Chapter 1

Ten Principles of
Economics

2002 by Nelson, a division of Thomson Canada Limited

In this chapter you will

Learn
Learn that
that economics
economics is
is about
about the
the
allocation
allocation of
of scarce
scarce resources.
resources.
Examine
Examine some
some of
of the
the tradeoffs
tradeoffs that
that
people
people face.
face.
Learn
Learn the
the meaning
meaning of
of opportunity
opportunity
cost.
cost.
See
See how
how to
to use
use marginal
marginal reasoning
reasoning
when
when making
making decisions.
decisions.

Mankiw et al.: Principles of Microeconomics,

In this chapter you will

Discuss
Discuss how
how incentives
incentives affect
affect
peoples
peoples behaviour.
behaviour.
Consider
Consider why
why trade
trade among
among people
people or
or
nations
nations can
can be
be good
good for
for everyone.
everyone.
Discuss
Discuss why
why markets
markets are
are aa good,
good, but
but
not
not perfect,
perfect, way
way to
to allocate
allocate
resources.
resources.
Learn
Learn what
what determines
determines some
some trends
trends
in
in the
the overall
overall economy.
economy.

Mankiw et al.: Principles of Microeconomics,

The Word Economy Comes

From
the Greek word for one who
manages a household.

Mankiw et al.: Principles of Microeconomics,

TEN PRINCIPLES OF ECONOMICS

A
Ahousehold
household and
and an
an economy
economy
face
face many
many decisions:
decisions:
Who
Who will
will work?
work?
What
What goods
goods and
and how
how many
many of
of them
them
should
should be
be produced?
produced?
What
What resources
resources should
should be
be used
used in
in
production?
production?
At
At what
what price
price should
should the
the goods
goods be
be
sold?
sold?

Mankiw et al.: Principles of Microeconomics,

TEN PRINCIPLES OF ECONOMICS

Society
Society and
and Scarce
Scarce Resources:
Resources:
The
The management
management of
of societys
societys
resources
resources is
is important
important because
because
resources
resources are
are scarce.
scarce.
Scarcity.
Scarcity. .. .. means
means that
that society
society has
has
limited
limited resources
resources and
and therefore
therefore cannot
cannot
produce
produce all
all the
the goods
goods and
and services
services
people
people wish
wish to
to have.
have.

Mankiw et al.: Principles of Microeconomics,

TEN PRINCIPLES OF ECONOMICS

Economics
Economics is
is the
the study
study of
of how
how society
society
manages
manages its
its scarce
scarce resources.
resources.
Economists
Economists study
study how
how people
people make
make
decisions:
decisions:
How
How much
much they
they work
work
What
What they
they buy
buy
How
How much
much they
they save
save
How
How they
they invest
invest their
their savings
savings

Mankiw et al.: Principles of Microeconomics,

TEN PRINCIPLES OF ECONOMICS

Economists
Economists also
also study
study how
how people
people
interact
interact such
such as
as buyers
buyers and
and sellers.
sellers.
Price
Price determination.
determination.
Economists
Economists also
also analyze
analyze forces
forces and
and
trends
trends that
that affect
affect the
the economy
economy as
as aa whole.
whole.
Growth
Growth in
in average
average income
income
The
The rate
rate of
of price
price increase.
increase.

Mankiw et al.: Principles of Microeconomics,

HOW PEOPLE MAKE DECISIONS

There
There is
is no
no mystery
mystery to
to what
what an
an economy
economy
is.
is.
Its
Its aa group
group people
people interacting
interacting with
with one
one
another
another as
as they
they go
go about
about their
their lives.
lives.
We
We start
start the
the study
study of
of economics
economics with
with four
four
principles
principles of
of individual
individual decision
decision making:
making:
People
Peopleface
facetradeoffs
tradeoffs
The
Thecost
costof
ofsomething
somethingis
iswhat
what you
yougive
giveup
upto
to
get
get it.
it.
Rational
Rational people
peoplethink
think at
atthe
the margin.
margin.
People
Peoplerespond
respond to
to incentives.
incentives.
Mankiw et al.: Principles of Microeconomics,

Principle 1: People Face Tradeoffs

There
There is
is no
no such
such thing
thing as
as aa free
free lunch
lunch
To
Toget
get something
something we
we like
like we
we usually
usually have
have
to
to give
give up
up something
something we
we dont
dont like.
like.
A
Astudent
student and
and her
her time:
time:
Studying
Studying vs.
vs. napping
napping or
or cycling.
cycling.
Societys
Societys tradeoffs:
tradeoffs:
Guns
Guns vs.
vs. Butter
Butter
Clean
Clean environment
environment and
and higher
higher income
income

Mankiw et al.: Principles of Microeconomics,

Principle 1: People Face Tradeoffs

Societys
Societys tradeoffs
tradeoffs (contd):
(contd):
Efficiency
Efficiency vs.
vs. Equity
Equity
Efficiency:
Efficiency: Society
Society getting
getting the
the most
most itit
can
can from
from its
its scarce
scarce resources.
resources.
Equity:
Equity: Distributing
Distributing economic
economic
prosperity
prosperity fairly
fairly among
among the
the members
members of
of
society.
society.

Mankiw et al.: Principles of Microeconomics,

Principle 2: The Cost of Something

is what You Give Up
Making
Making decisions
decisions requires
requires comparing
comparing
the
the costs
costs and
and benefits
benefits of
of alternative
alternative
courses
courses of
of actions.
actions.
To
Togo
goto
touniversity
universityor
ornot
not to
togo?
go?

Opportunity
Opportunity cost:
cost: Whatever
Whatever must
must be
be
given
given up
up to
to obtain
obtain some
some item.
item.

Mankiw et al.: Principles of Microeconomics,

Principle 3: Rational People Think

at the Margin
Marginal
Marginal changes:
changes: Small
Small incremental
incremental
adjustments
adjustments to
to marginal
marginal changes.
changes.
Individuals
Individuals and
and firms
firms can
can make
make better
better
decisions
decisions by
by thinking
thinking at
at the
the margin.
margin.
By
By comparing
comparing the
the marginal
marginal benefits
benefits
(MB)
(MB) with
with the
the associated
associated marginal
marginal costs
costs
(MC)
(MC) of
of aa decision.
decision.

Mankiw et al.: Principles of Microeconomics,

Principle 4: People Respond to

Incentive
Marginal
Marginal changes
changes in
in costs
costs or
or benefits
benefits
motivate
motivate people
people to
to respond.
respond.
When
When the
the price
price of
of apples
apples rise
rise
The
The decision
decision to
to choose
choose one
one alternative
alternative
over
over another
another occurs
occurs when
when that
that
alternatives
alternatives marginal
marginal benefits
benefits exceed
exceed its
its
marginal
marginal costs!
costs!

Mankiw et al.: Principles of Microeconomics,

HOW PEOPLE INTERACT

The
The first
first four
four principles
principles discussed
discussed how
how
individuals
individuals make
make decisions.
decisions.
The
The next
next three
three principles
principles concern
concern how
how
people
people interact
interact with
with one
one another.
another.

Mankiw et al.: Principles of Microeconomics,

Principle 5: Trade can Make

Everyone Better Off
People
People gain
gain from
from their
their ability
ability to
to trade
trade with
with
one
one another.
another.
Competition
Competition results
results in
in gains
gains from
from trading.
trading.
Trade
Trade allows
allows people
people to
to specialize
specialize in
in what
what
they
they do
do best.
best.

Mankiw et al.: Principles of Microeconomics,

Principle 6: Markets are Usually a

Good Way to Organize Economic
Activity
Market
Market economy:
economy: An
An economy
economy that
that
allocates
allocates resources
resources through
through the
the
decentralized
decentralized decisions
decisions of
of many
many firms
firms and
and
households
households as
as they
they interact
interact in
in markets
markets for
for
goods
goods and
and services.
services.
Firms
Firms decide
decide whom
whom to
to hire
hire and
and what
what to
to
make.
make.
Households
Households decide
decide which
which firms
firms to
to work
work
for
for and
and what
what to
to buy
buy with
with their
their incomes.
incomes.
Mankiw et al.: Principles of Microeconomics,

Principle 6: Markets are Usually a

Good Way to Organize Economic
Activity
Market
Market economy:
economy: An
An economy
economy that
that
allocates
allocates resources
resources through
through the
the
decentralized
decentralized decisions
decisions of
of many
many firms
firms and
and
households
households as
as they
they interact
interact in
in markets
markets for
for
goods
goods and
and services.
services.
Firms
Firms decide
decide whom
whom to
to hire
hire and
and what
what to
to
make.
make.
Households
Households decide
decide which
which firms
firms to
to work
work
for
for and
and what
what to
to buy
buy with
with their
their incomes.
incomes.
Mankiw et al.: Principles of Microeconomics,

Principle 7: Governments can

Sometimes Improve Market
Outcomes
When
When the
the invisible
invisible hand
hand does
does not
not work.
work.
Market
Market failure:
failure:AAsolution
solution in
in which
which aamarket
marketleft
left
on
onits
itsown
ownfails
failsto
toallocate
allocateresources
resources
efficiently.
efficiently.
Externality:
Externality: The
Theimpact
impact of
of one
onepersons
personsactions
actions
on
onthe
thewell-being
well-beingof
ofaabystander.
bystander.
Market
Market power:
power: The
Theability
abilityof
ofaasingle
single economic
economic
actor
actor(or
(orsmall
smallgroup
groupof
ofactors)
actors) to
tohave
haveaa
substantial
substantialinfluence
influenceon
onmarket
marketprices.
prices.

Mankiw et al.: Principles of Microeconomics,

HOW THE ECONOMY AS A

WHOLE WORKS
The
Thelast
lastthree
threeprinciples
principlesconcern
concern the
theworkings
workingsof
of
the
theeconomy
economyas
as aawhole.
whole.

Mankiw et al.: Principles of Microeconomics,

Principle 8: A Countrys Standard

of Living Depends on its Ability to
Produce Goods and Services
Standard
Standard of
of Living
Living may
may be
be measured
measured in
in
different
different ways
ways (e.g.
(e.g.personal
personalincome
incomeor
ortotal
total

market
marketvalue
valueof
of aanations
nationsproduction.)
production.)
Differences in standard of living between
Differences in standard of living between
countries
countriesor
oreven
evenprovinces
provincesis
isattributable
attributableto
to
the
theproductivity
productivity of
of the
thecountry
countryor
or province.
province.

Productivity:
Productivity: The
The amount
amount of
of goods
goods and
and
services
services produced
produced from
from each
each hour
hour of
of aa
workers
workers time.
time.
Productivity => Standard of Living
Mankiw et al.: Principles of Microeconomics,

Principle 9: Prices Rise when the

Government Prints Too Much
Money
In
In Germany
Germany

In
InJanuary
January1921,
1921,aadaily
dailynewspaper
newspapercost
cost0.30
0.30
marks.
marks.
In
InNovember
November1922,
1922,the
thesame
samepaper
papercost
cost70
70000
000
000
000 marks.
marks.
Inflation:
Inflation:An
Anincrease
increasein
in the
theoverall
overalllevel
levelof
of
prices
pricesin
in the
the economy.
economy.
One
Onecause
causeof
ofinflation
inflationis
isthe
thegrowth
growth in
inthe
the
quantity
quantityof
ofmoney.
money.
When
When the
thegovernment
governmentcreates
createslarge
largequantities
quantities of
of
money,
money,the
thevalue
valueof
ofthe
themoney
moneyfalls.
falls.

Mankiw et al.: Principles of Microeconomics,

Principle 10: Society Faces a

Short-Run Tradeoff Between
Inflation and Unemployment.
Phillips
Phillips curve:
curve: A
Acurve
curve that
that shows
shows the
the
short-run
short-run tradeoff
tradeoff between
between inflation
inflation and
and
unemployment.
unemployment.

Mankiw et al.: Principles of Microeconomics,

Summary
When
When individuals
individuals make
make decisions,
decisions, they
they
face
face tradeoffs
tradeoffs among
among alternative
alternative goals.
goals.
The
The cost
cost of
of any
any action
action is
is measured
measured in
in
terms
terms of
of foregone
foregone opportunities.
opportunities.
Rational
Rational people
people make
make decisions
decisions by
by
comparing
comparing marginal
marginal costs
costs and
and marginal
marginal
benefits.
benefits.
People
People change
change their
their behavior
behavior in
in response
response
to
to the
the incentives
incentives they
they face.
face.
Mankiw et al.: Principles of Microeconomics,

Summary

Trade
Trade can
can be
be mutually
mutually beneficial.
beneficial.
Markets
Markets are
are usually
usually aa good
good way
way of
of
coordinating
coordinating trade
trade among
among people.
people.
Government
Government can
can potentially
potentially improve
improve
market
market outcomes
outcomes ifif there
there is
is some
some market
market
failure
failure or
or ifif the
the market
market outcome
outcome is
is
inequitable.
inequitable.
Productivity
Productivity is
is the
the ultimate
ultimate source
source of
of
living
living standards.
standards.

Mankiw et al.: Principles of Microeconomics,

Summary
Money
Money growth
growth is
is the
the ultimate
ultimate source
source of
of
inflation.
inflation.
Society
Society faces
faces aa short-run
short-run tradeoff
tradeoff between
between
inflation
inflation and
and unemployment.
unemployment.

Mankiw et al.: Principles of Microeconomics,

The End

Mankiw et al.: Principles of Microeconomics,