CHAPTER

Ten Principles of Economics

Microeonomics
PRINCIPLES OF

N. Gregory Mankiw

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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?

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 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 3

 The principles of
HOW PEOPLE
MAKE DECISIONS
 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 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.

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 increase
output, 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 gas prices rise, consumers buy more
hybrid cars and fewer gas guzzling SUVs.
 When cigarette taxes increase,
teen smoking falls.

TEN PRINCIPLES OF ECONOMICS 11

ACTIVE LEARNING 1
Applying the principles
You are selling your 1996 Mustang. You have
already spent $1000 on repairs.
At the last minute, the transmission dies. You can
pay $600 to have it repaired, or sell the car “as is.”
In each of the following scenarios, should you
have the transmission repaired? Explain.
A. Blue book value is $6500 if transmission works,

$5700 if it doesn’t
B. Blue book value is $6000 if transmission works,
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ACTIVE LEARNING 1
Answers
Cost of fixing transmission = $600
A. Blue book value is $6500 if transmission works,
$5700 if it doesn’t
Benefit of fixing the transmission = $800
($6500 – 5700).
It’s worthwhile to have the transmission fixed.
B. Blue book value is $6000 if transmission works,
$5500 if it doesn’t
Benefit of fixing the transmission is only $500.
Paying $600 to fix transmission is not worthwhile.
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ACTIVE LEARNING 1
Answers
Observations:
 The $1000 you previously spent on repairs is
irrelevant. What matters is the cost and benefit
of the marginal repair (the transmission).
 The change in incentives from scenario A
to scenario B caused your decision to change.

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The principles of
HOW PEOPLE
INTERACT
 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 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
 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 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
 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.

TEN PRINCIPLES OF ECONOMICS 18

ADAM SMITH AND THE
”WEALTH OF NATIONS”
It is not from the benevolence of the
butcher, the brewer, or the baker,
that we expect our dinner, but from
their regard to their own interest.
We address ourselves, not to their
humanity but to their self-love, and
never talk to them of our necessities
but of their advantages.
ADAM SMITH AND THE
”THEORY OF MORAL
SENTIMENTS”
[The rich] consume little more than the
poor, and in spite of their natural
selfishness and rapacity…they divide with
the poor the produce of all their
improvements. They are led by an invisible
hand to make nearly the same distribution
of the necessaries of life, which would
have been made, had the earth been
divided into equal portions among all its
inhabitants, and thus without intending
it, without knowing it, advance the
interest of the society…
 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
 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.

TEN PRINCIPLES OF ECONOMICS 21

 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 22

 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 23
 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 24

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 26

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.
 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.
TEN PRINCIPLES OF ECONOMICS 27
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 28

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 29

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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