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0 Ten Principles of Economics
1 Ten Principles of Economics Microeconomics P R I N C I P L E S O F N. Gregory Mankiw Dear Colleague, Thank you for using the Premium PowerPoints for Mankiw’s Principles of Economics. I update these approximately once per year, to update the data, fix any typos, and incorporate the best suggestions from users like yourself. If you have any suggestions, corrections, or feedback, please me at Check the textbook’s website to make sure you’re always using the most recent version. In this area (the “notes” section), I occasionally include notes that are visible only to you and will not display during your presentation in class. In slides with data tables or charts, the notes area provides the source information (often a URL or web address to the original data). In other slides, the notes area provides information that might be helpful when teaching this material, particularly for new instructors and grad assistant teachers. For chapter 1, most instructors try to cover this chapter in a single class session (especially those that are teaching the second of a two-semester sequence). If you are teaching a “principles of microeconomics” course, you might consider skipping Principles 8-10, which deal with macroeconomics. Near the end of the chapter are four slides titled “FYI: How to Read Your Textbook.” In the notes section of these slides, I describe an in-class activity that teaches effective reading skills to students. Premium PowerPoint Slides by Ron Cronovich

1 In this chapter, look for the answers to these questions:
What kinds of questions does economics address? What are the principles of how people make decisions? What are the principles of how people interact? What are the principles of how the economy as a whole works? 1

2 What Economics Is All About
Scarcity: the limited nature of society’s resources Economics: the study of how society manages its scarce resources, e.g. how people decide what to buy, how much to work, save, and spend how firms decide how much to produce, how many workers to hire how society decides how to divide its resources between national defense, consumer goods, protecting the environment, and other needs You might want to elaborate a bit on some of the points made here. Some examples: “How do people decide how much to work?” Time is scarce resource – there’s just not enough time to do everything we’d like to do. How do we decide how much of our time to spend working? There’s a tradeoff: the more time we spend working, the higher our income, and therefore the more stuff we can buy. But, the more time we spend working, the less time we have for leisure – hanging out with friends, going hiking, watching movies, etc. (You might want to ask your students how THEY decide how much time to spend working. Some will say it depends on how many classes they are taking, or the time requirements of the available jobs. But probably at least a few will say the wage – the higher the wage, the more worthwhile to work.) “How do firms decide what kind of labor to hire?” Firms can hire unskilled or skilled workers. The skilled workers are more productive, but cost more than the unskilled workers. “How do firms decide how much to produce?” Ask your students, and see if any of them say “it depends on the price of the product they sell.” (Probably some will say “it depends on whether there’s a lot of demand for the product”. To which you might respond “and if there’s a lot of demand for the product, what does that mean for the price that firms can get for the product?”) TEN PRINCIPLES OF ECONOMICS 2

The principles of HOW PEOPLE MAKE DECISIONS Decision-making is at the heart of economics. The individual must decide how much to save for retirement, how much to spend on different goods and services, how many hours a week to work. The firm must decide how much to produce, what kind of labor to hire. Society as a whole must decide how much to spend on national defense (“guns”) versus how much to spend on consumer goods (“butter”). 3

Principle #1: People Face Tradeoffs All decisions involve tradeoffs. Examples: Going to a party the night before your midterm leaves less time for studying. Having more money to buy stuff requires working longer hours, which leaves less time for leisure. Protecting the environment requires resources that could otherwise be used to produce consumer goods. TEN PRINCIPLES OF ECONOMICS 4

Principle #1: People Face Tradeoffs Society faces an important tradeoff: efficiency vs. equality Efficiency: when society gets the most from its scarce resources Equality: when prosperity is distributed uniformly among society’s members Tradeoff: To achieve greater equality, could redistribute income from wealthy to poor. But this reduces incentive to work and produce, shrinks the size of the economic “pie.” HEADS UP. The 5th edition uses “equality.” The fourth and earlier editions used “equity” here. You may want to elaborate verbally on the last bullet to insure that the point is clear. “Redistribute income from wealthy to poor” is accomplished through the progressive tax system, as well as social programs like food stamps and unemployment insurance that try to provide a safety net for people at the low end of the income distribution. “But this reduces the incentive to work” – the reward for working hard is a high income. Taxes reduce this reward, and therefore reduce the incentive to work hard. TEN PRINCIPLES OF ECONOMICS 5

Principle #2: The Cost of Something Is What You Give Up to Get It Making decisions requires comparing the costs and benefits of alternative choices. The opportunity cost of any item is whatever must be given up to obtain it. It is the relevant cost for decision making. TEN PRINCIPLES OF ECONOMICS 6

Principle #2: The Cost of Something Is What You Give Up to Get It Examples: The opportunity cost of… …going to college for a year is not just the tuition, books, and fees, but also the foregone wages. …seeing a movie is not just the price of the ticket, but the value of the time you spend in the theater. Here’s a fun tangent if you have the class time and are so inclined: Ask your students about the saying “The best things in life are free.” Ask them to name some of these things that supposedly are free. Ask them what “free” means in this context. The idea here is to get them to see that even things without an explicit monetary cost are not truly “free” because they have an opportunity cost. For example, when you ask them to name the “best things” that are “free,” they will respond with answers like love, sitting at the top of a mountain you just climbed and enjoying an awesome view, or maybe witnessing the joy of a child who has just been given a new toy. In each case, there is no explicit monetary cost, but there’s an opportunity cost. For example, a day spent climbing a mountain represents a day of foregone wages. And the fact that the mountain offers the incredible view probably means that land has been set aside for a national park that might otherwise have been used to produce industrial chemicals, or for a subdivision of million-dollar homes. With love, it’s less obvious, but if prodded enough, your students will be able to think of non-monetary costs associated with love. For example, you might not want to see the latest Ashton Kutcher film, you might think he’s the world’s worst actor. But your boyfriend/girlfriend/teenage daughter or other loved one is DYING to see it, they are BEGGING you to take them. So you take them. That’s true love, don’t you think? And it’s certainly not free. TEN PRINCIPLES OF ECONOMICS 7

Principle #3: Rational People Think at the Margin Rational people systematically and purposefully do the best they can to achieve their objectives. make decisions by evaluating costs and benefits of marginal changes – incremental adjustments to an existing plan. TEN PRINCIPLES OF ECONOMICS 8

Principle #3: Rational People Think at the Margin Examples: When a student considers whether to go to college for an additional year, he compares the fees & foregone wages to the extra income he could earn with the extra year of education. When a manager considers whether to increase output, she compares the cost of the needed labor and materials to the extra revenue. See the textbook for two classic examples: 1. The diamond-water paradox: water is essential for life but virtually free; diamonds are inessential but expensive. 2. The near-zero marginal cost of an airline taking an extra passenger when the flight isn’t full. TEN PRINCIPLES OF ECONOMICS 9

Principle #4: People Respond to Incentives Incentive: something that induces a person to act, i.e. the prospect of a reward or punishment. Rational people respond to incentives. Examples: When gas prices rise, consumers buy more hybrid cars and fewer gas guzzling SUVs. When cigarette taxes increase, teen smoking falls. TEN PRINCIPLES OF ECONOMICS 10

11 A C T I V E L E A R N I N G 1 Applying the principles
You are selling your 1996 Mustang. You have already spent $1000 on repairs. At the last minute, the transmission dies. You can pay $600 to have it repaired, or sell the car “as is.” In each of the following scenarios, should you have the transmission repaired? Explain. A. Blue book value is $6500 if transmission works, $5700 if it doesn’t B. Blue book value is $6000 if transmission works, $5500 if it doesn’t Most of these PowerPoint chapters have two or three Active Learning activities. They break up the lecture with a short in-class activity for immediate reinforcement, application, or assessment of the material in the preceding slides. A good idea is to give students time to formulate their answers before asking for volunteers to share their answers with the class. When the questions or exercises are more complex, consider having them work in pairs. Digression on class participation: In general, it’s not a good idea to try to solicit participation by saying “Now who can tell me the answer to….”. The invariable result is regular participation by very few students – the quick thinkers who have the confidence to answer spontaneously in front of the class – while most students remain silent. When students have a bit of time to think through their answers, they are more likely to be comfortable sharing their answers with you and the class. Even better: try a simple, time-tested activity called “THINK-PAIR-SHARE.” Pair students up. Pose a question or problem. Have students work on the problem individually for a couple minutes. Then, allow a couple minutes to work in pairs: each student tries to explain to the other why his or her answer is correct, and the other offers feedback. In many cases, they come up with better answers by working together. Finally, ask for volunteers. Students are much more likely to participate since they have had the opportunity to “test” their answers on a classmate. And those who do not participate will at least have had the chance to share their answer with, and get feedback from, one other student. Activities like these are useful to break up a lecture every 20 minutes or so. They help maintain students’ attention spans, and increase their comprehension of the material you cover. These activities are also useful for quick, informal assessment – often, they will alert you to problems (such as students not getting what you think they’re getting) which you can then correct before moving on to cover additional material. End of digression. 11

12 A C T I V E L E A R N I N G 1 Answers
Cost of fixing transmission = $600 A. Blue book value is $6500 if transmission works, $5700 if it doesn’t Benefit of fixing the transmission = $800 ($6500 – 5700). It’s worthwhile to have the transmission fixed. B. Blue book value is $6000 if transmission works, $5500 if it doesn’t Benefit of fixing the transmission is only $500. Paying $600 to fix transmission is not worthwhile. 12

13 A C T I V E L E A R N I N G 1 Answers
Observations: The $1000 you previously spent on repairs is irrelevant. What matters is the cost and benefit of the marginal repair (the transmission). The change in incentives from scenario A to scenario B caused your decision to change. If you wish, you can omit this slide and just give this information to the class verbally. 13

14 The principles of HOW PEOPLE INTERACT
The principles of HOW PEOPLE INTERACT Whether we’re talking about the U.S. economy, or the local economy, the term “economy” simply means a group of people interacting with each other. These interactions play a critical role in the allocation of society’s scarce resources. For example, the interaction of buyers and sellers determines the prices of goods and the amounts produced and sold. These interactions are an important part of what economists study. 14

15 HOW PEOPLE INTERACT 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 other goods. Countries also benefit from trade & specialization: Get a better price abroad for goods they produce Buy other goods more cheaply from abroad than could be produced at home If each person had to grow his own food, make his own clothes, cut his own hair, we would have a world full of skinny, unfashionable poor people having bad hair days every day of the week. It’s far more efficient for each person to specialize in producing a good or service, and then exchanging it with other people for the things they produce. The statement “trade can make everyone better off” should not be hard to understand, if you think about it for a moment: Each of two parties would not voluntarily enter into an exchange if it made either of them worse off, now would they? The same principles apply at the national and international level: International trade allows countries to sell their exports abroad and get a higher price, and to buy things from abroad more cheaply than they could produce at home. In addition, trade gives a country’s consumers access to a greater variety of goods – including goods they might not be able to get at all. For example, U.S. consumers enjoy a variety of fresh produce year-round. This would not be possible without international trade. TEN PRINCIPLES OF ECONOMICS 15

16 HOW PEOPLE INTERACT 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 A market economy is “decentralized,” meaning that there is no government committee that makes the decisions about what goods to produce and so forth. Instead, many households and firms make their own decisions: * Each of many households decides who to work for and what goods to buy. * Each of many firms decides whom to hire and what goods to produce. TEN PRINCIPLES OF ECONOMICS 16

17 HOW PEOPLE INTERACT 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. In all versions of this textbook except Brief Principles of Macroeconomics, market efficiency and the invisible hand are covered more thoroughly in Chapter 7. TEN PRINCIPLES OF ECONOMICS 17

18 HOW PEOPLE INTERACT 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. TEN PRINCIPLES OF ECONOMICS 18

19 HOW PEOPLE INTERACT Principle #7: Governments Can Sometimes Improve Market Outcomes Important role for govt: enforce property rights (with police, courts) People are less inclined to work, produce, invest, or purchase if large risk of their property being stolen. [“Govt” is an abbreviation for government. Throughout all of the Premium PowerPoint chapters, I try to use abbreviations the way a thoughtful instructor would use them if writing on a chalkboard. If you prefer to spell the word out, just use your mouse to highlight “govt” and then type out the full word.] Two examples of the idea in the second bullet point: A restaurant won’t serve meals if customers do not pay before they leave. A music company won’t produce CDs if too many people avoid paying by making illegal copies. Many fledging market economies are struggling through the transition from central planning because they have not developed institutions that protect and enforce property rights. The British news magazine The Economist has lots of current examples of this. An older but still interesting example comes from a column that Mankiw wrote in the June 12, 2000 issue of Fortune magazine entitled “Ukraine: How Not To Run An Economy.” TEN PRINCIPLES OF ECONOMICS 19

20 HOW PEOPLE INTERACT Principle #7: Governments Can Sometimes Improve Market Outcomes Market failure: when the market fails to allocate society’s resources efficiently Causes: 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) In such cases, public policy may promote efficiency. TEN PRINCIPLES OF ECONOMICS 20

21 HOW PEOPLE INTERACT Principle #7: Governments Can Sometimes Improve Market Outcomes Govt 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. TEN PRINCIPLES OF ECONOMICS 21

22 A C T I V E L E A R N I N G 2 Discussion Questions
In each of the following situations, what is the government’s role? Does the government’s intervention improve the outcome? a. Public schools for K-12 b. Workplace safety regulations c. Public highways d. Patent laws, which allow drug companies to charge high prices for life-saving drugs The items in this list are meant to get students thinking about Principles 6 and 7 in the context of specific examples, and to generate discussion rather than arrive at definitive answers. NOTE: Discussing the entire list would consume a lot of class time (20-25 minutes). Two would suffice. Pick your favorite two and delete the others. Of course, you can skip this slide entirely if you wish to get through the chapter as quickly as possible. Here are some notes which might help guide the discussion: a. Public schools. The alternative would be private schools. The cost of education would be concentrated among those with school-aged children, rather than spread over all taxpayers, so the price per child would likely be high. Some families would not be able to afford to enroll their children in schools, and would either home-school the children or raise them without education. Is the benefit to society of having an educated population large enough to justify making people without children share in the cost? Could the private sector provide education more efficiently (either at lower cost or higher quality) than the public sector? b. Workplace safety regulations. Without such regulations, would firms provide a safe environment for their workers? Some students will say “no – look at how bad working conditions are in poor countries which have no safety regulations.” Another view is dropping such regulations would make workers better off. Workers may view the safety of their work environment as part of their wage: the less safe the environment at a specific firm, the higher the wage the firm will have to offer to make workers willing to work there. If workers vary with respect to their tolerance for unsafe conditions, then workers with a high risk tolerance would be better off if given the option to work for higher wages in factories that aren’t as safe. Such workers would be worse off if the government required all firms to provide equally safe conditions. c. Public highways. The alternative would be toll highways operated by the private sector. People who use highways more would pay more, and people that use them less would pay less, which seems fairer than having everyone pay equally for highways. (Actually, everyone does not pay equally - people who use public roads more buy more gas, and therefore pay more gas tax.) If there are external benefits to society of having a national highway system, then the private sector would under-provide this good. d. Patent laws. I’ve kind of loaded the question with the wording on the slide. If you wish, change it to just “Patent laws.” Is it fair that drug companies charge such high prices for drugs that some people need to stay alive? If drug prices are regulated, how might pharmaceutical firms respond? 22


Principle #8: A country’s standard of living depends on its ability to produce goods & services. Huge variation in living standards across countries and over time: Average income in rich countries is more than ten times average income in poor countries. The U.S. standard of living today is about eight times larger than 100 years ago. “Rich countries” refers to countries like the U.S., Japan, and Germany. “Poor countries” refers to countries like India, Indonesia, and Nigeria. TEN PRINCIPLES OF ECONOMICS 24

Principle #8: A country’s standard of living depends on its ability to produce goods & services. The most important determinant of living standards: productivity, the amount of goods and services produced per unit of labor. Productivity depends on the equipment, skills, and technology available to workers. Other factors (e.g., labor unions, competition from abroad) have far less impact on living standards. TEN PRINCIPLES OF ECONOMICS 25

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 govt creates money, the greater the inflation rate. TEN PRINCIPLES OF ECONOMICS 26

Principle #10: Society faces a short-run tradeoff between inflation and unemployment In the short-run (1 – 2 years), many economic policies push inflation and unemployment in opposite directions. Other factors can make this tradeoff more or less favorable, but the tradeoff is always present. While the long-run effect of increasing the quantity of money is inflation, the short-run effects are more complicated - and controversial. However, most mainstream economists believe the following: An increase in the quantity of money causes spending to rise, which causes prices to rise, which induces firms to produce more goods and services, which requires that they hire more workers. Hence, in the short-run, increasing the quantity of money causes inflation to rise, but unemployment to fall. Of course, REDUCING the quantity of money would have the opposite effects (inflation would fall, while unemployment would rise) in the short run. Keep in mind, though, the lesson from Principle #9: In the long run, changing the quantity of money only affects inflation. We will learn in a later chapter what determines the rate of unemployment in the long run, and we will see that it has nothing to do with the quantity of money. The second bullet addresses the following point: In some decades, due to factors outside of the control of policymakers, inflation and unemployment are both high (e.g. 1970s) – or low (e.g. 1990s). Yet, given these other factors, policymakers can always reduce unemployment temporarily by creating more inflation, or vice versa. TEN PRINCIPLES OF ECONOMICS 27

28 FYI: How to Read Your Textbook
1. Read before class. You’ll get more out of class. 2. Summarize, don’t highlight. Highlighting is a passive activity that won’t improve your comprehension or retention. Instead, summarize each section in your own words. Then, compare your summary to the one at the end of the chapter. Most new college students have not been taught good study skills, yet we professors often assume they have such skills. This is the first of four slides that summarize an FYI box which describes proven strategies for learning and retention. If you’re pressed for time, you can of course skip these slides, but please urge your students to read this FYI box. But if you can spare 30 minutes of class time, there’s a very effective activity you can do in class which lets students see for themselves the power of active reading and teaching a partner. I describe this activity in the notes section of the fourth “FYI: How to Read Your Textbook” slide. This activity could replace showing these four slides in class, though your students should still read the corresponding FYI box in the book. TEN PRINCIPLES OF ECONOMICS 28

29 FYI: How to Read Your Textbook
3. Test yourself. Try the “Quick Quiz” that follows each section before moving on to the next section. Write your answers down, compare them to the answers in the back of the book. If your answers are incorrect, review the section before moving on. 4. Practice, practice, practice. Work through the end-of-chapter review questions and problems. They are often good practice for the exams. And the more you use your new knowledge, the more solid it will become. If you do not like “They are often good practice for the exams,” please feel free to delete it. I’ve found, though, that students are more motivated to work practice problems when they think that doing so will help them earn a higher score on the exam. TEN PRINCIPLES OF ECONOMICS 29

30 FYI: How to Read Your Textbook
5. Go online. The book comes with excellent web resources, including practice quizzes, tools to strengthen your graphing skills, helpful video clips, and other resources to help you learn the textbook material more easily and effectively. Visit: 6. Study in groups. Get together with a few classmates to review each chapter, quiz each other, and help each other understand the material. If your classroom computer has a live internet connection, you should be able to click on the link and visit the textbook’s website. It’s worth taking 2-3 minutes of class time to show students the resources there. TEN PRINCIPLES OF ECONOMICS 30

31 FYI: How to Read Your Textbook
7. Teach someone. The best way to learn something is to teach it to someone else, such as a study partner or friend. 8. Don’t skip the real world examples. Read the Case Studies and “In The News” boxes in each chapter. They will help you see how the new terms, concepts, models, and graphs apply to the real world. As you read the newspaper or watch the evening news, see if you can find the connections with what you’re learning in the textbook. Here’s the activity I mentioned a few slides back. I have used it many times with terrific results. Find two newspaper articles on topical economic issues. The articles must be (1) short enough that a beginning college student can read either of them in 10 minutes or less, (2) appropriate for the lay reader, and (3) very interesting. Make enough copies for all students in your class. Use different colored paper for each article, e.g. yellow for Article 1 and blue for Article 2. In class, instruct students to pair up. In each student pair, one student is assigned Article 1, the other assigned Article 2. Tell students they will have 15 minutes to read their assigned article. Then, each student will have 5 minutes to teach the contents of his or her article to his or her partner. Tell students it is not acceptable to merely give a paragraph-by-paragraph summary when teaching their articles to their partner. Use your timer or a watch to announce when the 15 minutes are up and it’s time to start teaching. Five minutes later, announce when it’s time for the other student to teach his/her article. Five minutes later, stop the activity and re-group as a class. Ask your students the following four questions. 1) “How did you read your article, knowing that you were going to have to teach it to someone in a few minutes? Did you read it the same way as when you’re reading the paper on your own? Explain.” Ssummarize their responses on the board; you should come up with a list that includes the techniques they used to read the article. It will include things like “I took notes,” “I tried to identify the main point and the supporting information,” “I kept going back and re-reading sections of the article,” or “I kept jumping around the article, looking for connections.” After taking students responses, you can add a couple of your own if you like. 2) “Having read the article using these techniques, do you think you learned more from it and will retain more than if you read the article they way you would when you’re reading the paper on your own? Explain.” There should be a consensus that, yes, using these techniques leads to more learning and better retention. 3) “Are there any other contexts in which you might benefit from using these techniques while reading?” The students should realize the obvious answer: reading their textbooks. TEN PRINCIPLES OF ECONOMICS 31

32 CHAPTER SUMMARY The principles of decision making are:
People face tradeoffs. The cost of any action is measured in terms of foregone opportunities. Rational people make decisions by comparing marginal costs and marginal benefits. People respond to incentives. Each Premium PowerPoint chapter ends with a summary similar to the textbook’s chapter summaries. Many instructors do not cover these chapter summaries in class. 32

33 CHAPTER SUMMARY The principles of interactions among people are:
Trade can be mutually beneficial. Markets are usually a good way of coordinating trade. Govt can potentially improve market outcomes if there is a market failure or if the market outcome is inequitable. 33

34 CHAPTER SUMMARY The principles of the economy as a whole are:
Productivity is the ultimate source of living standards. Money growth is the ultimate source of inflation. Society faces a short-run tradeoff between inflation and unemployment. 34

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