1. Ten Principles of Economics1
Ten Principles of Economics

2. 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

3. 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

4. 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

5. 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

6. 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”)

7. 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

8. 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!

9. 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

10. 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

11. 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

12. 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.

13. 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

14. 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

15. The production possibilities frontier (a)1
The production possibilities frontier (a)
(a) Production Opportunities
Minutes needed to
Make 1 ounce of:
Amount produced in
8 hours
Meat
Potatoes
Farmer
Rancher
60 min/oz
20 min/oz
15 min/oz
10 min/oz
8 oz
24 oz
32 oz
48 oz
Panel (a) shows the production opportunities available to the farmer and the rancher.

16. The production possibilities frontier (b, c)1
The production possibilities frontier (b, c)
(b) The farmer’s production
possibilities frontier
(c) The rancher’s production
possibilities frontier
Meat (oz) 4 8
Meat (oz) 12 24
If there is no trade, the rancher chooses this production and consumption.
If there is no trade, the farmer chooses this production and consumption. B A
Potatoes (oz) 16 32
Potatoes (oz) 24 48
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

17. The opportunity cost of meat and potatoes1
The opportunity cost of meat and potatoes
Opportunity cost of:
1 oz of Meat
1 oz of Potatoes
Farmer
Rancher
4 oz potatoes
2 oz potatoes
¼ oz meat
½ oz meat

18. 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 trade

19. Farmer’s Gains From Trade
Potatoes
Meat
No Trade
With 32 28 29 1 24 26 2 20 23 3 16 4 12 17 5 8 14 6 11 7

20. Rancher’s Gains From Trade

21. Greg’s Final Solution (text)2
Greg’s Final Solution (text)
(a) The farmer’s production
and consumption
(b) The rancher’s production
and consumption
Meat (oz) 4 8
Meat (oz) 12 24
Farmer's
production and
consumption
without trade
Rancher’s production with trade
Rancher’s production and consumption without trade
Farmer's
consumption
with trade 18 12 13 B* A* 27
Rancher’s consumption with trade B 5
Farmer's
production
with trade 17 A
Potatoes (oz) 16 32
Potatoes (oz) 24 48
Farmer and Rancher agree to trade 5 oz of Meat for 15 oz of Potatoes (3:1)
Start at corners (specialization)

22. 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

23. 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

24. 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

25. Ten principles of economics1
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