Principles of Economics

Principles of how people make decisions

Principles of how people interact
Principles of how the economy as a whole works

N.G.Mankiw

HOW PEOPLE MAKE DECISIONS

Decision making is at
the heart of economics.

The first four principles

deal with how people
make decisions.

HOW PEOPLE MAKE DECISIONS

Principle
Principle #1:
#1: People
People Face
Face Tradeoffs
Tradeoffs
All decisions involve tradeoffs.
Trade-off is a situation that involves losing
one
quality or aspect of something in return for gaining
another quality or aspect.
Examples:

Student how to allocate time - Going to a party the

night before exam leaves less time for studying.

Parent how to spend income When they spend

an extra dollar on one good, they have less to spend
on some other.
Contd..

HOW PEOPLE MAKE DECISIONS

Contd..

Society faces some tradeoffs:

1. Guns vs. Butter
2. Clean environment vs. High income
3. Efficiency vs. Equity

efficiency: getting the most out of scarce resources

equity: distributing prosperity fairly among societys
members

To increase equity, can redistribute income from the

well-off to the poor.

But this reduces the incentive to work and produce,

and reduces efficiency.

HOW PEOPLE MAKE DECISIONS

Principle
Principle #2:
#2: The
The Cost
Cost of
of Something
Something Is
Is What
What
You
You Give
Give Up
Up to
to Get
Get ItIt == opportunity
opportunity cost
cost

Making decisions requires comparing the costs

and benefits of alternative choices.

It is the relevant cost for decision making.

Example:
College athletes can earn millions if they drop out &
play professional sports.
But may decide that benefit of college education is
greater than its opportunity cost.
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HOW PEOPLE MAKE DECISIONS

Principle
Principle #3:
#3: Rational
Rational People
People Think
Think at
at the
the
Margin
Margin

A person is rational if she systematically and

purposefully does the best she can to achieve her
objectives.

Decisions depend on marginal changes

incremental adjustments to an existing plan.

Evaluate the costs and benefits of marginal

changes.

Rational people make decisions by comparing

marginal benefits and marginal costs.
Contd.

HOW PEOPLE MAKE DECISIONS

Contd.

Examples: Case of an airline firm- how much to

charge passengers who fly standby.

a 200 seat plane

Costs $ 1,00,000 per lap of travel to the airline.
Cost of each seat (AC) = $500
Airline should not sell ticket less than $500

imagine.

Plane is about to take off with 10 empty seats

Standby passenger offers to pay $300
Should the airline issue ticket to the standby passenger?
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HOW PEOPLE MAKE DECISIONS

Principle
Principle #4:
#4: People
People Respond
Respond to
to Incentives
Incentives

incentive: something that induces a person to

act, i.e. the prospect of a reward or punishment.

Rational people respond to incentives because

they make decisions by comparing costs and
benefits.

Example:
In response to higher cigarette taxes,

teen smoking falls.

In response to higher price of apple, market
discourages buyers from buying more &
induces producers to produce & sell more.

Case Study: Incentive Effects of Gasoline

Prices
Oil price skyrocketed during 2005-08 in the world market.

Reasonslimited supplies & surging demand from robust

growth.

In US price of gasoline rose from $2 to $ 4/gallon.

How people responded?

Buyers shifted to small cars

Rise in scooter sales
Rise in bicycle sales
Increased use of public transport
Camel demand up in Rajasthan
Drive students to online courses

HOW PEOPLE INTERACT

An economy is just
a group of people
interacting with
each other.

The next
three principles
deal with how people
interact.

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HOW PEOPLE INTERACT

Principle
Principle #5:Trade
#5:Trade Can
Can Make
Make Everyone
Everyone Better
Better Off
Off

People/country can specialize in producing one

good or service in which he/it has advantage.

Later, exchange it for other goods others.

Both the trading parties/countries benefit from
trade & specialization:
get a better price abroad for goods they
produce.
buy other goods more cheaply from abroad
than could be produced at home.
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HOW PEOPLE INTERACT

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

A market is a group of buyers and sellers.

(They need not be in a single location.)

Organize economic activity means determining

what goods to produce

how to produce them
how much of each to produce
who gets them

In a market economy, these decisions result from the

interactions of many households and firms.
Adam Smiths insight- Each of these households and
firms acts as if led by an invisible hand to promote
general economic well-being.

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HOW PEOPLE INTERACT

Principle #7: Governments Can Sometimes
Improve Market Outcomes
By three ways:

Enforcing property rights.

Promoting efficiency to tackle market failures.
Promoting equity

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HOW PEOPLE INTERACT

Contd..

Govt. enforce property rights

(with police, courts)

People are less inclined to work, produce, invest, or

purchase if large risk of their property being stolen.

A restaurant wont serve meals if customers

do not pay before they leave.

A music company wont produce CDs if too many

people avoid paying by making illegal copies.
Contd..
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HOW PEOPLE INTERACT

Contd..

Govt promote efficiency

market failure, when the market fails to allocate

societys resources efficiently. Causes:
externalities, when the production or consumption
of a good affects bystanders (e.g. pollution)
market power, a single buyer or seller has
substantial influence on market price (e.g. monopoly)

In such cases, public policy may promote efficiency.

Contd..

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HOW PEOPLE INTERACT

Contd..

Govt promote equity

Markets leave disparities in economic well-being.

It doesnt ensure everyone has sufficient food, decent
clothing, adequate health care etc.

Public (Govt.) policies for more equal distribution

Taxes
Welfare schemes

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HOW THE ECONOMY AS A WHOLE WORKS

The last three

principles deal with
the economy as a
whole.

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HOW THE ECONOMY AS A WHOLE WORKS

Principle
Principle #8:
#8: A
A countrys
countrys standard
standard of
of living
living
depends
depends on
on its
its ability
ability to
to produce
produce goods
goods &
&
services.
services.

Huge variation in living standards across

countries and over time:
Average income in rich countries is more than
ten times average income in poor countries.
The U.S. standard of living today is about
eight times larger than 100 years ago.
Contd..
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HOW THE ECONOMY AS A WHOLE WORKS

Contd..

The most important determinant of living standards:

productivity, the amount of goods and services
produced per unit of labor.

Productivity depends on the equipment, skills, and

technology available to workers.

Public policy makers to boost std. of living by

ensuring workers are educated, have tools, have
access to the best available technology.
.
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HOW THE ECONOMY AS A WHOLE WORKS

Principle
Principle #9:
#9: Prices
Prices rise
rise when
when the
the
government
government prints
prints too
too much
much money.
money.

Inflation: increases in the general level of prices.

Excessive growth in the quantity of money
causes.

The faster the govt. creates money,

the greater the inflation rate.

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HOW THE ECONOMY AS A WHOLE WORKS

Principle
Principle #10:
#10: Society
Society faces
faces aa short-run
short-run
tradeoff
tradeoff between
between inflation
inflation and
and unemployment
unemployment
In the short-run (1 2 years),
many economic policies push inflation and
unemployment in opposite directions.

Govt. policy instruments: change expenditure, taxes,

money prints etc.

Real case: Economic downturn in U.S economy during

2008-09.

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CONCLUSION
Economics offers many insights about the
behavior of people, markets, and economies.

It is based on a few ideas that can be applied

in many situations.

Whenever we refer back to one of the

Ten Principles from this chapter,
you will see an icon like this one:

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CHAPTER SUMMARY
The principles of decision making are:

People face tradeoffs.

The cost of any action is measured in terms of
foregone opportunities.

Rational people make decisions by comparing

marginal costs and marginal benefits.

People respond to incentives.

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CHAPTER SUMMARY
The principles of interactions among people are:

Trade can be mutually beneficial.

Markets are usually a good way of
coordinating trade.

Govt can potentially improve market

outcomes if there is a market failure

or if the market outcome is inequitable.

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CHAPTER SUMMARY
The principles of the economy as a whole are:

Productivity is the ultimate source of living

standards.

Money growth is the ultimate source of

inflation.

Society faces a short-run tradeoff between

inflation and unemployment.

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