Economics PRINCIPLES OF By N. Gregory Mankiw Principles of Economics 5e N. Gregory Mankiw © 2009 Cengage PowerPoint slides prepared by: Andreea Chiritescu Eastern Illinois University

Ten Principles of Economics 1 Ten Principles of Economics

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 3

Ten Principles of Economics Economy – “oikonomos” (Greek) “One who manages a household” Economy is composed of households and firms Economics is the study of how households and firms make decisions under scarcity Scarcity – all resources are scarce (finite) Decisions about how to use them implies tradeoffs are involved

1 The circular flow This diagram is a schematic representation of the organization of the economy. Decisions are made by households and firms. Households and firms interact in the markets for goods and services (where households are buyers and firms are sellers) and in the markets for the factors of production (where firms are buyers and households are sellers). The outer set of arrows shows the flow of dollars, and the inner set of arrows shows the corresponding flow of inputs and outputs. 5

Ten Principles of Economics Scarcity - limited nature of society’s resources Economics Study of how society manages its scarce resources Economists study: How people make decisions How people interact with one another Analyze forces and trends that affect the economy as a whole

How People Make Decisions Principle 1: People face trade-offs Making decisions Trade off one goal against another Society 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 Efficiency Society - maximum benefits from its scarce resources Size of the economic pie Equality Benefits - uniformly distributed among society’s members How the pie is divided into individual slices

The production possibilities frontier 2 The production possibilities frontier Quantity of Computers Produced The production possibilities frontier shows the combinations of output - in this case, cars and computers - that the economy can possibly produce. The economy can produce any combination on or inside the frontier. Points outside the frontier are not feasible given the economy’s resources. C 1,000 3,000 F Production Possibilities Frontier A 2,200 B 2,000 600 700 D 1,000 300 E Quantity of Cars Produced 9

The Economist as a Scientist Efficient levels of production Economy’s getting all it can From the scarce resources available Points on the production possibilities frontier Trade-off: The only way to get more of one good Is to get less of the other good Inefficient levels of production Points inside production possibilities frontier 10

How People Make Decisions Principle 2: The cost of something is what you give up to get it People face trade-offs Make decisions Compare cost with benefits of alternatives Opportunity cost Whatever most be given up to obtain one item PPF – Opportunity cost is what you give up as you produce more of another good

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 Marginal changes Small incremental adjustments to a plan of action Rational decision maker – take action only if Marginal benefits > Marginal costs

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

Incentives for Firms First Law of Supply: the higher the market price the greater the quantity supplied by each firm

Incentives - Consumers First Law of Demand The higher the price, the lower is quantity demanded

Can Economic Incentives Get You Pregnant? http://freakonomics.blogs.nytimes.com/2008/01/16/can-economic-incentives-get-you-pregnant/ Can fertility rates be linked to financial incentives (or disincentives) to have children? Alma Cohen, Rajeev Dehejia, and Dmitri Romanov, “Do Financial Incentives Affect Fertility?” We find a significant positive effect on fertility, with the mean level of child subsidies producing a 7.8 percent increase in fertility. we find that a large, unanticipated reduction in child subsidies that occurred in 2003 had a substantial negative impact on fertility. Overall, our results support that fertility responds to financial incentives and indicate that the child subsidy policies used in many countries can have a significant influence on incremental fertility decisions.

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 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

How People Interact Disparities in economic wellbeing Market economy Rewards people - ability to produce things that other people are willing to pay for Government intervention Public policies May diminish inequality Process far from perfect