Chapter
1
Ten Principles of Economics
Key Terms
• Common understanding of key terms
– 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
3
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
4
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
5
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”)
6
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
9
• 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
11
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
• Trade
– 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
13
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
14
1
The production possibilities frontier (a)
(a) Production Opportunities
Minutes needed to
Make 1 ounce of:
Farmer
Rancher
Amount produced in
8 hours
Meat
Potatoes
Meat
Potatoes
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.
15
1
The production possibilities frontier (b, c)
(b) The farmer’s production
Meat (oz) possibilities frontier
If there is no trade, the farmer
chooses this production and
consumption.
(c) The rancher’s production
Meat (oz) possibilities frontier
24
8
12
4
0
If there is no trade, the
rancher chooses this
production and consumption.
B
A
16
Potatoes (oz)
32
0
24
48
Potatoes (oz)
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
16
1
The opportunity cost of meat and potatoes
Opportunity cost of:
Farmer
Rancher
1 oz of Meat
1 oz of Potatoes
4 oz potatoes
2 oz potatoes
¼ oz meat
½ oz meat
17
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
18
Farmer’s Gains From Trade
Farmer
Potatoes
Meat
No Trade
With
32
32
0
28
29
1
24
26
2
20
23
3
16
20
4
12
17
5
8
14
6
4
11
7
0
8
8
35
30
25
20
Taters - No Trade
15
Taters - Trade
10
5
0
0
1
2
3
4
5
6
7
8
19
Rancher’s Gains From Trade
80
70
60
50
Taters - No Trade
40
Taters - Trade
30
20
10
0
24
22
20
18
16
14
12
10
8
6
4
2
0
20
2
Greg’s Final Solution (text)
(a) The farmer’s production
Meat (oz) and consumption
Farmer's
production and
consumption
without trade
8
Farmer's
consumption
with trade
0
A
16 17
Farmer's
production
with trade
32
18
B*
13
12
0
Rancher’s
production and
consumption
without trade
Rancher’s
production
with trade
24
A*
5
4
(b) The rancher’s production
Meat (oz) and consumption
Rancher’s
consumption
with trade
B
12
27
24
48
Potatoes (oz)
Potatoes (oz)
Farmer and Rancher agree to trade 5 oz of Meat for 15 oz of Potatoes (3:1)
Start at corners (specialization)
21
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
22
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
23
How People Interact
• 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
24
Table
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
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