Ten Principles of Economics

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 Ten Principles of Economics
Table 1

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 How People Make Decisions

Principle 1: People face trade-offs

Making decisions
Trade off one goal against another
Student time
Parents income
Society
National defense vs. consumer goods
Clean environment vs. high level of income
Efficiency vs. equality

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 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 must 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
Marginal benefits
Marginal costs
Take action only if:
Marginal benefits > Marginal costs

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 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 peoples behavior

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 How People Interact

Principle 5: Trade can make everyone better off

Trade
Allows each person to specialize in the
activities he or she does best
Enjoy a greater variety of goods and services at
lower cost

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 How People Interact

Principle 6: Markets are usually a good way to

organize economic activity
Adam Smiths invisible hand
Households and firms interacting in markets
Act as if they are guided by an invisible hand
Leads them to desirable market outcomes
Corollary: Government intervention
Prevents the invisible hands ability to coordinate
the decisions of the households and firms that
make up the economy

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 How People Interact

Principle 7: Governments can sometimes improve

market outcomes
We need government
Enforce rules and maintain institutions
Enforce property rights
Promote efficiency
Avoid market failure
Limit market power
Internalize externalities
Promote equality (?)
Avoid disparities in economic wellbeing

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 How the Economy as a Whole Works

Principle 8: A countrys standard of living depends

on its ability to produce goods and services
Large differences in living standards
Among countries
Over time
Explanation: differences in productivity

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 How the Economy as a Whole Works

Principle 9: Prices rise when the government prints

too much money
Inflation
An increase in the overall level of prices in the
economy
Causes for large / persistent inflation
Growth in quantity of money
Value of money falls

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 How the Economy as a Whole Works

Principle 10: Society faces a short-run trade-off

between inflation and unemployment
Short-run effects of monetary injections:
Stimulates the overall level of spending
Higher demand for goods and services
Firms raise prices; hire more workers;
produce more goods and services
Lower unemployment

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Thinking Like an Economist

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 The Economist as Policy Advisor
As scientists, economists make
positive statements,
which attempt to describe the world as it is.
As policy advisors, economists make
normative statements,
which attempt to prescribe how the world should be.
Positive statements can be confirmed or refuted,
normative statements cannot.
Govt employs many economists for policy advice.
E.g., the U.S. President has a Council of Economic
Advisors, which the author of this textbook chaired
from 2003 to 2005.
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 ACTIVE LEARNING 3
Identifying positive vs. normative

Which of these statements are positive and which

are normative? How can you tell the difference?
a. Prices rise when the government increases the
quantity of money.
b. The government should print less money.
c. A tax cut is needed to stimulate the economy.
d. An increase in the price of burritos will cause an
increase in consumer demand for music
downloads.

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 ACTIVE LEARNING 3
Answers

a. Prices rise when the government increases the

quantity of money.
Positive describes a relationship, could use
data to confirm or refute.

b. The government should print less money.

Normative this is a value judgment, cannot be
confirmed or refuted.

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 ACTIVE LEARNING 3
Answers

c. A tax cut is needed to stimulate the economy.

Normative another value judgment.

d. An increase in the price of burritos will cause an

increase in consumer demand for music
downloads.
Positive describes a relationship.
Note that a statement need not be true to be
positive.

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 Interdependence and
the Gains from Trade

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 Comparative Advantage

Absolute advantage
Produce a good using fewer inputs than
another producer
Opportunity cost
Whatever must be given up to obtain some item
Measures the trade-off between the two goods
that each producer faces

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 The Opportunity Cost of Meat and Potatoes

Table 1

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 Comparative Advantage

Comparative advantage
Produce a good at a lower opportunity cost than
another producer
Reflects the relative opportunity cost
Principle of comparative advantage
Each good - produced by the individual that has
the smaller opportunity cost of producing that
good

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 Comparative Advantage

One person
Can have absolute advantage in both goods
Cannot have comparative advantage in both
goods
For different opportunity costs
One person - comparative advantage in one
good
The other person - comparative advantage in
the other good

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 Comparative and absolute advantage

Table 1

Absolute advantage

Time needed to produce:

1 oz of Meat 1 oz of Potatoes
Farmer 60 minutes 15 minutes
Rancher 20 minutes 10 minute

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 The Market Forces of
Supply and Demand

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 The Equilibrium of Supply and Demand
Price of
Ice-Cream
Figure 8
Cones Equilibrium Supply
$3.00

2.50
Equilibrium
price 2.00 Equilibrium
quantity
1.50

1.00
Demand
0.50

0
1 2 3 4 5 6 7 8 9 10 11 12
Quantity of Ice-Cream Cones
The equilibrium is found where the supply and demand curves intersect. At the
equilibrium price, the quantity supplied equals the quantity demanded. Here the
equilibrium price is $2.00: At this price, 7 ice-cream cones are supplied, and 7 ice-
cream cones are demanded.
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 How an increase in demand affects the equilibrium
Figure 10
Price of 1. Hot weather increases the
Ice-Cream demand for ice cream . . .
Cones Supply
2. resulting in
a higher price . . .
New equilibrium
$2.50
Initial equilibrium
2.00

3. and a higher
D1 D2
quantity sold.

0 7 10 Quantity of Ice-Cream Cones

An event that raises quantity demanded at any given price shifts the demand curve to the right.
The equilibrium price and the equilibrium quantity both rise. Here an abnormally hot summer
causes buyers to demand more ice cream. The demand curve shifts from D1 to D2, which causes
the equilibrium price to rise from $2.00 to $2.50 and the equilibrium quantity to rise from 7 to 10
cones.
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 How a Decrease in Supply Affects the Equilibrium
Figure 11
Price of 1. An increase in the price of sugar reduces
Ice-Cream the supply of ice cream . . .
Cones
New equilibrium S2
2. resulting in
a higher price . . .
S1
$2.50

2.00
Initial equilibrium
3. and a smaller
quantity sold.
Demand

0 4 7 Quantity of Ice-Cream Cones

An event that reduces quantity supplied at any given price shifts the supply curve to the left. The
equilibrium price rises, and the equilibrium quantity falls. Here an increase in the price of sugar
(an input) causes sellers to supply less ice cream. The supply curve shifts from S 1 to S2, which
causes the equilibrium price of ice cream to rise from $2.00 to $2.50 and the equilibrium
quantity to fall from 7 to 4 cones.
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Elasticity and Its Application

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 The Elasticity of Demand

Computing the price elasticity of demand

Percentage change in quantity demanded
divided by percentage change in price
Use absolute value (drop the minus sign)
Midpoint method
Two points: (Q1, P1) and (Q2, P2)

(Q2 Q1 )/[(Q2 Q1 )/ 2 ]
Price elasticityof demand
(P2 P1 )/[(P2 P1 )/ 2 ]

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 Supply, Demand,
and Government Policies

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 Consumers, Producers,
and the Efficiency of Markets

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 Application:
The Costs of Taxation

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