Ten Principles of Economics
The scarcity of nearly all resources
requires that we manage their use –
we simply cannot produce all of the
goods and services that people
would wish to have…
…each member of society cannot
have everything they might want or
achieve the highest standard of living
to which they might aspire…
Economics is the study of how individuals
and societies make decisions about how to
utilize their scarce resources…
Resources are generally placed into one of three
categories (or “Factors of Production”)…
“Land” refers to the materials
required to produce goods and
services
“Labor” refers to the manpower
required to produce goods and
services
“Capital” refers to the equipment,
machinery and facilities required
to produce goods and services
How people make decisions…
Principle #1: Trade-offs
(There is no such thing as a free lunch!)
To get one thing
we want, we often
have to give up
something else we
want
Making decisions
often require that
we trade-off one
goal against
another
Some classic economic trade-offs:
• “Guns or Butter” – National defense or Consumer goods?
• Clean environment or Lower prices and Higher income?
• “Equality or Efficiency” – Government redistribution of wealth (welfare,
unemployment, Medicare, etc.) helps promote equality in society but reduces
incentives for maximizing production (loss of profit through taxation)
Principle #2: Cost-Benefit Analysis
Every decision
had both costs
and benefits!
(Oh, what could have been!)
The costs (or
benefits) of a decision
aren’t always obvious:
• Time
• Loss of resources that
could be used for other
goals
• Loss of currently available
alternative opportunities
and activities
• Reputation
• Future opportunities or
consequences
The goals and resources that you give up to get something
are called the Opportunity Cost of that decision.
Principle #3: Rationality
(Living on the edge!)
This child faces a decision about whether to
add one more block to her tower. She must
consider:
•
The extra block will make her tower taller and
more impressive (benefit)
• The extra block will make the tower fall (cost)
She is considering a “marginal change” in her
plan of action by weighing the marginal costs
and marginal benefits of adding a block.
Most of our decisions are not black or white, they
are in the gray area - at the margin, or edge – does
the marginal benefit outweigh the marginal cost of
one added unit of resource (material, time, effort)?
A Case in Point…
Pricing for Stand-by Flights
A 200 seat airplane
costs $100,000
dollars to fly
The average cost
per passenger is
therefore $500
Never sell tickets
for less than
$500
But what if there are empty seats on the flight?
Each empty seat
costs the airline
$500.
If the seat is sold for
$300, only the marginal
(extra cost) of that
passenger is lost since
the seat would be empty
anyway ($500 lost)
The only marginal
cost is the peanuts
and soda the
passenger gets ($3).
So, it is better to sell the seat for less than $500 than
to let it go empty (the marginal benefit - $300 – is
greater than the marginal cost – ($3 for soda and a
bag of peanuts)
Principle #4: Incentives
(What’s in it for me?)
People will work hard for rewards
and go out of their way to avoid
punishment. This basic
psychological idea is the foundation
of all economic behavior – the rest
is detail.
Some examples:
• High prices punish consumers (so they buy less), but reward producers (they will
make more)
• Low interest rates punish savers (they get less for saving) but reward borrowers (they
have to pay less for their loans)
• Tax deductions for mortgage interest reward homeowners (they pay less tax) and
encourage people to buy houses
• Higher gas taxes would reward (and so encourage) carpooling, hybrid cars and use
of public transportation
A Case in Point…
The National Seatbelt Law
Before seatbelts…
Takes longer
Drive slowly
and carefully?
The requirement of seat
belts changed the
incentives for drivers
Drive slowly
and carefully?
Arrive safely,
survive
accidents
Drivers were rewarded for
slow speeds with more safety
– fewer accidents
Drive slowly
and carefully!
After seatbelts…
Takes
longer
Drive much
faster!
Arrive safely,
survive accidents
and changed their behavior –
more accidents, more pedestrian
deaths, fewer passenger deaths
How people interact…
Principle #5: Trade
Allows nations to
specialize in what they
do best and have
resources to produce.
Allows nations to
enjoy a greater
variety of goods
and services
(Everyone wins when trade is fair and free)
Competition can
keep prices lower
Can lead to more
efficient, costeffective use of
resources
Some trade terms…
Balance of Trade: the balance between a
nation’s exports (goods sold to trading
partners – money in!) and imports (goods
bought from trading partners – money
out!)
Trade Deficit: imports (money
out!) outweigh exports (money in!)
Imports
Trade Surplus: exports (money in!)
outweigh imports (money out!)
Imports
Exports
Money in
Exports
Imports
Exports
Money out
Money in
We spend more on foreign goods
than we make selling our goods
Money out
We make more from selling our goods
than we lose buying foreign goods
Principle #6: Markets
The “Invisible
Hand” was coined
by Adam Smith to
describe the
behavior of
people in a
market
(The Invisible Hand that drives the economy)
The “Invisible
Hand” uses price
to guide the selfinterested
behavior of
people interacting
in a market
A market economy is one
in which buyers
(consumers) and sellers
(producers) interact – all
trying independently to
minimize their costs and
maximize their benefits…
The result of their interactions is
the regulation of prices and the
available quantity of goods and
services – without a centralized
decision-maker.
A Case in Point…
The Demise of the Sony Walkman
As the iPod became popular,
demand for the Walkman
decreases, by fall 2002, the
Walkman sells for $78!
Behold the Walkman
– take your music with
you!! - $259.00
Enter the iPod –
smaller, more capacity,
no tapes!! - $299.00
In the market for personal audio
devices, consumer demand and
producer innovation (iPod Touch,
iPhone, iPad – all with audio) have
determined both the quantity, type
and price of players available.
Apple Launches iTunes in 2003,
demand for iPods grows.
Walkman can be bought for under
$30 !!
Principle #7: Government
(A helping hand for the Invisible Hand)
Government
protects property
rights through rules
and regulations
Without these
protections, there
would be less
incentive to produce
Government action in the economy serves one of two specific goals:
Promote
efficiency
The
Economic
Pie
Make more and bigger pies:
•
Increase efficiency of production
and use of resources – encourage
production and investment
• Prevent harmful externality (negative
impact of a person’s actions on the
well being of others) – ex. Pollution
• Prevent market power (the ability of
one person to control market prices)
– ex. monopolies
Promote
equality
Divide the pie more evenly:
• Use income taxes and public
programs to achieve a more equal
distribution of economic well-being
• Balance economic inequalities
created by social prejudices and
discrimination
How the Economy works as a Whole…
Principle #8: Productivity
(Got to keep producing stuff)
Productivity is the amount of goods
and services produced by a unit of
labor.
Productivity =
Standard of Living
Average Income
Some Key Factors: Education of labor
force, quality tools and technology
Principle #9: Inflation (The cost of having too much money!)
Inflation is a general rise in the prices of
goods and services. It can come from
three sources (all related to quantity of
money):
Demand Pull: Too
much money chasing
after too few goods
(very high demand for
a good raises prices)
Government allows too
much money in
circulation: Lowers the
value of the money, raising
prices of goods
Cost Push: Something
happens to raise the cost
of producing a good or
service (raising the price
of the good)
Principle #10: Inflation and Unemployment
(More Trade-off)
Here’s how the trade-off works:
•
•
These are short-run effects that
can be manipulated by
government policy to respond to
the business cycle (fluctuations in
employment and production).
•
•
Increasing money stimulates spending and demand
Higher spending and demand raises prices
(increasing inflation)
Higher spending and demand also encourages
businesses to hire workers (decreasing
unemployment)
Decreasing money does the opposite
So, lets review…
• People make trade-offs in all economic decisions (No free lunches!)
• The cost of something is exactly what you give up to get it (Opportunity cost!)
• Rational people make decisions at the margins (The cost/benefit of just one
more!)
• People respond and act according to incentives (What’s in it for me!)
• Trade can make everybody better off (Variety is the spice of life!)
• Markets are a good way to regulate price and quantity of goods (The helpful
Invisible Hand!)
• Governments can sometimes improve market outcomes (Helping the helpful
Invisible Hand!)
• Productivity determines Standard of Living (Must keep producing goods!)
• Inflation is almost always about too much money (The cost of too much
money!)
• In the short-run we trade-off between inflation and unemployment (Wiggle
room!)
Terminology
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Scarcity
Economics
Trade-off
Efficiency
Equality
Opportunity Cost
Cost/Benefit Analysis
Rationality
Margin
Marginal Change
Marginal Cost
Marginal Benefit
Incentive
Market Economy
Invisible Hand
Property Rights
Market Failure
Externality
Market Power
Productivity
Inflation
Demand Push
Cost Pull
Trade Surplus
Trade Deficit
Trade Balance
Business Cycle
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Limits on the availability of nearly all resources
The study of how we make decisions about how to use our scarce resources
Giving up one item/goal in order to achieve another item/goal
Society getting the most that it can out of its resources
Distributing economic prosperity uniformly among members of society
Whatever is given up in order to obtain some item/goal
Weighing the relative importance of the costs and benefits of a decision
Systematically doing the best possible to achieve goals given available opportunity
The edge (adding or subtracting one more unit of something)
Small, incremental changes in a plan to achieve a goal
The cost of adding one more unit of something
The benefit of adding one more unit of something
A reward, positive outcome that encourages an action(disincentive is the opposite)
An economy that uses resources according to the interaction of many people
Self-interest that guides and regulates a market through the price of goods
The right to own and exercise control over one’s scarce resources
When a market, left on its own, fails to use resources efficiently
The effect of one person’s actions on the well-being of others
The ability of a single person to substantially impact market prices
Quantity of goods and services produced by one unit of labor
General increase in prices
Inflation caused by too much money chasing too few goods (too high demand)
Inflation caused by rising prices of production (land, labor, capital)
When the value of exports exceeds the value of imports
When the value of imports exceeds the value of exports
When the value exports and imports is equal
Normal fluctuations in production and employment