Lecture 1 introduction

Ten Principles of Economics• Scarcity - limited nature of society’s resources • Economics – Study of how society manages its scarce resources • Economists study: – How people make decisi

PRINCIPLES OF

By N Gregory Mankiw

Economics

LECTURE 1

INTRODUCTION

Some ground rules so that we can

all get along

1 All cellphones are in silent mode

2 Attendance check is compulsory

3 No switching between tutorial classes

4 When writing emails, please be polite

5 Problems with grades are handled within

1 The basic concept of Economics

2 Ten principles of Economics

3 Economist as a scientist

4 Economist as an advisor

Ten Principles of Economics

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Ten Principles of Economics

• Economy – “oikonomos” (Greek)

– “One who manages a household”

• Household - many decisions

– Allocate scarce resources

• Ability, effort, and desire

• Society - many decisions

– Allocate resources

– Allocate output

• Resources are scarce

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Ten Principles of Economics

• Scarcity - limited nature of society’s resources

• Economics

– Study of how society manages its scarce

resources

• Economists study:

– How people make decisions

– How people interact with one another

– Analyze forces and trends that affect the

economy as a whole

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How People Make Decisions

Principle 1: People face trade-offs

• National defense vs consumer goods

• Clean environment vs high level of income

• Efficiency vs equality

How People Make Decisions

Principle 1: People face trade-offs

How People Make Decisions

Principle 2: The cost of something is what you give up to get it

• People face trade-offs

If a girl receives 10 proposals from 10 different guys and she ends

up marrying 1, what is her opportunity cost?

How People Make Decisions

Principle 3: Rational people think at the margin

• Rational people

– Systematically & purposefully do the best

they can to achieve their objectives

• Marginal changes

– Small incremental adjustments to a plan of

action Example: students and bonus points

• Rational decision maker – take action only if

– Marginal benefits > Marginal costs

How People Make Decisions

Principle 4: People respond to incentives

• 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

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How People Make Decisions

Principle 4: People respond to incentives

How People Interact

Principle 5: Trade can make everyone better off

How People Interact

Principle 6: Markets are usually a good way to

organize economic activity

• Communist countries – central planning

– Government officials (central planners)

• Allocate economy’s scarce resources

– Decided

» What goods & services were produced

» How much was produced

» Who produced & consumed these goods & services

• Theory: only the government could organize economic activity to promote economic well-being for the

country as a whole

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How People Interact

Principle 6: Markets are usually a good way to organize economic activity

• Market economy - allocates resources

– Decentralized decisions of many firms and

households

– As they interact in markets for goods and

services

– Guided by prices and self interest

– Adam Smith’s “invisible hand”

How People Interact

Principle 7: Governments can sometimes

improve market outcomes

• We need government

– Enforce the rules

– Maintain institutions - key to market economy

• Enforce property rights

• Property rights

– Ability of an individual to own and exercise

control over scarce resources

How People Interact

Principle 7: Governments can sometimes

improve market outcomes

How People Interact

• Market failure

– Situation in which the market on its own fails

to produce an efficient allocation of resources

• Causes for market failure

How People Interact

• Disparities in economic wellbeing

How the Economy as a Whole Works

Principle 8: A country’s standard of living

depends on its ability to produce goods and services

https://www.youtube.com/watch?v=4-2nqd6-Z Xg

How the Economy as a Whole Works

Principle 9: Prices rise when the government

prints too much money

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How the Economy as a Whole Works

Principle 10: Society faces a short-run trade-off between inflation and unemployment

Thinking Like an Economist

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The Economist as a Scientist

• Economics = science

• Economists = scientists

– Devise theories

– Collect data

– Analyze these data

• Verify or refute their theories

• Scientific method

– Dispassionate development and testing of

The Economist as a Scientist

The scientific method: observation, theory, and more observation

The Economist as a Scientist

The role of assumptions

• Assumptions

– Can simplify the complex world

• Make it easier to understand

– Focus our thinking - essence of the problem

• Different assumptions

– To answer different questions

– Short-run effects

The Economist as a Scientist

Economic models

• Diagrams & equations

• Omit many details

• Allow us to see what’s truly important

• Built with assumptions

• Simplify reality to improve our understanding

of it

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The Economist as a Scientist

Our first model: The circular-flow diagram

• Circular-flow diagram

– Visual model of the economy

– Shows how dollars flow through markets among households and firms

The Economist as a Scientist

Our first model: The circular-flow diagram

• Firms

– Produce goods and services

– Use factors of production / inputs

• Households

– Own factors of production

– Consume goods and services

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The Economist as a Scientist

Our first model: The circular-flow diagram

• Markets for goods and services

• Markets for inputs

The circular flow

1

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The Economist as a Scientist

Our second model: The production possibilities frontier

• Production possibilities frontier

– A graph

– Combinations of output that the economy

can possibly produce

– Given the available

• Factors of production

• Production technology

The production possibilities frontier

Produced

0 300 600 700 1,000

3,000

A B C

The production possibilities frontier shows the

combinations of output - in this case, cars and

computers - that the economy can possibly produce

The economy can produce any combination on or

inside the frontier

Points outside the frontier are not feasible given the economy’s resources.

He can either write songs or record his own songs,

which one is more profitable?

The Economist as a Scientist

• Efficient levels of production

– Economy’s getting all it can

• From the scarce resources available

– Points on the production possibilities frontier– Trade-off:

• The only way to get more of one good is to get less of the other good

• Inefficient levels of production

– Points inside production possibilities frontier

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The Economist as a Scientist

• Opportunity cost of one good

– Give up the other good

• Bowed out production possibilities frontier

– Opportunity cost of a car – highest

• Economy - producing many cars and fewer computers

– Opportunity cost of a car – lower

• Economy - producing fewer cars and many computers

The Economist as a Scientist

A shift in the production possibilities frontier

2,300

A technological advance in the computer industry

enables the economy to produce more computers for any given number of cars As a result, the production possibilities frontier shifts outward If the economy moves from point A to point G, then the production of both cars and computers increases.

4,000

G

The Economist as a Scientist

Microeconomics and Macroeconomics

– The study of economy-wide phenomena,

including inflation, unemployment, and

economic growth

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The Economist as a Policy Advisor

Positive vs Normative analysis

The Economist as a Policy Advisor (Self-study)

Economists in Washington

– Council of Economic Advisers

• Advise the president of the United states

• Write the annual Economic Report of the President– Department of Treasury

– Department of Labor

– Department of Justice

– Congressional Budget Office

– The Federal Reserve

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The Economist as a Policy Advisor (Self-study)

Why economists’ advice is not always followed

Why Economists Disagree

• Economists - may disagree

– Validity of alternative positive theories about how the world works

• Economists - may have different values

– Different normative views about what policy should try to accomplish

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Why Economists Disagree

Perception vs Reality

• Rent control - adversely affects availability

and quality of housing

– Costly way of helping the neediest members

of society

– Many cities use rent control

• Trade barriers – economist oppose it

– Import on certain goods - restricted

Ten principles of economics

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How People Make Decisions

1: People Face Trade-offs

2: The Cost of Something Is What You Give Up to Get It

3: Rational People Think at the Margin

4: People Respond to Incentives

How People Interact

5: Trade Can Make Everyone Better Off

6: Markets Are Usually a Good Way to Organize Economic Activity

7: Governments Can Sometimes Improve Market Outcomes

How the Economy as a Whole Works

8: A Country’s Standard of Living Depends on Its Ability to Produce

Goods and Services

9: Prices Rise When the Government Prints Too Much Money

10: Society Faces a Short-Run Trade-off between Inflation and

Unemployment

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