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Chapter
Ten Principles of Economics
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Key Terms• Common understanding of key terms
– Use them as shorthand for the concept; but have a precise/exact meaning
• Scarcity– There are not enough resources to produce and consume all
of the goods and services we desire• Opportunity costs
– What must be given up (next best alternative use) as a result of a decision or choice
– “No such thing as a free lunch” (Milton Friedman)• Cost-benefit analysis
– Every decision/action has tradeoffs
How People Make Decisions
Principle 1: People face trade-offs• Making decisions
– Trade off one goal against another• Student – time (sleeping versus studying)• Parents – income (consume or save)• National defense vs. consumer goods• Clean environment vs. high level of income• Efficiency vs. equality
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How People Make Decisions
Principle 1: People face trade-offs (examples)• Efficiency
– Society - maximum benefits from its scarce resources
– Size and distribution of the economic pie (national income and distribution)
• Equality– Benefits - uniformly distributed among
society’s members– How the pie is divided into individual slices
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How People Make Decisions
Principle 2: The cost of something is what you give up to get it
• Because people face trade-offs when making choices – you have to give something up to get something – Benefit/Cost Analysis to make decisions
• Compare cost with benefits of alternatives• Implies and opportunity cost is incurred
– Whatever most be given up to obtain one item
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How People Make Decisions
Principle 3: Rational people think at the margin• Rational people
– Systematically & purposefully do the best they can to achieve their objectives
• Rational decision maker – take action only if– Marginal benefits > Marginal costs
• Marginal Benefits – change (or increase) in total benefits from choice
• Marginal Costs – change/increase in costs from choice (opportunity costs of “not chosen”)
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3. Optimal decisions are made at the “margin”
• What do we mean?– When making an economic decision, e.g. to purchase 1 more
unit of a good, we compare the marginal (or incremental) benefits against the marginal costs
• For example– When studying for an exam
• Given you’ve already studied 8 hours, when deciding whether or not to study 1 more hour, you compare
– the expected benefits (a “marginal” improvement in your grade– Versus the next best (highest valued) use of your time
» E.g., sleeping, eating, time with friends
Marginal Decisions
• Back to the First Law of Demand– How much of a good do you buy?
• If the marginal/incremental value of the next unit is less than what it costs, are you willing to buy it?
MV < priceDon’t buy!
MV < priceDo buy!
How People Make Decisions
Principle 4: People respond to incentives• Incentive
– Something that induces a person to act– Higher price
• Buyers - consume less• Sellers - produce more
– Public policy• Change costs or benefits• Change people’s behavior
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• An example: the First Law of Demand– As the price per unit of the good declines, a
consumer (all other things held constant, e.g. their income) will choose to buy more of the good over the same time period
How People Make Decisions
Principle 4: People respond to incentives– Gasoline tax
• Car size & fuel efficiency; carpool; public transportation
– Unintended consequences• Policymakers fail to consider how their policies
affect incentives
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•Will Women Have More Babies if the Government Pays Them To?
Makingthe
Connection
Learning Objective 1.1
The Estonian government is encouraged by the results of providing economic incentives and is looking for ways to provide additional incentives to raise thebirthrate further.
How People Interact
Principle 5: Trade can make everyone better off • Trade
– Specialization• Allows each person/country to specialize in the
activities he/she does best
– People/countries can buy a greater variety of goods and services at lower cost
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A Parable for the Modern Economy
• Two goods: meat and potatoes• Two people: rancher and farmer• If rancher produces only meat
– And farmer produces only potatoes– Both gain from trade
• If both rancher and farmer produce both meat and potatoes– They still gain from specialization and trade
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The production possibilities frontier (a)
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(a) Production Opportunities
Minutes needed toMake 1 ounce of:
Amount produced in8 hours
Meat Potatoes Meat Potatoes
FarmerRancher
60 min/oz20 min/oz
15 min/oz10 min/oz
8 oz24 oz
32 oz48 oz
Panel (a) shows the production opportunities available to the farmer and the rancher.
The production possibilities frontier (b, c)
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(b) The farmer’s production possibilities frontier
Panel (b) shows the combinations of meat and potatoes that the farmer can produce. Panel (c) shows the combinations of meat and potatoes that the rancher can produce. Both production possibilities frontiers are derived assuming that the farmer and rancher each work 8 hours per day. If there is no trade, each person’s production possibilities frontier is also his or her consumption possibilities frontier
(c) The rancher’s production possibilities frontierMeat (oz)
0
4
8
Potatoes (oz)
16 32
A
If there is no trade, the farmer chooses this production and consumption.
Meat (oz)
0
12
24
Potatoes (oz)
24 48
B
If there is no trade, the rancher chooses this production and consumption.
The opportunity cost of meat and potatoes
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Opportunity cost of:
1 oz of Meat 1 oz of Potatoes
FarmerRancher
4 oz potatoes2 oz potatoes
¼ oz meat½ oz meat
A Parable for the Modern Economy
• Specialization and trade– Farmer – specialize in growing potatoes
• More time growing potatoes• Less time raising cattle
– Rancher – specialize in raising cattle• More time raising cattle• Less time growing potatoes
– Trade• Willing to trade: 3 oz of meat for 1 oz potatoes• Final trade -5 oz of meat for 15 oz of potatoes
– Both gain from specialization and trade18
Farmer’s Gains From TradeFarmer
Potatoes Meat
No Trade With
32 32 0
28 29 1
24 26 2
20 23 3
16 20 4
12 17 5
8 14 6
4 11 7
0 8 8
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Rancher’s Gains From Trade
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Greg’s Final Solution (text)
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(a) The farmer’s production and consumption
Farmer and Rancher agree to trade 5 oz of Meat for 15 oz of Potatoes (3:1)Start at corners (specialization)
(b) The rancher’s production and consumptionMeat (oz)
0
4
8
Potatoes (oz)
16 32
A
Farmer'sproduction andconsumptionwithout trade
Meat (oz)
0
12
24
Potatoes (oz)
24 48
B
Rancher’s production and consumption without trade
Farmer'sproductionwith trade
5
17
A*
Farmer'sconsumptionwith trade 13
18
12 27
B*Rancher’s consumption with trade
Rancher’s production with trade
Comparative Advantage
• Absolute advantage– Produce a good using fewer inputs than
another producer– Rancher: 20 min/1 oz M; 10 min/1 oz P– Farmer: 60 min/ 1 oz M; 15 min/ 1 oz P
• Opportunity cost– Measures the trade-off between the two goods
that each producer faces– Rancher -1 oz M -> 2 oz P– Farmer: 3 oz P -> -1 oz M
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How People Interact
Principle 7: Governments can sometimes improve market outcomes
• Government intervention– Change allocation of resources– To promote efficiency
• Avoid market failure
– To promote equality• Avoid disparities in economic wellbeing
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How People Interact
• Market failure– Situation in which the market on its own fails
to produce an efficient allocation of resources• Causes for market failure
– Externality• Impact of one person’s actions on the well-being
of a bystander
– Market power• Ability of a single person (or small group) to
unduly influence market prices24
Table
Ten principles of economics
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How People Make Decisions1: People Face Trade-offs2: The Cost of Something Is What You Give Up to Get It3: Rational People Think at the Margin4: People Respond to Incentives
How People Interact5: Trade Can Make Everyone Better Off6: Markets Are Usually a Good Way to Organize Economic Activity7: Governments Can Sometimes Improve Market Outcomes
How the Economy as a Whole Works8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services9: Prices Rise When the Government Prints Too Much Money10: Society Faces a Short-Run Trade-off between Inflation and Unemployment
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