Acoute Summary of: N. Gregory Mankiw's Principles of Microeconomics (7th edition)

Introduction

This unofficial Acoute summary of the 7th edition of Principles of Microeconomics textbook written by Dr. N. Gregory Mankiw provides a concise but detailed and readable summary of all 22 chapters, including news articles and case studies.

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Important vocabulary words and ideas are in bold.

The numbers in parentheses such as (p 27) show the page number of where you can find the original material in Mankiw's 7th edition Principle’s of Microeconomics textbook.

Answers to Questions for Review and Quick Check Multiple Choice questions are provided at the end of each chapter summary.

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1. Ten Principles of Economics

In this first chapter, we have a brief introduction to the 10 economic principles.

The first 4 principles are about how individuals and firms make decisions. The next 3 principles are about how people and firms interact. The last 3 principles are about the economy as a whole.

In economics, resources (products such as iPads, clothes, money, and even time) are scarce, meaning there is only a limited amount of those things.

The aim of economics is to study how these scarce resources are allocated (divided up) in a society. As we all know, not everyone will be able to have an iPhone 7 or get to vacation in Dubai, economics can tell us why that is.

Principle 1: People Face Trade-Offs

Everything we do in life involves trade-offs. Trade-off is giving up something in order to get something else. If you want an iPhone 7, the trade-off is the money needed to buy that phone which could be used for other things like clothes or rent. So instead of having new clothes, you get a new phone. You can choose to spend an extra 30 minutes studying your economics textbook or to watch Netflix. If you chose to study more, then that's less time for watching TV.

While individuals face trade-offs, so do societies. A society has to decide if it wants to spend more on national security or on social welfare programs. The more the society spends on security, the less money there is to provide for social welfare programs. This is a classic "guns and butter" economic trade-off.

Another important trade-off (which you will learn about in greater detail in later chapters) is between efficiency and equality. Efficiency is about getting as much as you can from the input (scarce resources) while equality is about how equally the spoils (or prosperity) is split among the people.

Principle 2: The Cost of Something is What You Gave Up to Get It.

If you want something, you will need to give up something else in order to get it. In the example above, if you want an iPhone 7, you will need to give up money to pay for it. But this principle also takes into account the opportunity cost of what you could have done with the money, such as earning interest. Opportunity cost is what you need to give up in order to do something else. 

Let’s look at the opportunity cost of attending college. In addition to the tuition cost, money you could have made if you were not going to college should also be included. Room and board costs may be partially counted toward your opportunity cost because no matter what you choose to do, you still need a place to live and food to eat (p 5-6).

For college athletes who is deciding whether or not to finish their degree before turning pro, their opportunity cost of finishing their degree would be what they would make if they played professionally instead (p. 6).

Principle 3: Rational People Think at the Margin

In economics, we assume that people are rational, meaning they want to achieve their objective. Rational people maximize their life satisfaction through achieving the income they want, work the hours they want to work, own the things they want to own, etc.

Why do diamonds cost more than water?

Even though water is a necessity to life—if you don't drink water, you will die—water cost a lot less than diamonds. Why? Because water is plentiful, an extra sip of water doesn't provide you with that much more satisfaction or happiness.

On the other hand, diamonds are very rare, having an extra diamond creates a lot of satisfaction. And since rational people think at the margin, and since an extra diamond provides a lot more satisfaction than an extra sip of water, an extra diamond cost a lot more than an extra sip of water.

In economics, a person's willingness to pay for a unit of something is equal to the marginal benefit (satisfaction) the extra unit brings him (p. 7).

Companies also operate the same way. If a flight cost $100,000 to operate and the airplane has 200 seats, then the average cost of a seat would be $500 (that is $100,000/200). You would assume that the airline would not sell a ticket below $500. But that's not true. If there are 10 empty seats, the marginal cost of an extra passenger would be the cost of an extra serving of snacks. So for the airline, it is willing to sell a ticket for under $500 per person since the cost of one more passenger is so low (p 6-7).

Principle 4: People Respond to Incentives

Incentive plays a big role in economics. If the price of a food item increases, we might buy less of it while the producers would like to sell more of it. An increase in price provides an incentive for sellers to produce more while the higher price is an incentive for buyers to buy less of it.

A tax on gasoline is a good example of incentives at work. A high gasoline tax provides incentive for people to drive more fuel-efficient or smaller cars. Europe has higher gasoline tax than the U.S. and Europeans do generally drive smaller cars than Americans (p 7).

The seat belt law showed the double-edged nature of incentives at work. Seat-belts make people safer in crashes. And since people feel safer, they drive faster. Although seat belts save lives in crashes, after seat belts become mandatory in cars, the rate of car accidents increased!

Principle 5: Trade Can Make Everyone Better Off

There is a lot of news how low-cost Chinese workers are stealing American jobs. But for the most part, trade makes everyone, including countries, better off.

As individuals, we compete with one another for jobs and for things at the store (we all want to buy the best item for the lowest price). But this competition is better than living in isolation where we need to make our own food and clothes and build our own homes. When countries trade with one another, each country can specialize on what it does best. Trade allows countries to enjoy more variety of goods and services and makes everyone better off (p 10).

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

Centrally planned economy, such as the old Soviet Union and other communist countries, believes that the government is best at deciding what economic activities the society should engage in. The central planner sets the prices of the goods and services and the quantity these goods should be produced at. This can lead to too many or too few goods and services.

Adam Smith, the father of economics, wrote a very famous book in 1776 called An Inquiry into the Nature and Causes of the Wealth of Nations or commonly referred to as The Wealth of Nations, that an invisible hand guides the interaction between firms and households (p 10).

In a market economy, the economic activities are determined by individuals and firms. People choose what they want to buy and firms choose what they want to sell and the price they want to sell their goods at.

Buyers and sellers in a market economy are mostly interested in their own self-interest (either maximizing their happiness for individuals or profit for firms). A market economy has no central planner and prices are flexible. Producers (or sellers) use the price of an item as a guide to determine how many goods they want to produce. Buyers look at the price to determine how many they want to buy. In a market economy, price acts as the invisible hand that coordinates the economic activity in a society (p 10).

Principle 7: Governments Can Sometimes Improve Market Outcomes

The invisible hand can only work its magic when the government does its job by enforcing rules such as property rights. Property right is the right that a person or entity has that allows him the ability to control and do what the person wants with his property. In order to improve market outcomes, the government needs to have in place a structure, such as legal institutions, to protect these rights.

The government may decide to interfere in a market economy when it wants to either increase efficiency (increase the economic pie) or increase equality (how wealth, or the economic pie, is shared) in the economy.

When economic efficiency fails.

Sometimes, the market economy fails, such as when the economic pie is not maximized. The economy can fail due to 2 reasons (p 12).

Market externality. This is when one person's action has an impact on the well-being of someone else, such as pollution. When a factory produces something while polluting the neighborhood, the market economy by itself may not be able to address this issue.

A producer's market power may interfere with market efficiency. In cases where a single or a few producers can influence the price of a good, they are said to have market power.

When economic equality fails.

Even if you do not follow world-class chess matches, you probably would have guessed that world class basketball players get paid a whole lot more than world-class chess players. Is that right or fair?

While economics can't answer this subjective question, it can tell us why. Since a lot more people are interested in basketball games and willing to pay to watch these games than chess matches, basketball players are paid more than chess players.

Remember, actions can have unintended consequences. Just because the government can improve an economic outcome does not mean that its actions will lead to an improvement in outcome. Government is staffed by political actors who may not have all the necessary information to make sound decisions. Or sometimes, decisions may be made for political and not purely economic reasons (p 12).

Principle 8: A Country's Standard of Living Depends on Its Ability to Produce Goods and Services.

It's probably not surprising to you that the standard of living varies a lot around the world. Higher income usually means higher living standards and better quality of life. People in higher income countries can buy more goods, have better access to healthcare, and have a longer life-expectancy than those who live in countries with lower standards of living (p 13).

In 2011, the average yearly income in different countries are:

USA $48,000

Mexico $9,000

China $5,000

Nigeria $1,200

The living standards of different countries are mainly due to the different levels of productivity of the people in that country. Productivity is how much output of goods or services from each unit of labor input.

Productivity can be influenced by education, tools, and technology.  If in Country A, each hour of labor produces 5 units of output while in Country B, each hour of labor produces 15 units of output, then Country B is more productive than Country A and will enjoy a higher standard of living. This is intuitive, the more goods and services a country can produce, the more goods and services the people in that country can enjoy.

Productivity gains will lead to rising living standards. In the U.S., income grows at around 2% a year. This means that income will double after 35 years. When productivity in the country stalls or doesn't grow, the average income will do the same.

In the U.S., American productivity stalled in the 1970's and 80s, and so did the average U.S. income. Although some attributed the flagging U.S. income to Japanese competition, it was really due to stalling American productivity (p 13).

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

Inflation, a rise in the overall prices of goods and services in an economy, happens when the government prints too much money.

In the beginning of 1921, a newspaper in Germany cost 0.30 marks; near the end of 1922, a newspaper cost 70,000,000 marks. Germany suffered from a very severe case of inflation and this was due to the German government printing a lot of money during that time. Economists like to say that there's no free lunch. So when the government prints too much money, people don't get wealthier, it is just that the prices go up.

In the US during the 1970s, we suffered a milder case of inflation when the overall prices of things doubled in that decade. High inflation is not desirable for many reasons (to be discuss in later chapters). We generally want low inflation. In 2000s, the U.S. had an inflation rate of around 2.5% a year, which means that overall prices will double in 30 years, and not the 10 years as was the case in the 1970s (p 14).

The cause of inflation is the growth in the quantity of moneyin the economy.

Principle 10: Society Faces a Short-Run Trade-Off between Inflation and Unemployment

Most economists agree that in the short-run, there is an inverse relationship between inflation and unemployment. In the short-run, when inflation is high, unemployment will be low. An increase in the quantity of money in the economy will cause businesses to produce more in the short-run, and that means more people will be hired and unemployment will decrease.  The inverse relationship (when one goes up, the other goes down) only holds in the short-run.

Chapter 1: Questions for Review

1.The 3 examples of important trade-offs I face in my life are: (1)whether to continue to go to college or start working now, (2)whether I should spend the time to cook my own food thus saving money or eat take-out food thus saving time, and (3)whether I should use public transportation, thus saving money but requiring more time, or having my own car.

2.The opportunity cost of a vacation to Disneyland include the money for the vacation and what I could have been doing (earning money, studying, etc) if I'm not at Disneyland.

3.Although water is necessary for life, the marginal benefit of a glass of water is small because not drinking that extra glass of water will not affect me too much.

4.Policymakers should think about incentives because people and firms change their behavior when incentives change.

5.Trade between countries make all countries better off. All countries win from trade and there is no losers.

6.The invisible hand directs market activity in an economy and usually leads to desirable market outcomes.

7.The two main causes of market failures are (1)externalities such as pollution and (2)market power when a single firm or a small group of firms have the power to set the price of a good or product.

8.Productivity is important because greater productivity leads to higher living standards for the people.

9.Inflation is when the overall prices in an economy increases. The happens when the amount of money in an economy increases.

10.In the short-run, inflation leads to a decrease in unemployment. This is because in the short-run, when prices of goods or services rises, firms will hire more workers so unemployment goes down.

Quick Check Multiple Choice.

1.a

2.c

3.b

4.b

5.d

6.a

2. Thinking like an Economist

In Chapter 2, you will learn about the methods and models used by economists to do what they do. You will even learn about how economists help to make your online multiplayer games more realistic.

Economists, like biologists and physicists, have their own language. Physicists use words like acceleration and momentum, while economists use words like supply, demand, deadweight loss, elasticity, and comparative advantage (p 19). Over time, you will be familiar and even use these words yourself.

There are two types of economists, economic scientist and policy advisor. Economic scientists tell us how the economy is while policy advisors are concerned with how things ought to be (p 27).

Economics is studied at two levels.

Microeconomics (micro for short) looks at how households and firms make their decisions. An question for microeconomics would be how