Chapter 1 10 principles of economics

Economy, "oikonomos" (Greek) ECONOMICS

The study of how society manages its scarce resources

One who manages a household"- Households and economies have much in common

Allocate scarce resources• Taking into account: ability, effort, desire

Society faces many decisions

Allocate resources and output

Resources are



the limited nature of society's resourcesSociety has limited resources and therefore cannot produce all the goods and services people wish to have

Economists study

How people make decisions• Work, buy, save, invest- How people interact with one another

- The forces and trends that affect the economy as a whole

• Growth in average income• Fraction of the population that cannot find work• Rate at which prices are rising

How people make decisions

Principle 1: People face trade-offsPrinciple 2: The cost of something is what you give up to get itPrinciple 3: Rational people think at the margin Principle 4: People respond to incentives

How people interact

Principle 5: Trade can make everyone better offPrinciple 6: Markets are usually a good way to organize economic activityPrinciple 7: Governments can sometimes improve market outcomes

How the economy as a whole works

Principle 8: A country's standard of living depends on its ability to produce goods and services Principle 9: Prices rise when the government prints too much money Principle 10: Society faces a short-run trade-off between inflation andunemployment8

Principle 1: People Face Trade-offs• "There ain't no such thing as a free lunch"- To get something that we like, we usually have to give up something else that we also like

Making decisions- Requires trading off one goal against another: to study one more hour, give up one hour of TV


Students: how to allocate time- Parents: how to spend income

Society faces trade-offs

National defense and consumer goods(guns and butter)- Clean environment and high level of income- Efficiency and equality


Society is getting the maximum benefits from its scarce resources- The size of the economic pie


Distributing economic prosperity uniformly among the members of society- How the pie is divided into individual slices

Efficiency and Equality trade-off

- Public policies aimed at equalizing the distribution of economic well-being~ Welfare system, unemployment insurance~ Individual income tax~ Achieve greater equality but reduce efficiency

Principle 2: The Cost of Something Is What You Give Up to Get ItRecognizing that people face trade-offs

Does not by itself tell us what decisions they will or should make

People face trade-offs; making decisions:

- Compare costs with benefits ofalternatives- Need to include opportunity costs

Opportunity cost

whatever must be given up to obtain some item

Principle 3: Rational People Think at the MarginRational people

Systematically and purposefully do the best they can to achieve their objectives- Given the available opportunities

marginal changes

Small incremental adjustments to a plan of action

Rational decision maker

Make decisions by comparing marginal benefits and marginal costs- Take action only if: Marginal benefits > Marginal costs "Is the marginal benefit of this call greater than the marginal cost?

Why is water so cheap, while diamonds are so expensive?

Water - needed to survive- Diamonds - not a necessity- A person's willingness to pay for a good• Based on the marginal benefit that an extra unit of the good would yield• The marginal benefit depends on how many units a person already has.

Principle 4: People Respond to IncentivesIncentive

Incentive- Something that induces a person to act- Higher price• Buyers consume less; Sellers produce more- Public policy• Change costs or benefits• Change people's behavior• Can have unintended consequences

Seat belt law alters a driver's cost-benefit calculation (Sam Peltzman, 1975)

Seat belts make accidents less costly(reduce the likelihood of injury or death)• Reduce the benefits of slow, careful driving- People drive faster and less carefully:• Larger number of accidents

Net result:

little change in the number of driver deaths and an increase in the number of pedestrian deaths.

Principle 5: Trade Can Make Everyone Better OffTrade

Allows each person to specialize in the activities he or she does best- Enjoy a greater variety of goods and services

Principle 6: Markets Are Usually a Good Way to Organize Economic ActivityCommunist countries, central planning

Government officials (central planners) are in the best position to allocate the economy's scarce resources• What goods and services were produced• How much was produced• Who produced and consumed these goods and services

Market economy, allocation of resources

Through decentralized decisions of many firms and households- As they interact in markets for goods and services- Guided by prices and self-interest

Market economies

No one is looking out for the economic well-being of society as a whole- Have proven remarkably successful inorganizing economic activity to promote overall economic well-being.

Adam Smith's "invisible hand

Households and firms interacting in markets• Act as if they are guided by an "invisiblehand"• Leads them to desirable market outcomes


Prevents the invisible hand's ability to coordinate the decisions of the households and firms that make up the economy.

Principle 7: Governments Can Sometimes Improve Market OutcomesWe need government

Enforce rules and maintain institutions that are key to a market economy- Need institutions to enforce property rights- Promote efficiency, avoid market failure- Promote equality, avoid disparities in economic well being

Property rights

Ability of an individual to own and exercise control over scarce resources

Market failure

Situation in which the market left on its own fails to allocate resources efficiently- Externalities- Market power


Impact of one person's actions on the well-being of a bystander- Pollution

Market power

Ability of a single economic actor (or small group of actors) to have a substantial influence on market prices.

Disparities in economic wellbeing

- Market economy rewards people• According to their ability to produce things that other people are willing to pay for- Government intervention, public policies• Aim to achieve a more equal distribution of economicwell-being• May diminish inequality • Process far from perfect

Principle 8: A Country's Standard of Living Depends on Its Ability to Produce Goods and ServicesLarge differences in living standards

Among countries:• Average annual income, 2014: $55,000 (U.S.);$17,000 (Mexico); $13,000 (China); $6,000(Nigeria)- Over time: In the U.S. incomes have historically grown about 2% per year


differences in productivity


Quantity of goods and services produced from each unit of labor input

Higher productivity

higher standard of living

Growth rate of nation's productivity

Determines growth rate of its average income32

Principle 9: Prices Rise When the Government Prints Too Much Money

Inflation: an increase in the overall level of prices in the economy

Causes for large or persistent inflation

Growth in quantity of money- Value of money falls

Principle 10: Society Faces a Short-RunTrade-off between Inflation and Unemploymentshort-run effects of monetary injections

Stimulates the overall level of spending and the demand for goods and services- Firms raise prices, hire more workers, produce more goods and services- Lower unemployment

Short-run trade-off between unemployment and inflation

Over a period of a year or two, many economic policies push inflation and unemployment in opposite directions- Key role - analysis of business cycle

Business cycle

Fluctuations in economic activity, such as employment and production

Principle 1

People face trade offs

Principal 2

The cost of something is what you give up to get it

principal 3

Rational people think at the margin

principle 4

People respond to incentives

Principle 5

Trade can make everyone better off

principle 6

Markets are usually a good way to organize economic activity

Principle 7

Governments can sometimes improve market outcomes

principle 8

A country's standard of living depends on its ability to produce goods and services

principle 9

Prices rise when the government prints too much money

principle 10

Society faces a short-run trade-off between inflation and unemployment