Chapter

Ten Principles of Economics

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Ten Principles of Economics
Scarcity - limited nature of societys 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
"There is no such thing as a free lunch!
To get one thing, we usually have to give up another thing.
Guns v. butter
Food v. clothing
Leisure time v. work
Efficiency v. equity

Making decisions requires trading off one goal against another.

Efficiency vs. Equity
Efficiency means society gets the most that it can from its scarce
resources.
Equity means the benefits of those resources are distributed fairly
among the members of society.
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How People Make Decisions
Principle 2: The cost of something is what you give up to get it.

People face trade-offs
Make decisions
Compare cost with benefits of alternatives
Opportunity cost
Whatever most be given up to obtain one item
Decisions require comparing costs and benefits of alternatives.

Whether to go to college or to work?
Whether to study or go to play cricket?
Whether to go to class or sleep in?

The opportunity cost of an item is what you give up to obtain that item.


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How People Make Decisions
Let's say you have $15,000 and your choice is
to either buy shares of Company ABC or leave
the money in a Current Deposit that earns
only 5% per year. If the Company ABC stock
returns 10%, you've benefited from your
decision because the alternative would have
been less profitable. However, if Company
ABC returns 2% when you could have had 5%
from the Current Deposit, then your
opportunity cost is (5% - 2% = 3%).
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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
Rational decision maker take action only if
Marginal benefits > Marginal costs
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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

The decision to choose one alternative over another
occurs when that alternative's marginal benefits exceed
its marginal costs!

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How People Interact
Principle 5: Trade can make everyone better off
Trade
Specialization
Allows each person/country to specialize in the
activities he/she does best
People/countries can buy a greater variety of
goods and services at lower cost
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How People Interact
Principle 6: Markets are usually a good way to
organize economic activity
Communist countries central planning
Government officials (central planners)
Allocate economys scarce resources
Decided
What goods & services were produced
How much was produced
To whom to produced
How to distribute these goods & services
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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 Smiths invisible hand
Smith assumed that individuals try to maximize their own good (and become
wealthier), and by doing so, through trade and entrepreneurship, society as a
whole is better off. Furthermore, any government intervention in the economy
isn't needed because the invisible hand is the best guide for the economy.
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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
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How People Interact
Principle 7: Governments can sometimes improve
market outcomes
Government intervention
Changes allocation of resources
To promote efficiency
Avoid market failure
To promote equality
Avoid disparities in economic wellbeing
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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
Market power
Ability of a single person (or small group) to
unduly influence market prices.
Externality
Impact of one persons actions on the well-being
of a bystander

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How People Interact

Externality
Externalities are defined as third party (or spill-over) effects arising from the production
and/or consumption of goods and services for which no appropriate compensation is
paid.

Externalities can cause market failure if the price mechanism does not take into
account the full social costs and social benefits of production and consumption.

Social cost includes all the costs of production of the output of a particular good or
service. We include the third party (external) costs arising, for example, from pollution of
the atmosphere.

SOCIAL COST = PRIVATE COST + EXTERNALITY

For example: a chemical factory emits wastage as a by-product into nearby rivers and
into the atmosphere. This creates negative externalities which impose higher social costs
on other firms and consumers. E.g. Clean up costs and Health costs.

The overall cost and benefit to society is defined as the sum of the imputed monetary
value of benefits and costs to all parties involved. Thus, it is said that, goods with
externalities do not reflect the full social costs or benefit of the transaction.

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How the Economy as a Whole Works
Principle 8: A countrys standard of living depends on its
ability to produce goods and services
Productivity
Quantity of goods & services produced from each
unit of labor input
Higher productivity
Higher standard of living
Growth rate of nations productivity
Determines growth rate of its average income
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How the Economy as a Whole Works
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 / persistent inflation
Growth in quantity of money
Value of money falls
The quantity theory of money states that there is a direct relationship
between the quantity of money in an economy and the level of prices
of goods and services sold. According to QTM, if the amount of money
in an economy doubles, price levels also double, causing inflation (the
percentage rate at which the level of prices is rising in an economy).
The consumer therefore pays twice as much for the same amount of
the good or service.
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How the Economy as a Whole Works
Principle 10: Society faces a short-run trade-off between inflation
and unemployment
The controversy over the problem of controlling inflation and the consequent
unemployment has given rise to the concept of Inflation & Unemployment trade-off.
A.W. Phillips conducted a research in UK about the relationship between wages and
prices during 1816 and 1957 and this was illustrated by a curve called Phillips Curve.
Phillips found that in the UK, the periods of low unemployment were correlated with
the periods of rising wages.

When unemployment is high, the rate of increase in money wages is low. This is
because workers are reluctant to offer their services at less than the prevailing rates
when the demand for labour is low and unemployment is high so that wage rates fall
very slowly.

When unemployment is low, the rate of increase in money wages is high. This is
because when the demand for labour is high and there are very few unemployed, we
should expect employers to bid wage rates up quite rapidly.

Nature of the Business Activity: In the period of rising business activity when
unemployment falls with increasing demand for labour, the employers will bid up
wages. Conversely in a period of falling business activity when demand for labour is
decreasing and unemployment is rising, employers will be reluctant to grant wage
increases.

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Table
Ten principles of economics
1
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 Countrys 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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