Ten priciples of economics

8  Resources are scarce  Scarcity – The limited nature of society’s resources – Society has limited resources and therefore cannot produce all the goods and services people wish to hav

Principles of Economics

Session I Introduction to the

Course &

Ten Principles of

Economics

Part I Introduction to the

Course

 What is Economics?

– Microeconomics vs Macroeconomics

 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?

 By the end of this session, students should

understand:

– that economics is about the allocation of scarce

resources

– that individuals face trade-offs

– the meaning of opportunity cost

– how to use marginal reasoning when making

decisions

– how incentives affect people’s behavior

 Students should understand: (cont’d)

– why trade among people or nations can be good for everyone

– why markets are a good, but not a perfect way to

allocate resources

– what determines some trends in the overall

economy

Learning Objectives

Part II Ten Principles of

Economics

Ten Principles of Economics

 Economy

– “One who manages a household”

– Households and economies have much in common

 Households face many decisions

– Allocate scarce resources

• Ability, effort, and desire

 Society faces many decisions

– Allocate resources and output

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 Resources are scarce

 Scarcity

– The limited nature of society’s resources

– Society has limited resources and therefore cannot

produce all the goods and services people wish to

have

 Economics: the study of how society manages its

scarce resources

– Microeconomics vs Macroeconomics

 Economics

– How people make decisions

• Work, buy, save, invest

– How people interact with one another

– Analyze 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

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What is Economics? (cont’d)

1 How People Make

Decisions

Ten Principles of Economics

 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

Principle #1: People Face Tradeoffs

How People Make Decisions

 All decisions involve tradeoffs

 Examples:

– Playing vs Studying

– Working vs Leisure

– Protecting the environment vs Consumer goods

Principle #1: People Face 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 exists

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Principle #1: People Face Tradeoffs

How People Make Decisions

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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

all that must be given up to obtain it

 It is THE relevant cost for decision making

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Principle #2: The Cost of Something Is

What You Give Up to Get It

How People Make Decisions

Examples:

The opportunity cost of…

…going to college for a year is…

…seeing a movie is…

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Principle #2: The Cost of Something Is

What You Give Up to Get It

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 What is the common feature between the two in terms

of opportunity costs?

Principle #2: The Cost of Something Is

What You Give Up to Get It

Source: official website of each

How People Make Decisions

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Principle #3: Rational People Think at the Margin

 Rational people make decisions by evaluating costs

and benefits of marginal changes – incremental

adjustments to an existing plan

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Principle #3: Rational People Think at the Margin

Exercise I-1:

Buying and Selling Your Textbook

 Why would buying and selling your textbooks benefit

you at the margin? Explain

– You buy a textbook at the start of the term, often at

a full price, and sell it back at the end of the term for half the price you paid  a bad investment!

– Break the decision into two separate components:

the decision to buy & the decision to sell

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Source: Mateer & Coppock (2013)

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Principle #4: People Respond to Incentives

How People Make Decisions

 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

decreases

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Principle #4: People Respond to Incentives

You are selling your 2000 Sonata You have already

spent $1,000 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 Benchmark car value is $6,500 if transmission

2 How People Interact

Ten Principles of Economics

 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 People Interact

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Principle #5: Trade Can Make Everyone Better Off

 Rather than being self-sufficient,

people can specialize in producing a 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 cheaper from abroad than could be produced at home

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Principle #5: Trade Can Make Everyone Better Off

How People Interact

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Principle #6: Markets Are Usually A Good Way to

Organize Economic Activity

 “Organize economic activity” means determining

– what goods to produce

– how to produce them

– how much of each to produce

– who gets them

 Market: a group of buyers and sellers

(need not be in a single location)

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Principle #6: Markets Are Usually A Good Way to

Organize Economic Activity

How People Interact

 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):

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Principle #6: Markets Are Usually A Good Way to

Organize Economic Activity

Each of these households and firms acts as if “led by an

invisible hand ” to promote general economic well-being

 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

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Principle #6: Markets Are Usually A Good Way to

Organize Economic Activity

How People Interact

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Principle #7: Governments Can Sometimes Improve

Market Outcomes

Important role for the government: enforce property

rights (with police, courts)

Market failure: when the market fails to allocate

society’s resources efficiently

Governments may alter market outcomes to promote

equity

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Principle #7: Governments Can Sometimes Improve

Market Outcomes

4 How the Economy As a

Whole Works

Principles of Economics

 How the economy as a whole works

8 A country’s standard of living

depends on its ability to produce goods & services

9 Markets Prices rise when the

government prints too much money

10 Society faces a short-run tradeoff

between inflation and unemployment

How the Economy as a Whole Works

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

on its ability to produce goods & services

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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:

 The most important determinant of living standards:

productivity, the amount of goods and services

produced per unit of labor

How the Economy As a Whole

Works

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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 gov’t creates money, the greater the

inflation rate

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Principle #9: Prices rise when the government prints

too much money

How the Economy As a Whole

Works

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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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Principle #10: Society faces a short-run tradeoff

between inflation and unemployment

Quiz: True or False?

1 Tuition is the single-largest cost of attending

college for most students

2 Equality refers to how the pie is divided, and

efficiency refers to the size of the economic pie

The principles of decision making are :

 People face tradeoffs

 The cost of any action is measured in terms of

 Rational people make decisions by comparing

 People respond to incentives

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The principles of interactions among people are :

 Trade can be mutually beneficial

if there is a market failure or if the market outcome is

inequitable

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Summary II

The principles of the economy as a whole are :

 Money growth is the ultimate source of inflation

 Society faces a short-run tradeoff between inflation

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