Economics is the study of mankind,
in the ordinary business of life.
- Alfred Marshall
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Economics is a study of mankind in the ordinary
business of life; it examines that part of individual
and social action which is most closely connected
with the attainment and with the use of the material
requisites of well-being. Thus it is on the one side a
study of wealth; and on the other, and more
important side, a part of the study of man.
- Alfred Marshall, Principles of Economics,1920
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Economy. . .
. . . The word economy comes from a Greek
word for “one who manages a household.”
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TEN PRINCIPLES OF ECONOMICS
A household and an economy face many decisions:
 Who will work?
 What goods and how many of them should be
produced?
 What resources should be used in production?
 At what price should the goods be sold?
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TEN PRINCIPLES OF ECONOMICS
• Society and Scarce Resources:
• The management of society’s resources is
important because resources are scarce.
• Scarcity. . . means that society has limited
resources and therefore cannot produce all the
goods and services people wish to have.
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TEN PRINCIPLES OF ECONOMICS
Economics is the study of how society manages
its scarce resources.
Or,
Economics is the study of how society decides to
use its scarce resources.
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TEN PRINCIPLES OF ECONOMICS
Decision making is at the heart of economics
First four principles deal with how people make
decisions
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HOW PEOPLE MAKE DECISIONS
• People face trade-offs.
• The cost of something is what you give up to
get it.
• Rational people think at the margin.
• People respond to incentives.
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Principle #1: People Face Trade-offs.
• “There is no such thing as a free lunch!”
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Principle #1: People Face Trade-offs.
• To get one thing, we usually have to give up
another thing.
•
•
•
•
Guns v. butter
Food v. clothing
Leisure time v. work
Efficiency v. equity
Making decisions requires trading
off one goal against another.
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Principle #1: People Face Trade-offs
• Efficiency v. Equity
• Efficiency means society gets the most that it can
from its scarce resources.
• Equity means the benefits of those resources are
distributed fairly among the members of society.
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Principle #2: The Cost of Something Is
What You Give Up to Get It.
• Decisions require comparing costs and benefits
of alternatives.
• Whether to go to college or to work?
• Whether to study or go out on a date?
• Whether to go to class or sleep in?
• The opportunity cost of an item is what you
give up to obtain that item.
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Principle #2: The Cost of Something Is
What You Give Up to Get It.
• Basketball star
LeBron James
understands
opportunity costs and
incentives. He chose
to skip college and go
straight from high
school to the pros
where he earns
millions of dollars.
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Principle #3: Rational People Think at the
Margin.
• Marginal changes are small, incremental
adjustments to an existing plan of action.
People make decisions by comparing
costs and benefits at the margin.
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Principle #3: Rational People Think at the
Margin.
• Rational people systematically and
purposefully do the best to achieve their
objectives.
• Firms want to produce the level of output that
maximizes their profits.
• Consumers buy goods to obtain the greatest level of
satisfaction
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Choosing a Coffee Maker
On/Off Switch
No Auto shut-off
Made by: Toastmaster
Programmable
1-hour Auto shut-off
Made by: Mr. Coffee
$5.99
$15.99
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Principle #3: Rational People Think at the
Margin.
• Why is water so cheap?
• Why are diamonds so expensive?
• Think of the answers in terms of marginal
benefit and scarcity.
- based on the marginal benefit that an extra unit of the
good would yield.
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Principle #4: People Respond to
Incentives.
• Marginal changes in costs or benefits motivate
people to respond.
• When the price of a good rises, consumers will buy
less of it.
• The decision to choose one alternative over
another occurs when that alternative’s marginal
benefits exceed its marginal costs!
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A C T I V E L E A R N I N G 1:
Exercise
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?
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
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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.
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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 (sunk cost). 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.
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HOW PEOPLE INTERACT
• Trade can make everyone better off.
• Markets are usually a good way to organize
economic activity.
• Governments can sometimes improve
economic outcomes.
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Principle #5: Trade Can Make Everyone
Better Off.
• People gain from their ability to trade with one
another.
• Trade is not like a sport where someone loses
• Competition results in gains from trading.
• Trade allows people to specialize in what they
do best.
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Principle #6: Markets Are Usually a Good
Way to Organize Economic Activity.
• A market economy is an economy that allocates
resources through the decentralized decisions of
many firms and households as they interact in
markets for goods and services.
• Households decide what to buy and where to work.
• Firms decide who to hire and what to produce.
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Principle #6: Markets Are Usually a Good
Way to Organize Economic Activity.
• Adam Smith made the observation that
households and firms interacting in markets act
as if guided by an “invisible hand.”
• Because households and firms look at prices when
deciding what to buy and sell, they unknowingly
take into account the social costs of their actions.
• As a result, prices guide decision makers to reach
outcomes that tend to maximize the welfare of
society as a whole.
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Principle #7: Governments Can
Sometimes Improve Market Outcomes.
• Markets work only if property rights are
enforced.
• Property rights are the ability of an individual to
own and exercise control over a scarce resource
• That is, the right to ownership and the right to sell
anything that he owns/produces.
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Principle #7: Governments Can
Sometimes Improve Market Outcomes.
• Market failure occurs when the market fails to
allocate resources efficiently.
• When the market fails (breaks down)
government can intervene to promote efficiency
and equity.
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Principle #7: Governments Can
Sometimes Improve Market Outcomes.
• Market failure may be caused by:
• an externality, which is the impact of one person or
firm’s actions on the well-being of a bystander.
• such as pollution
• market power, which is the ability of a single
person or firm to unduly influence market prices.
• monopoly, one large producer who controls the market
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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
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HOW THE ECONOMY AS A
WHOLE WORKS
• A country’s standard of living depends on its
ability to produce goods and services.
• Prices rise when the government prints too
much money.
• Society faces a short-run trade-off between
inflation and unemployment.
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Principle #8: A Country’s Standard of Living
Depends on Its Ability to Produce Goods and
Services.
• Standard of living may be measured in different
ways:
• By comparing personal incomes.
• By comparing the total market value of a nation’s
production.
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Principle #8: A Country’s Standard of Living
Depends on Its Ability to Produce Goods and
Services.
• Almost all variations in living standards are
explained by differences in countries’
productivities.
• Productivity is the amount of goods and
services produced from each hour of a worker’s
time.
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GDP growth is based on Productivity
growth
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Principle #9: Prices Rise When the
Government Prints Too Much Money.
• Inflation is an increase in the overall level of
prices in the economy.
• One cause of inflation is the growth in the
quantity of money.
• When the government creates large quantities
of money, the value of the money falls.
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Principle #10: Society Faces a Short-run Tradeoff between Inflation and Unemployment.
• More money  More spending  More demand
• Short run this causes firms to hire more workers
• Leads to lower unemployment, but also inflation
• Inflation or unemployment?
• It’s a short-run trade-off!
• The trade-off plays a key role in the analysis of
the business cycle—fluctuations in economic
activity, such as employment and production
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Summary
• The principles of personal decision making
are:
–
–
–
–
People face trade-offs.
The cost of something is what you give up to get it.
Rational people think at the margin.
People respond to incentives.
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Summary
• The principles of economic interaction are:
– Trade can make everyone better off.
– Markets are usually a good way to organize
economic activity.
– Governments can sometimes improve market
outcomes.
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Summary
• The principles of the economy as a whole are:
– A country’s standard of living depends on its
ability to produce goods and services.
– Prices rise when the government prints too much
money.
– Society faces a short-run trade-off between
inflation and unemployment.
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For next class
1. Read Chapter 2
2. Practice Problems –
Study Guide –
Review Terms and Definitions (1-18)
True/False Questions (1-15)
Multiple Choice Questions (1-20)
Mankiw Text –
Problems and Applications (1e, 3, 5, 7, 8, 9b, 14)
Quiz on Chapter 1 Due Next Thursday
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