CHAPTER
Ten Principles of Economics
Microeonomics
PRINCIPLES OF
N. Gregory Mankiw
© 2009 South-Western, a part of Cengage Learning, all rights reserved
In this chapter,
look for the answers to these questions:
▪ What kinds of questions does economics address?
▪ What are the principles of how people make
decisions?
▪ What are the principles of how people interact?
▪ What are the principles of how the economy as a
whole works?
1
What Economics Is All About
▪ Scarcity: the limited nature of society’s
resources
▪ Economics: the study of how society manages
its scarce resources, e.g.
▪ how people decide what to buy,
how much to work, save, and spend
▪ how firms decide how much to produce,
how many workers to hire
▪ how society decides how to divide its resources
between national defense, consumer goods,
protecting the environment, and other needs
TEN PRINCIPLES OF ECONOMICS 2
The principles of
HOW PEOPLE
MAKE DECISIONS
HOW PEOPLE MAKE DECISIONS
Principle #1: People Face Tradeoffs
All decisions involve tradeoffs. Examples:
▪ Going to a party the night before your midterm
leaves less time for studying.
▪ Having more money to buy stuff requires working
longer hours, which leaves less time for leisure.
▪ Protecting the environment requires resources
that could otherwise be used to produce
consumer goods.
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HOW PEOPLE MAKE DECISIONS
Principle #1: People Face Tradeoffs
▪ Society faces an important tradeoff:
efficiency vs. equality
▪ Efficiency: when society gets the most from its
scarce resources
▪ Equality: when prosperity is distributed uniformly
among society’s members
▪ Tradeoff: To achieve greater equality,
could redistribute income from wealthy to poor.
But this reduces incentive to work and produce,
shrinks the size of the economic “pie.”
TEN PRINCIPLES OF ECONOMICS 5
HOW PEOPLE MAKE DECISIONS
Principle #2: The Cost of Something Is
What You Give Up to Get It
▪ Making decisions requires comparing the costs
and benefits of alternative choices.
▪ The opportunity cost of any item is
whatever must be given up to obtain it. Value of
the next best alternative.
▪ It is the relevant cost for decision making.
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HOW PEOPLE MAKE DECISIONS
Principle #2: The Cost of Something Is
What You Give Up to Get It
Examples:
The opportunity cost of…
…going to college for a year is not just the tuition,
books, and fees, but also the foregone wages.
…seeing a movie is not just the price of the ticket,
but the value of the time you spend in the theater.
TEN PRINCIPLES OF ECONOMICS 7
HOW PEOPLE MAKE DECISIONS
Principle #3: Rational People Think at the
Margin
Rational people
▪ systematically and purposefully do the best they
can to achieve their objectives.
▪ make decisions by evaluating costs and benefits
of marginal changes – incremental adjustments
to an existing plan.
TEN PRINCIPLES OF ECONOMICS 8
HOW PEOPLE MAKE DECISIONS
Principle #3: Rational People Think at the
Margin
Examples:
▪ When a student considers whether to go to
college for an additional year, he compares the
fees & foregone wages to the extra income
he could earn with the extra year of education.
▪ When a manager considers whether to increase
output, she compares the cost of the needed
labor and materials to the extra revenue.
TEN PRINCIPLES OF ECONOMICS 9
HOW PEOPLE MAKE DECISIONS
Principle #4: People Respond to Incentives
▪ Incentive: something that induces a person to
act, i.e. the prospect of a reward or punishment.
▪ Rational people respond to incentives.
Examples:
▪ When gas prices rise, consumers buy more
hybrid cars and fewer gas guzzling SUVs.
▪ When cigarette taxes increase,
teen smoking falls.
TEN PRINCIPLES OF ECONOMICS 10
ACTIVE LEARNING 1
Applying the principles
You are selling your 1996 Mustang. You have
already spent $1000 on repairs.
At the last minute, the transmission dies. You can
pay $600 to have it repaired, or sell the car “as is.”
In each of the following scenarios, should you
have the transmission repaired? Explain.
A. Blue book value is $6500 if transmission works,
$5700 if it doesn’t
B. Blue book value is $6000 if transmission works,
$5500 if it doesn’t
11
ACTIVE LEARNING 1
Answers
Cost of fixing transmission = $600
A. Blue book value is $6500 if transmission works,
$5700 if it doesn’t
Benefit of fixing the transmission = $800
($6500 – 5700).
It’s worthwhile to have the transmission fixed.
B. Blue book value is $6000 if transmission works,
$5500 if it doesn’t
Benefit of fixing the transmission is only $500.
Paying $600 to fix transmission is not worthwhile.
12
ACTIVE LEARNING 1
Answers
Observations:
▪ The $1000 you previously spent on repairs is
irrelevant. What matters is the cost and benefit
of the marginal repair (the transmission).
▪ The change in incentives from scenario A
to scenario B caused your decision to change.
13
The principles of
HOW PEOPLE
INTERACT
HOW PEOPLE INTERACT
Principle #5: Trade Can Make Everyone
Better Off
▪ Rather than being self-sufficient,
people can specialize in producing one good or
service and exchange it for other goods.
▪ Countries also 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
TEN PRINCIPLES OF ECONOMICS 15
HOW PEOPLE INTERACT
Principle #6: Markets Are Usually A Good Way
to Organize Economic Activity
▪ Market: a group of buyers and sellers
(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
TEN PRINCIPLES OF ECONOMICS 16
HOW PEOPLE INTERACT
Principle #6: Markets Are Usually A Good Way
to Organize Economic Activity
▪ A market economy allocates resources through
the decentralized decisions of many households
and firms as they interact in markets.
▪ Famous insight by Adam Smith in
The Wealth of Nations (1776):
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 #6: Markets Are Usually A Good Way
to Organize Economic Activity
▪ The invisible hand works through the price system:
▪ The interaction of buyers and sellers
determines prices.
▪ Each price reflects the good’s value to buyers
and the cost of producing the good.
▪ Prices guide self-interested households and
firms to make decisions that, in many cases,
maximize society’s economic well-being.
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HOW PEOPLE INTERACT
Principle #7: Governments Can Sometimes
Improve Market Outcomes
▪ Important role for 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.
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HOW PEOPLE INTERACT
Principle #7: Governments Can Sometimes
Improve Market Outcomes
▪ Market failure: when the market fails to allocate
society’s 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.
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HOW PEOPLE INTERACT
Principle #7: Governments Can Sometimes
Improve Market Outcomes
▪ Govt may alter market outcome to promote equity
▪ If the market’s distribution of economic well-being
is not desirable, tax or welfare policies can change
how the economic “pie” is divided.
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