Ten Principles of Economics 1 Ten Principles of Economics

Key Terms Common understanding of key terms Scarcity Opportunity costs 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

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

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

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”)

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 < price Don’t buy! MV < price Do 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

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

Will Women Have More Babies if the Government Pays Them To? Learning Objective 1.1 Making the Connection Will Women Have More Babies if the Government Pays Them To? The Estonian government is encouraged by the results of providing economic incentives and is looking for ways to provide additional incentives to raise the birthrate further.

How People Interact Principle 5: Trade can make everyone better off 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

How People Interact Principle 6: Markets are usually a good way to organize economic activity Communist countries – central planning Government officials (central planners) Allocate economy’s scarce resources Decided What goods & services were produced How much was produced Who produced & consumed these goods & services Theory: only the government could organize economic activity to promote economic well-being for the country as a whole

How People Interact Principle 6: Markets are usually a good way to organize economic activity Market economy - allocates resources Decentralized decisions of many firms and households As they interact in markets for goods and services Guided by prices and self interest Adam Smith’s “invisible hand”

How People Interact Principle 7: Governments can sometimes improve market outcomes We need government Enforce the rules/property rights Maintain institutions - key to market economy Enforce property rights Property rights Ability of an individual to own and exercise control over scarce resources

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

How People Interact Market failure Causes for 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 prices

Ten principles of economics 1 Ten principles of economics How People Make Decisions 1: People Face Trade-offs 2: The Cost of Something Is What You Give Up to Get It 3: Rational People Think at the Margin 4: People Respond to Incentives How People Interact 5: Trade Can Make Everyone Better Off 6: Markets Are Usually a Good Way to Organize Economic Activity 7: Governments Can Sometimes Improve Market Outcomes How the Economy as a Whole Works 8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services 9: Prices Rise When the Government Prints Too Much Money 10: Society Faces a Short-Run Trade-off between Inflation and Unemployment