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Principles of Economics

Ten Principles of Economics

Jiaming Mao

Fall 2015

Principle 1: People face tradeoffs

All decisions involve trade offs. To get one thing we like, we usuallyhave to give up another thing we like.

IComputer or Xbox

IPlaying basketball or studying for an exam

IEnvironmental protection or economic growth

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

IComputer or Xbox

Society faces an important tradeoff: Efficiency vs. Equality.

Efficiency: when society gets the most from its scarce resourcesI

“the size of the pie”

Equality: when prosperity is distributed uniformly among society’smembers

I“how the pie is divided”

Tradeoff Example: progressive income tax, welfare

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

I“the size of the pie”

Principle 2: The cost of something is what you give up to

get it

Making decisions requires a comparison of costs and benefits acrossalternatives.

The opportunity cost of an item is the value of what must be givenup to obtain it.Opportunity cost can include both explicit cost and implicit cost.

IThe cost of going to college:

FExplicit cost: tuition, etc.

FImplicit cost: lost wages, etc.

IThe cost of seeing a movie

FExplicit cost: movie ticket

FImplicit cost: the value you can get by using the time to do things

other than watching the movie

get it

Making decisions requires a comparison of costs and benefits acrossalternatives.The opportunity cost of an item is the value of what must be givenup to obtain it.

Opportunity cost can include both explicit cost and implicit cost.I

The cost of going to college:

get it

Making decisions requires a comparison of costs and benefits acrossalternatives.The opportunity cost of an item is the value of what must be givenup to obtain it.Opportunity cost can include both explicit cost and implicit cost.

get it

Definition

Opportunity cost is the net benefit foregone by not choosing the next bestopportunity.

Opportunity cost is the relevant cost for decision making.

get it

Definition

Opportunity cost is the net benefit foregone by not choosing the next bestopportunity.

Opportunity cost is the relevant cost for decision making.

get it

Example

You are given a free ticket to see a performance at Min-nan Theatre (whichhas no resale value). Xiamen Philharmonic is performing on the same nightand is your next-best alternative activity. Tickets to the XMP concert cost$50. On any given day, you would be willing to pay up to $100 to attendan XMP concert. Assume there are no other costs of seeing eitherperformance. What is the opportunity cost of going to see the performanceat Min-Nan theatre?

Principle 3: Rational people think at the margin

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

A rational person makes decisions by comparing marginal benefit

and marginal cost.I

As opposed to comparing average benefit and average cost.

A rational person does not consider sunk cost in decision making.

Rational people systematically and purposefully do the best they canto achieve their objectives, given the available opportunities.A rational person makes decisions by comparing marginal benefit

and marginal cost.

IAs opposed to comparing average benefit and average cost.

and marginal cost.I

Example

A 200-seat plane is about to take off with 10 empty seats. The flight coststhe airline $100,000. A passenger arriving at the last minute is hoping topurchase a ticket for one of the remaining seats. How much should theairline charge her?

Principle 4: People respond to incentives

Incentive: something that induces a person to act, such as theprospect of a punishment or reward.

IWhen gas taxes rise, people use public transportation, and travel less.

IWhen interest rates rise, people save more and consume less.

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

Principle 5: Trade can make everyone better off

Rather than being self-sufficient, people can specialize in producingone good or service and exchange it for another.

IConsider a world in which every person has to grow her own food,

makes her own clothing, performs her own surgeries, etc.

Countries likewise benefit from trade and specialization.

Principle 6: Markets are usually a good way to organize

economic activity

Market economy allocates resources through the decentralizeddecisions of many firms and households as they interact in markets forgoods and services.

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.

economic activity

Market economy allocates resources through the decentralizeddecisions of many firms and households as they interact in markets forgoods and services.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.

economic activity

The invisible hand works through the price system:

IThe interaction of buyers and sellers determines prices.

IEach price reflects the good’s value to buyers and the cost of producing

the good.

IPrices guide self-interested households and firms to make decisions

that, in many cases, maximize society’s economic well-being.

economic activity

The invisible hand works through the price system:I

The interaction of buyers and sellers determines prices.

the good.

economic activity

the good.

economic activity

the good.

Principle 7: Governments can sometimes improve market

outcomes

Government’s role in improving market outcomes:

1Enforce property rights

IPeople are less inclined to work, produce, invest, or purchase if large

risk of their property being stolen.

2Address market failure and promote efficiency

IMarket failure: when the market fails to allocate society’s resources

efficiently.

ICauses of market failure:

FExternalities: the production or consumption of a good affects

bystanders (e.g. pollution)

FMarket power: a single buyer or seller has substantial influence on

market price (e.g. monopoly)

3Promote equity

IIf the market’s distribution of economic well-being is not desirable, tax

or welfare policies can change how the economic “pie” is divided.

outcomes

Government’s role in improving market outcomes:1

Enforce property rights

efficiently.

3Promote equity

outcomes

efficiently.

3Promote equity

outcomes

efficiently.

3Promote equity

outcomes

efficiently.

3Promote equity

outcomes

efficiently.

3Promote equity

outcomes

efficiently.

3Promote equity

outcomes

efficiently.

3Promote equity

outcomes

efficiently.

3Promote equity

Principle 8: A country’s standard of living depends on its

ability to produce goods and services

Variation in living standards is mainly attributable to differences incountries’ productivity: the quantity of goods and services producedfrom 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 growthin the quantity of money, which causes the value of money to fall.The faster the government creates money, the greater the inflationrate.

much money

Inflation: increases in the general level of prices.In the long run, inflation is almost always caused by excessive growthin the quantity of money, which causes the value of money to fall.

The faster the government creates money, the greater the inflationrate.

much money

Inflation: increases in the general level of prices.In the long run, inflation is almost always caused by excessive growthin the quantity of money, which causes the value of money to fall.The faster the government creates money, the greater the inflationrate.

Principle 10: Society typically faces a short-run tradeoff

between inflation and unemployment

In economic booms, demand is strong relative to the economy’scapacity to produce.

Higher demand may cause firms to raise their prices. It also encouragesthem to hire more workers and produce a larger quantity of goods andservices, which results in higher wages and lower unemployment.Central banks can stimulate demand through monetary injections.As prices and wages are not set every day, how much firms would raisetheir prices and how much workers would demand higher wages alsodepend on their expectations of future inflation.

IAs a result, inflation today depends on expected inflation in the

future.

Holding inflation expectations constant, society typically faces ashort-run tradeoff between inflation and unemployment.

In economic booms, demand is strong relative to the economy’scapacity to produce.Higher demand may cause firms to raise their prices. It also encouragesthem to hire more workers and produce a larger quantity of goods andservices, which results in higher wages and lower unemployment.

Central banks can stimulate demand through monetary injections.As prices and wages are not set every day, how much firms would raisetheir prices and how much workers would demand higher wages alsodepend on their expectations of future inflation.

future.

In economic booms, demand is strong relative to the economy’scapacity to produce.Higher demand may cause firms to raise their prices. It also encouragesthem to hire more workers and produce a larger quantity of goods andservices, which results in higher wages and lower unemployment.Central banks can stimulate demand through monetary injections.

As prices and wages are not set every day, how much firms would raisetheir prices and how much workers would demand higher wages alsodepend on their expectations of future inflation.

future.

In economic booms, demand is strong relative to the economy’scapacity to produce.Higher demand may cause firms to raise their prices. It also encouragesthem to hire more workers and produce a larger quantity of goods andservices, which results in higher wages and lower unemployment.Central banks can stimulate demand through monetary injections.As prices and wages are not set every day, how much firms would raisetheir prices and how much workers would demand higher wages alsodepend on their expectations of future inflation.

future.

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 inhis favor, and show them that it is for their own advantage to dofor him what he requires of them...

Give me that which I want, and you shall have this which youwant, is the meaning of every such offer; and it is in this mannerthat we obtain from one another the far greater part of thosegood offices which we stand in need of.

The Wealth of Nations

It is not from the benevolence of the butcher, the brewer, or thebaker, that we expect our dinner, but from their regard to theirown interest. We address ourselves, not to their humanity but totheir self-love, and never talk to them of our own necessities butof their advantages...

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

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