CHAPTER

Ten Principles of Economics

Microeonomics
PRINCIPLES OF

N. Gregory Mankiw

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by Ron Cronovich
© 2009 South-Western, a part of Cengage Learning, all rights reserved
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?

2
 Group discussion
 As a group, think of any decision you recently
had to make regarding some purchase of any
good or service.
 Think about the following questions:
 With whom did you interact when purchasing
this good/service?
 What were the alternative products available to
you?
 What factors determined your choice of the
product that you finally bought?

TEN PRINCIPLES OF ECONOMICS 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
 What economics studies
Factors of production

L-Land K-Capital

H: Human Entreprene
capital urship

Limited resources Unlimited desires

5
 Check yourself
Economics deals primarily with the concept
of
A. scarcity.
B. money.
C. poverty.
D. banking.

TEN PRINCIPLES OF ECONOMICS 6

 Check yourself
1. A society allocates its scarce resources to various
jobs. These scarce resources include
A. land.
B. people.
C. machines.
D. All of the above are correct.

What is #4?

TEN PRINCIPLES OF ECONOMICS 7

 Check yourself
The phenomenon of scarcity stems from the fact that
A. most economies’ production methods are not
very good.
B. in most economies, wealthy people consume
disproportionate quantities of goods and
services.
C. governments restrict production of too many
goods and services.
D. resources are limited.

TEN PRINCIPLES OF ECONOMICS 8

 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 10

 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 11
 Connect the boxes

Achieving the goals within

short period of time no
efficiency
matter what

Equal distribution of benefits

among all effectiveness

Equal opportunities
equality
available to all

Getting the maximum benefit

equity
out of the limited resources

12
Give ONE word that would best
capture the notion of

efficiency effectiveness

equality equity

13
 As a result of a successful attempt by government to
cut the economic pie into more equal slices,
a. the pie gets larger, and there will be more pie
overall.
b.the pie gets smaller, and there will be less pie
overall.
c. it increases the reward for working hard,
resulting in people producing more goods and
services.
d.those who earn more income pay less in taxes.

TEN PRINCIPLES OF ECONOMICS 14

 Equality and cheating
1. Consequences of such
help to YOU?
2. Your suggestions re.
my actions?
3. What is cheating?
Quizzes and exam
questions purchased
copying and letting
others to copy your work
Paraphrasing answers
 From the internet
 From ‘friends’

TEN PRINCIPLES OF ECONOMICS 15

 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 16

 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.
… getting a good grade with your ‘friend’s help’….

TEN PRINCIPLES OF ECONOMICS 17

 Conclusion

We face tradeoffs

Limited resources

Owning any
resource leads to
increase of the
opportunity costs

18
1. Suppose that you have received $300 as a birthday
gift. You can spend it today or you can put the money
in a bank account for a year and earn 5 percent
interest. The opportunity cost of spending the money
today, in terms of what you could have after one year,
is
A. $0.
B. $15.
C. $305.
D. $315.

19
1. Melody decides to spend three hours working
overtime rather than going to the park with her
friends. She earns $20 per hour for overtime work.
Her opportunity cost of working is
A. the $60 she earns working.
B. the $60 minus the enjoyment she would have
received from going to the park.
C. the enjoyment she would have received had she
gone to the park.
D. nothing, since she would have received less than
$60 worth of enjoyment from going to the park.

20
3. Hamid spends an hour studying instead of watching TV
with his friends. The opportunity cost to him of studying is
A. the improvement in his grades from studying for the
hour.
B. the improvement in his grades from studying minus
the enjoyment of watching TV.
C. the enjoyment he would have received if he had
watched TV with his friends.
D. zero. Since Hamid chose to study rather than to
watch TV, the value of studying must have been
greater to him than the value of watching TV.

21
 Economic decision-making
Principle
Principle #1:
#1: People
People Face
Face Tradeoffs
Tradeoffs

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
Principle
Principle #3:
#3: Rational
Rational People
People Think
Think at
at the
the
Margin.
Margin.

Principle
Principle #4:
#4: People
People Respond
Respond to
to Incentives
Incentives

TEN PRINCIPLES OF ECONOMICS 22

 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.
With your groups:
 depict an image of what you think a rational and
irrational person would look like (make a picture or
use any symbols)
OR
 an example of a rational and irrational decision
5 minutes!
23
 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.
Rational people ->
Bounded rationality (not all available
information is processed)
Behavioral economics
24
Marginal means… (two words)

additional future

25
 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 26

 Revision
 Efficiency and equality in economy
 Opportunity cost
 Rational economic people
 Marginal changes

TEN PRINCIPLES OF ECONOMICS 27

 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 gasoline prices rise, consumers buy
more hybrid cars and fewer gasoline consuming
cars.
 When cigarette taxes increase,
teen smoking falls.
TEN PRINCIPLES OF ECONOMICS 28
 HOW PEOPLE MAKE DECISIONS
Principle
Principle #4:
#4: People
People Respond
Respond to
to Incentives
Incentives

economic social moral

 E.g.: vaccination and incentives for/against

 E.g.: an experiment in Israel’s babies’ day-care

TEN PRINCIPLES OF ECONOMICS 29

 Overview
Principle
Principle #1:
#1: People
People Face
Face Tradeoffs
Tradeoffs

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
Principle
Principle #3:
#3: Rational
Rational People
People Think
Think at
at the
the
Margin.
Margin.

Principle
Principle #4:
#4: People
People Respond
Respond to
to Incentives
Incentives

TEN PRINCIPLES OF ECONOMICS 30

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,
$5500 if it doesn’t
31
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.
32
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.

33
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 35

 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)
 “Organized 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 36
 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 37

 The system of communication in
economy

L-Land K-Capital ?

H: Human Entreprene
capital urship

38
Examples of spontaneous markets

USSR: market relationships during

the deficit times

Market relations among prisoners of

war after WorldWar II
Redford. Economic Organization of
POW camp. 1945
 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 40
 Conclusions from the trade

 Why the prices offered by the sellers differ?

 What is the price that ensures the maximum
number of goods traded?

TEN PRINCIPLES OF ECONOMICS 41

 Conclusion #2

Market efficiency

Adam Smith (XVIII century) Adam Smith: invisible hand

. The Weath of the Nations
42
 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.
 Discussion: what are the pros and cons of KZT 42500
payments to KZ citizen during the coronavirus
lockdown for the economy of Kazakhstan?

TEN PRINCIPLES OF ECONOMICS 43

 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 44
 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 45

 How people interact? Summary
Principle
Principle #5:
#5: Trade
Trade Can
Can Make
Make Everyone
Everyone
Better
Better Off
Off

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

Principle
Principle #7:
#7: Governments
Governments Can
Can Sometimes
Sometimes
Improve
Improve Market
Market Outcomes
Outcomes

TEN PRINCIPLES OF ECONOMICS 46

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 secondary education
b. Workplace safety regulations
c. Public highways
d. Patent laws, which allow drug companies to
charge high prices for life-saving drugs

47
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 49

 Question
 In our Padlet country, what goods are produced?
 What determines the total ‘revenue’ of the
sellers?
 What determines the number of videos that will
be produced in our ‘Padlet country’?
 If the number of videos and points given for each
video is not limited in this course, will the
average grade for the course increase? Will you
be better off in this case?

TEN PRINCIPLES OF ECONOMICS 50

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 51
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 52

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 53

 FYI: How to Read Your Textbook
1. Read before class.
You’ll get more out of class.
2. Summarize, don’t highlight.
Highlighting is a passive activity that won’t improve
your comprehension or retention.
Instead, summarize each section in your own
words. Then, compare your summary to the one
at the end of the chapter.

TEN PRINCIPLES OF ECONOMICS 54

 FYI: How to Read Your Textbook
3. Test yourself.
Try the “Quick Quiz” that follows each section
before moving on to the next section.
Write your answers down, compare them to the
answers in the back of the book. If your answers
are incorrect, review the section before moving on.
4. 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.

TEN PRINCIPLES OF ECONOMICS 55

 FYI: How to Read Your Textbook
5. 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. Visit:
http://academic.cengage.com/economics/mankiw
6. Study in groups.
Get together with a few classmates to review each
chapter, quiz each other, and help each other
understand the material.

TEN PRINCIPLES OF ECONOMICS 56

 FYI: How to Read Your Textbook
7. Teach someone.
The best way to learn something is to teach it to
someone else, such as a study partner or friend.
8. Don’t skip the real world examples.
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.

TEN PRINCIPLES OF ECONOMICS 57

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.
58
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.

59
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.

60