Economy. . .

. . . The word economy comes from a Greek

word for “one who manages a household.”

Ten Principles of
Economics

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TEN PRINCIPLES OF ECONOMICS TEN PRINCIPLES OF ECONOMICS

• A household and an economy Society and Scarce Resources:
face many decisions: • The management of society’s resources is
• Who will work? important because resources are scarce.
• What goods and how many of them should be • Scarcity. . . means that society has limited resources
produced? and therefore cannot produce all the goods and
• What resources should be used in production? services people wish to have.
• At what price should the goods be sold?

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TEN PRINCIPLES OF ECONOMICS TEN PRINCIPLES OF ECONOMICS

Economics is the study of how society manages • How people make decisions.
its scarce resources. • People face tradeoffs.
• The cost of something is what you give up to get it.
• Rational people think at the margin.
• People respond to incentives.

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 TEN PRINCIPLES OF ECONOMICS TEN PRINCIPLES OF ECONOMICS
• How people interact with each other. • The forces and trends that affect how the
• Trade can make everyone better off. economy as a whole works.
• Markets are usually a good way to organize • The standard of living depends on a country’s
economic activity. production.
• Governments can sometimes improve economic • Prices rise when the government prints too much
outcomes. money.
• Society faces a short-run tradeoff between inflation
and unemployment.

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Principle #1: People Face Tradeoffs. Principle #1: People Face Tradeoffs.

To get one thing, we usually have to give up

“There is no such thing as a free lunch!” another thing.
• Guns v. butter
• Food v. clothing
• Leisure time v. work
• Efficiency v. equity

Making decisions requires trading

off one goal against another.

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Principle #2: The Cost of Something Is What You

Principle #1: People Face Tradeoffs
Give Up to Get It.
• Efficiency v. Equity
• Decisions require comparing costs and benefits
• Efficiency means society gets the most that it can
from its scarce resources. of alternatives.
• Equity means the benefits of those resources are • Whether to go to college or to work?
distributed fairly among the members of society. • Whether to study or go out on a date?
• 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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Principle #3: Rational People Think at the
Principle #4: People Respond to Incentives.
Margin.
• Marginal changes in costs or benefits motivate
• Marginal changes are small, incremental people to respond.
adjustments to an existing plan of action.
• The decision to choose one alternative over
another occurs when that alternative’s marginal
benefits exceed its marginal costs!
People make decisions by comparing
costs and benefits at the margin.

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Principle #5: Trade Can Make Everyone Better Principle #6: Markets Are Usually a Good Way to
Off. Organize Economic Activity.
• People gain from their ability to trade with one • A market economy is an economy that allocates
another. resources through the decentralized decisions of
• Competition results in gains from trading. many firms and households as they interact in
• Trade allows people to specialize in what they markets for goods and services.
do best. • Households decide what to buy and who to work
for.
• Firms decide who to hire and what to produce.

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Principle #6: Markets Are Usually a Good Way to Principle #7: Governments Can Sometimes
Organize Economic Activity. Improve Market Outcomes.

• Adam Smith made the observation that • Market failure occurs when the market fails to
households and firms interacting in markets act allocate resources efficiently.
as if guided by an “invisible hand.” • When the market fails (breaks down)
• Because households and firms look at prices when government can intervene to promote efficiency
deciding what to buy and sell, they unknowingly and equity.
take into account the social costs of their actions.
• As a result, prices guide decision makers to reach
outcomes that tend to maximize the welfare of
society as a whole.

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Principle #7: Governments Can Sometimes Principle #8: The Standard of Living Depends on
Improve Market Outcomes. a Country’s Production.
• Market failure may be caused by • Almost all variations in living standards are
• an externality, which is the impact of one person or explained by differences in countries’
firm’s actions on the well-being of a bystander. productivities.
• market power, which is the ability of a single • Productivity is the amount of goods and
person or firm to unduly influence market prices. services produced from each hour of a worker’s
time.

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Principle #8: The Standard of Living Depends on Principle #9: Prices Rise When the Government
a Country’s Production. Prints Too Much Money.
• Inflation is an increase in the overall level of
• Standard of living may be measured in different prices in the economy.
ways:
• One cause of inflation is the growth in the
• By comparing personal incomes. quantity of money.
• By comparing the total market value of a nation’s
production.
• When the government creates large quantities
of money, the value of the money falls.

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Principle #10: Society Faces a Short-run Tradeoff

Between Inflation and Unemployment. Summary
• The Phillips Curve illustrates the tradeoff • When individuals make decisions, they face
between inflation and unemployment: tradeoffs among alternative goals.
òInflation ð ñUnemployment • The cost of any action is measured in terms of
It’s a short-run tradeoff! foregone opportunities.
• Rational people make decisions by comparing
marginal costs and marginal benefits.
• People change their behavior in response to the
incentives they face.

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 Summary Summary
• Trade can be mutually beneficial. • Productivity is the ultimate source of living
• Markets are usually a good way of coordinating standards.
trade among people. • Money growth is the ultimate source of
• Government can potentially improve market inflation.
outcomes if there is some market failure or if • Society faces a short-run tradeoff between
the market outcome is inequitable. inflation and unemployment.

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Thinking Like an Economist

• Every field of study has its own terminology
• Mathematics
• integrals  axioms  vector spaces
• Psychology
• ego  id  cognitive dissonance
Thinking Like an • Law
• promissory  estoppel  torts  venues
Economist • Economics
• supply  opportunity cost  elasticity  consumer
surplus  demand  comparative advantage 
deadweight loss
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Copyright © 2004 South-Western/Thomson Learning

Thinking Like an Economist THE ECONOMIST AS A SCIENTIST

• Economics trains you to. . . . • The economic way of thinking . . .
• Think in terms of alternatives. • Involves thinking analytically and objectively.
• Evaluate the cost of individual and social choices. • Makes use of the scientific method.
• Examine and understand how certain events and
issues are related.

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The Scientific Method: Observation, Theory, and
The Role of Assumptions
More Observation
• Uses abstract models to help explain how a • Economists make assumptions in order to
complex, real world operates. make the world easier to understand.
• The art in scientific thinking is deciding which
• Develops theories, collects, and analyzes data to assumptions to make.
evaluate the theories. • Economists use different assumptions to
answer different questions.

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Economic Models Our First Model: The Circular-Flow Diagram

• Economists use models to simplify reality in • The circular-flow diagram is a visual model of the
order to improve our understanding of the economy that shows how dollars flow through
world markets among households and firms.
• Two of the most basic economic models
include:
• The Circular Flow Diagram
• The Production Possibilities Frontier

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Figure 1 The Circular Flow

Our First Model: The Circular-Flow Diagram

• Firms
MARKETS
Revenue FOR Spending
GOODS AND SERVICES
•Firms sell

• Produce and sell goods and services

Goods Goods and
and services •Households buy services
sold bought

• Hire and use factors of production

FIRMS
•Produce and sell
goods and services
HOUSEHOLDS
•Buy and consume
goods and services
• Households
• Buy and consume goods and services
•Hire and use factors •Own and sell factors
of production of production

• Own and sell factors of production

Factors of MARKETS Labor, land,
production FOR and capital
FACTORS OF PRODUCTION
Wages, rent, •Households sell Income
and profit •Firms buy
= Flow of inputs
and outputs
= Flow of dollars

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Our First Model: The Circular-Flow Diagram Our First Model: The Circular-Flow Diagram

• Markets for Goods and Services • Factors of Production

• Firms sell • Inputs used to produce goods and services
• Households buy • Land, labor, and capital
• Markets for Factors of Production
• Households sell
• Firms buy

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Figure 2 The Production Possibilities Frontier

Our Second Model: The Production Possibilities
Frontier Quantity of
Computers
Produced
• The production possibilities frontier is a graph that
shows the combinations of output that the
economy can possibly produce given the 3,000 D
available factors of production and the available
production technology. 2,200
C
A
2,000
Production
possibilities
frontier
1,000 B

0 300 600 700 1,000 Quantity of

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Cars
Copyright
Produced
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Learning

Our Second Model: The Production Possibilities

Microeconomics and Macroeconomics
Frontier
• Concepts Illustrated by the Production • Microeconomics focuses on the individual parts
Possibilities Frontier of the economy.
• Efficiency • How households and firms make decisions and how
• Tradeoffs they interact in specific markets
• Opportunity Cost • Macroeconomics looks at the economy as a
• Economic Growth whole.
• Economy-wide phenomena, including inflation,
unemployment, and economic growth

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