Module 1

Ten Principles of Economics

Principles of Microeconomics
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 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
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 HOW PEOPLE MAKE DECISIONS

 Decision making is at
the heart of
economics.

 The first four

principles deal with
how people make
decisions.

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 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.

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 HOW PEOPLE MAKE DECISIONS

Principle #1: People Face Tradeoffs

 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.”

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 HOW PEOPLE MAKE DECISIONS

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.

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 HOW PEOPLE MAKE DECISIONS

Principle #2: The Cost of Something is What You

Give Up to Get It
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.

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 HOW PEOPLE MAKE DECISIONS

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.
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 HOW PEOPLE MAKE DECISIONS

Principle #3: Rational People Think at the Margin

Examples:
 A student considers whether to go to college
for an additional year, comparing the fees &
foregone wages to the extra income he could earn
with an extra year of education.
 A firm considers whether to increase output,
comparing the cost of the needed labor and
materials to the extra revenue.
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 HOW PEOPLE MAKE DECISIONS

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.

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A C T I V E L E A R N I N G 1:
Exercise
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?
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
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A C T I V E L E A R N I N G 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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A C T I V E L E A R N I N G 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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 HOW PEOPLE INTERACT

 An “economy” is just
a group of people
interacting with
each other.

 The next
three principles
deal with how people
interact.

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 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

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 HOW PEOPLE INTERACT

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

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 HOW PEOPLE INTERACT

Principle #6: Markets Are Usually A Good Way to

Organize Economic Activity
 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.

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 HOW PEOPLE INTERACT

Principle #6: Markets Are Usually A Good Way to

Organize Economic Activity
 The invisible hand works through the price system:
• The interaction of buyers and sellers
determines prices of goods and services.
• 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.
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 HOW PEOPLE INTERACT

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.

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 HOW PEOPLE INTERACT

Principle #7: Governments Can Sometimes Improve

Market Outcomes

 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.
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 HOW PEOPLE INTERACT

Principle #7: Governments Can Sometimes Improve

Market 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.

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A C T I V E L E A R N I N G 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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HOW THE ECONOMY AS A WHOLE WORKS

 The last three

principles deal with
the economy as a
whole.

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 HOW THE ECONOMY AS A WHOLE WORKS

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.

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 HOW THE ECONOMY AS A WHOLE WORKS

Principle #8: A country’s standard of living depends

on its ability to produce goods & 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.

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 HOW THE ECONOMY AS A WHOLE WORKS

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.

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 HOW THE ECONOMY AS A WHOLE WORKS

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.

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 CONCLUSION
 Economics offers many insights about the behavior
of people, markets, and economies.
 It is based on a few ideas that can be applied
in many situations.

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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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