3. 10 Principles of Economics

How people make decisions

Principle 1: People face trade-offs

• To get something that we like, we usually have to give up something else that we also like. Making decisions requires trading off one goal against another.

• Consider a student who must decide how to allocate her most valuable resource — her time. She can spend all of her time studying economics, spend all of it studying psychology, or divide it between the two fields. For every hour she studies one subject, she gives up an hour she could have used studying the other.

Principle 2: The Cost of Something Is What You Give Up to Get It

• Because people face trade-offs, making decisions requires comparing the costs and benefits of alternative courses of action.

• The opportunity cost of an item is what you give up to get that item. When making any decision, decision makers should take into account the opportunity costs of each possible action. In fact, they usually do. College athletes who can earn millions dropping out of school and playing professional sports are well aware that their opportunity cost of attending college is very high.

• Giving up jobs to study may have a cost of tuition fee, books etc. But those cost are not the only cost. Opportunity cost indicates all costs that are given up for study. For example, having a job instead of studying, money, time, energy etc.

Principle 3: Rational People Think at the Margin

• Rational people systematically and purposefully do the best they can to achieve their objectives, given the available opportunities.

• Economists use the term marginal change to describe a small incremental adjustment to an existing plan of action. Rational people make decisions by comparing marginal benefits and marginal costs.

• Say the cost of producing a garment is $3. An engineer has an order to produce 500 garments, so the total cost of production is $3 \times 500$ or $1500. But the engineer can also produce 501 garments with a little extra cost of $1. So the marginal cost of producing 501 garments is $3 \times 500 + 1$ or $1501. So the marginal cost of producing 501 garments is 1501 - 1500 or $1.

Principle 4: People Respond to Incentives

• An incentive is something that induces a person to act, such as the prospect of a punishment or reward.

• Incentives are key to analyzing how markets work. For example, when the price of apples rises, people decide to eat fewer apples.

• Consider how a seat belt law alters a driver’s cost–benefit calculation. Seat belts make accidents less costly by reducing the risk of injury or death. In other words, seat belts reduce the benefits of slow and careful driving. People respond to seat belts as they would to an improvement in road conditions—by driving faster and less carefully. The result of a seat belt law, therefore, is a larger number of accidents.

How People Interact

Principle 5: Trade Can Make Everyone Better Off

• Trade allows each person to specialize in the activities she does best, whether it is farming, sewing, or home building. By trading with others, people can buy a greater variety of goods and services at lower cost.

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

• In a market economy, the decisions of a central planner are replaced by the decisions of millions of firms and households. Firms decide whom to hire and what to make. Households decide which firms to work for and what to buy with their incomes. These firms and households interact in the marketplace, where prices and self-interest guide their decisions.

• Prices are the instrument with which the invisible hand directs economic activity. In any market, buyers look at the price when deciding how much to demand, and sellers look at the price when deciding how much to supply. As a result of these decisions, market prices reflect both the value of a good to society and the cost to society of making the good.

Principle 7: Governments Can Sometimes Improve Market Outcomes

• One reason we need government is that the invisible hand can work its magic only if the government enforces the rules and maintains the institutions that are key to a market economy. Most important, market economies need institutions to enforce property rights so, individuals can own and control scarce resources.

• A farmer won’t grow food if she expects her crop to be stolen; a restaurant won’t serve meals unless it is assured that customers will pay before they leave; and a film company won’t produce movies if too many potential customers avoid paying by making illegal copies.

How the Economy as a Whole Works

Principle 8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services

• Almost all variation in living standards is attributable to differences in countries’ productivity—that is, the amount of goods and services produced by each unit of labor input. In nations where workers can produce a large quantity of goods and services per hour, most people enjoy a high standard of living; in nations where workers are less productive, most people endure a more meager existence. Similarly, the growth rate of a nation’s productivity determines the growth rate of its average income.

Principle 9: Prices Rise When the Government Prints Too Much Money

• Inflation: an increase in the overall level of prices in the economy
• Because high inflation imposes various costs on society, keeping inflation at a reasonable rate is a goal of economic policymakers around the world.
• In almost all cases of large or persistent inflation, the culprit is growth in the quantity of money. When a government creates large quantities of the nation’s money, the value of the money falls.

Principle 10: Society Faces a Short-Run Trade-Off between Inflation and Unemployment

• Most economists describe the short-run effects of money growth as follows:
  • Increasing the amount of money in the economy stimulates the overall level of spending and thus the demand for goods and services.
  • Higher demand may over time cause firms to raise their prices, but in the meantime, it also encourages them to hire more workers and produce a larger quantity of goods and services.
  • More hiring means lower unemployment.
• This line of reasoning leads to one final economy-wide trade-off: a short-run trade-off between inflation and unemployment.

Acknowledgement

• Reference Principles of Economics by N. Gregory Mankiw - Chapter 1