other resources to help you learn the textbook material more easily and
effectively.
5. Study in groups.
Get together with a few of your classmates to review each chapter, quiz
each other, and help each other understand the material in the chapter.
6. Don’t forget the real world.
Read the Case Studies and In The News boxes in each chapter. They will
help you see how the new terms, concepts, models, and graphs apply to
the real world. As you read the newspaper or watch the evening news,
see if you can find the connections with what you’re learning in the
textbook.
 END WITH THANKS
QUESTIONS, COMMENTS AND APPRECIATIONS IF ANY!