PRINCIPLES OF ECONOMICS J. Mao

Principle #1: People Face Tradeoffs

¨  All decisions involve trade offs. To get one thing we like, we usually have to give up another thing we like. ¤ Xbox or Iphone 6 ¤ Playing basketball or studying for an exam ¤ Environmental protection or economic growth

¨  Milton Friedman: “There is no such thing as a free lunch”

Principle #1: People Face Tradeoffs

¨  Society faces an important tradeoff: Efficiency vs. Equality ¤ Efficiency: when society gets the most from its scarce

resources n This effects the size of the pie

¤ Equality: when prosperity is distributed uniformly among society’s members n equality determines how the pie is divided among society’s

members

¨  Tradeoff Example: Progressive Income Tax, Welfare

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

¨  Making decisions requires a comparison of costs and benefits across alternatives

¨  The opportunity cost of an item is equal to the value of what must be foregone to obtain it

¨  Opportunity cost is the relevant cost for decision making

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

¨  More precisely, the opportunity cost is the net benefit foregone by not choosing the next best opportunity.

¨  Opportunity cost includes both explicit cost and implicit cost

¨  Examples: ¤ The cost of going to going to college

n explicit cost: tuition, etc. n  Implicit cost: lost wages, etc.

¤ The cost of seeing a movie

Opportunity cost

¨  You are given a free ticket to see a performance at Min-nan Theatre (which has no resale value). Xiamen Philharmonic is performing on the same night and is your next-best alternative activity. Tickets to the XMP concert cost 50 Yuan. On any given day, you would be willing to pay up to 100 Yuan to attend an XMP concert. Assume there are no other costs of seeing either performance. Based on this information, what is the opportunity cost of going to see the performance at Min-Nan theatre?

Principle #3: Rational People Think at the Margin

A rational decision maker ¨  makes decisions by evaluating costs and benefits of

marginal changes ¨  Takes an action if the marginal benefit of the

action exceeds the marginal cost ¨  Does not consider sunk cost in decision making

Principle #4: People Respond to Incentives

¨  Incentive: something that induces a person to act, i.e. the prospect of a punishment or reward

¨  Steven Landsburg: “Most of economics can be summarized in four words: ‘People respond to incentives.’ The rest is commentary”

Principle #4: People Respond to Incentives

Examples ¨  When gas taxes rise, consumers buy more hybrid

cars, use public transportation more, and travel less ¨  When students receive extra credit for class

participation, students hopefully(!!!) participate in class discussions more actively

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 another

¨  Countries also benefit from trade and specialization

Principle #5: Trade can make everyone better off

As an example, consider a world in which everyone… ¨  Grows his own food ¨  Cuts his own hair ¨  Makes his own clothing ¨  Performs his own surgeries

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

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.

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

Adam Smith, The Wealth of Nations: “Man has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love in his favor, and show them that it is for their own advantage to do for him what he requires of them… Give me that which I want, and you shall have this which you want, is the meaning of every such offer; and it is in this manner that we obtain from one another the far greater part of those good offices which we stand in need of. It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages…

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

Every individual…neither intends to promote the public interest, nor knows how much he is promoting it… He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”

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.

Principle #7: Governments Can Sometimes Improve Market Outcomes

¨  Important role of government: enforce property rights (with police, courts)

¨  People are less inclined to work, produce, invest, or purchase if large risk of their property being stolen.

Principle #7: Governments Can Sometimes Improve Market Outcomes

¨  Market failure: when the market fails to allocate society’s resources efficiently

¨  Causes of market failure: ¤ 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)

¨  Public policy may promote efficiency.

Principle #7: Governments Can Sometimes Improve Market Outcomes

¨  Government 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.

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

Almost all variation in living standards is attributable to differences in countries’ productivity: the quantity of goods and services produced from each unit of labor input

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

¨  Inflation: increases in the general level of prices ¨  In the long run, inflation is almost always caused by

excessive growth in the quantity of money, which causes the value of money to fall.

¨  The faster the government creates money, the greater the inflation rate.

Hyperinflation

¨  Weimar Germany: Aug 1922 – Dec 1923 ¤ To pay for reparations as a result of its defeat in WWI ¤ Daily inflation rate: 21%, price doubled every 3 days ¤ Daily In January 1921, a daily newspaper in Weimar

Germany cost 0.3 marks. Two years later, in Nov 1922, the same newspaper cost 70,000,000 marks.

Hyperinflation

¨  Zimbabwe: March 2007 – Nov 2008. ¤ Robert Mugabe’s land reforms of 2000-2001: land

was expropriated largely from white farmers and redistributed to the majority black populace.

¤ Economic decline + huge government deficits led the government to resort of monetization of its debt

¤  Daily inflation 98%, prices doubled every 25 hours

Hyperinflation

Hyperinflation

¨  China: Oct 1947 – May 1949 ¤ To fund the civil war, the Nationalists resorted to

running huge budget deficits, which they eventually looked to cover by printing money

¤  Daily inflation 14%, prices doubled every 5 days

Hyperinflation

China’s paper money experiment

¨  The Chinese were the first to use paper money.

¨  In 806 – 821, during the reign of Emperor Hien Tsung of the Song Dynasty, a severe shortage of copper for making coins caused the emperor to issue paper money notes, made from mulberry bark.

Jiaozi (Song Dynasty), the world's earliest paper money.

China’s paper money experiment

¨  In 1020, quantity of Chinese paper money reached an excessive level. The total amount was nominally worth 2,830,000 ounces of silver. Vast amounts of cash were used to buy off potential invaders from the north and to pay for imports causing a cash famine. As a result the authorities increased the note issues thus fuelling inflation.

¨  In 1455, China abandoned paper money. After well over 500 years of experience with paper currencies, during which there had been repeated episodes of inflation and currency reform, China ceased to use paper money.

Principle #10: Society Faces a Short-run Tradeoff Between Inflation and Unemployment

¨  The short-run effects of monetary injections:  ¨  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

Summary

¨  Summary Concepts: ¤ Economics is the Study of the allocation of scarce

resources. ¤ At Least Ten Key Principles guide human and firm

behavior in all decision making (know these concepts)

¨  Summary Vocab: Economics, Efficiency, Equality, Externalities, Incentive, Inflation, Marginal Changes, Markets, Market Failure, Market Power, Opportunity Cost, Scarcity, Specialize

Just for fun

¨  Mankiw’s Ten Principles of Economics, Translated