Week1 Chapter1 Ten Principles

Microeconomics
Fifth Edition
PRINCIPLES OF
By N. Gregory Mankiw
2009 Cengage Learning
1
Ten Principles of Economics
Overview
Economics is a broad-ranging discipline, both in the
questions it asks and methods it uses to seek answers.
Many of the worlds most pressing problems are

economic in nature:
Recessions: how can we prevent/reserse economic downturns? Poverty: how can we reduce poverty domestically and internationally?
Climate change: how can reduce greenhouse gas emissions?

TEN PRINCIPLES OF ECONOMICS
CHAPTER 1
In this chapter, look for the answers to these questions:
What kinds of questions does economics

address?
What are the principles of how people make

decisions?
What are the principles of how people interact? What are the principles of how the economy as a
whole works?
CHAPTER 1
What Economics Is All About

Scarcity refers to the limited nature of societys
resources.
Economics is the study of how society manages

its scarce resources, including how people decide how much to work, save, and spend, and what to buy how firms decide how much to produce, how many workers to hire how society decides how to divide its resources between national defense, consumer goods, protecting the environment, and other needs
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS
HOW PEOPLE MAKE DECISIONS

Decision making is
at the heart of economics.
The first four

principles deal with how people make decisions.
CHAPTER 1
Principle #1: People Face Tradeoffs

All decisions involve tradeoffs. Examples:
Going to a party the night before your midterm

leaves less time for studying.
Having more money to buy stuff requires working

longer hours, which leaves less time for leisure.
Protecting the environment requires resources

that might otherwise be used to produce consumer goods.

Society faces an important tradeoff: efficiency vs. equity efficiency: Society is getting the maximum benefits from its scarce resources Refers to the size of the economic pie Example: the economy is operating at full potential
- There is no unemployed labor - There is no unused capital
equity: Benefits are uniformly distributed among memders of a society Refers to how the economic pie is slided Example: Every household in the country has the same level of
income
CHAPTER 1
The cost of increased equality is a reduction in

the efficient use of our scare resources
Tradeoff: To increase equity, can redistribute

income from the well-off to the poor.
But this reduces the incentive to work and produce,

and shrinks the size of the economic pie.

Scarcity and the fundamental economic questions
1. What should be produced?
Producing one thing requires to giving up another
Every society must decide what it will produce with its scare resources There are many ways to produce G&S Every society must decide how it will produce its G&S
2. How should goods & services (G&S) be produced?
3. For whom should G&S be produced? If a good or service is produced, a decision must be made about who will get it Every society must decide how to distribute the wealth acquired from its scarce resources
Principle #2: The Cost of Something Is What You Give Up to Get It
Making decisions requires comparing the costs

and benefits of alternative choices.
It is the relevant cost for decision making.
It is not always as obvious as they might appear
CHAPTER 1
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Principle #2: The Cost of Something Is What You Give Up to Get It

What are the costs associated with a college education? Money spent on tuition, fees, room and board, books Even if you were not in college, you would still need to eat & have a place to live. What would you be doing if you were not in college? Working-Earning a wage Forgone wages are cost of going to college
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Principle #2: The Cost of Something Is What You Give Up to Get It The opportunity cost of any item is whatever must be
given up to obtain it.
The accounting cost of an item is the total monetary

value of expenditures for an item.
Opportunity costs=economic costs Opportunity costs are different from accounting costs Opportunity costs of going college Tuition and fees Books Without wages
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Principle #3: Rational People Think at the Margin
A person is rational if she systematically and

purposefully does the best she can to achieve her objectives.
Many decisions are not all or nothing,

but involve marginal changes incremental adjustments to an existing plan.
Evaluating the costs and benefits of marginal

changes is an important part of decision making.
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What does at the margin" mean in this context? Economists often speak in terms of `marginal' this
or that - Marginal product (Y/ X) - Marginal revenue (dTR/dQ) - Marginal utility - Marginal rate of substitution - Marginal rate of transformation - and on and on Rational decision makers take an action only if the marginal benefit of the action exceeds the marginal cost.
CHAPTER 1
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Examples:
A student considers whether to go to college

for an additional year, comparing the fees & foregone wages to the extra income he could earn with an extra year of education.
A firm considers whether to increase output,

comparing the cost of the needed labor and materials to the extra revenue.
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As an individual, a person tries to be as `happy' as

possible, and decisions are made about the incremental costs and benefits of a course of action
Example: Pho Restaurant Each Pho costs $1 The first Pho tastes delicious, and you were
hungry...definitely worth your dollar! The second Pho tastes good, but you're not so hungry anymore...still worth a dollar though The third Pho is still tasty, but you are starting to feel really full You feel ill and another Pho will put you over the edge...no way are you paying for a fourth Pho!
CHAPTER 1
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What are the marginal costs and benefits?
The marginal cost (i.e. the cost of the next Pho) is

always $1
However, the marginal benefit (i.e. the `happiness'

you get from eating the next Pho) decreases as you eat more and more of them.
So, after eating a three Phos, the `happiness' you'll

get from eating the fourth Pho (the marginal benefit) is not worth $1 (the marginal cost) so you choose not to buy it.
You'll keep buying and eating Phos as long as

marginal benefit > marginal cost!
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Principle #4: People Respond to Incentives
incentive: something that induces a person to act,

i.e. the prospect of a reward or punishment.
Rational people respond to incentives because they

make decisions by comparing costs and benefits. Examples: In response to higher gas prices, sales of hybrid cars (e.g., Toyota Prius) rise. In response to higher cigarette taxes, teen smoking falls. Incentives implemented by the government change the marginal costs or benefits and hence may change behavior.
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ACTIVE LEARNING
Exercise
1:
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 doesnt B. Blue book value is $6000 if transmission works, $5500 if it doesnt
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ACTIVE LEARNING
Answers
1:
Cost of fixing transmission = $600

A. Blue book value is $6500 if transmission works, $5700 if it doesnt
Benefit of fixing the transmission = $800 ($6500 5700). Its worthwhile to have the transmission fixed.
B. Blue book value is $6000 if transmission works, $5500 if it doesnt
Benefit of fixing the transmission is only $500. Paying $600 to fix transmission is not worthwhile.
20
ACTIVE LEARNING
Answers
Observations:
1:
The $1000 you previously spent on repairs is

irrelevant. 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

An economy is just
a group of people interacting with each other.
The next
three principles deal with how people interact.
CHAPTER 1
22
HOW PEOPLE INTERACT
Principle #5: Trade Can Make Everyone Better Off
Rather than being self-sufficient, people can

specialize in producing one good or service and exchange it for other goods.
Countries also benefit from trade & specialization:
get a better price abroad for goods they
produce buy other goods more cheaply from abroad than could be produced at home
CHAPTER 1
23
Principle #5: Trade Can Make Everyone Better Off

Gains From Trade Examples:
Colombia excels at coffee production but is not good at

manufacturing autos
Japan's land and climate are not suitable for growing

coffee but has a highly efficient auto industry
It is wise for each country to specialize in the activity

where they have the advantage and then trade with the other
Otherwise, each country would have to allocate scarce

resources to the inefficient production of goods and services that they do not have an advantage in
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HOW PEOPLE INTERACT
Principle #6: Markets Are Usually A Good Way to Organize Economic Activity
A market is a group of buyers and sellers.

(They need not be in a single location.)
Organize economic activity means determining
what goods to produce how to produce them how much of each to produce who gets them
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HOW PEOPLE INTERACT
In a market economy, these decisions result from

the interactions of many households and firms.
Famous insight by Adam Smith in

The Wealth of Nations (1776): Each of these households and firms acts as if led by an invisible hand to promote general economic well-being.
CHAPTER 1
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HOW PEOPLE INTERACT
The invisible hand works through the price system:
The interaction of buyers and sellers

determines prices of goods and services.
Each price reflects the goods value to buyers

and the cost of producing the good.
Prices guide self-interested households and

firms to make decisions that, in many cases, maximize societys economic well-being.
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HOW PEOPLE INTERACT
Principle #7: Governments Can Sometimes Improve Market Outcomes
Important role for govt: enforce property rights

(with police, courts)
People are less inclined to work, produce, invest, or

purchase if large risk of their property being stolen.
A restaurant wont serve meals if customers do not pay before they leave. A music company wont produce CDs if too many people avoid paying by making illegal copies.
CHAPTER 1
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HOW PEOPLE INTERACT
Govt may alter market outcome to promote efficiency market failure, when the market fails to allocate
societys resources efficiently. Causes: externalities, when the production or consumption of a good affects bystanders (e.g. pollution) market power, a single buyer or seller has substantial influence on market price (e.g. monopoly)
In such cases, public policy may increase efficiency.

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HOW PEOPLE INTERACT
Govt may alter market outcome to promote equity If the markets distribution of economic well-being
is not desirable, tax or welfare policies can change how the economic pie is divided.
CHAPTER 1
30
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 governments role? Does the governments 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
The last three

principles deal with the economy as a whole.
CHAPTER 1
32
Principle #8: A countrys standard of living depends on its ability to produce goods & services.
Huge variation in living standards across

countries and over time:
Average income in rich countries is more than

ten times average income in poor countries. The U.S. standard of living today is about eight times larger than 100 years ago.
CHAPTER 1
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Principle #8: A countrys standard of living depends on its ability to produce goods & services.
The most important determinant of living standards:

productivity, the amount of goods and services produced per unit of labor.
Productivity depends on the equipment, skills, and

technology available to workers.
Other factors (e.g., labor unions, competition from

abroad) have far less impact on living standards.
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Principle #9: Prices rise when the government prints too much money.
Inflation: increases in the general level of prices. In the long run, inflation is almost always caused
by excessive growth in the quantity of money, which causes the value of money to fall.
The faster the govt creates money,

the greater the inflation rate.
CHAPTER 1
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Principle #10: Society faces a short-run tradeoff between inflation and unemployment
In the short-run (1 2 years),

many economic policies push inflation and unemployment in opposite directions.
Other factors can make this tradeoff more or less

favorable, but the tradeoff is always present.
CHAPTER 1
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FYI: How to Read Your Textbook

1. Summarize, dont highlight. Highlighting is a passive activity that wont improve your comprehension or retention. Instead, summarize each section in a few sentences of your own words. When you finish, compare your summary to the one at the end of the chapter. 2. Test yourself. Try the QuickQuiz that follows each section before moving on to the next section. Write your answers down, and compare them to the answers in the back of the book. If your answers are incorrect, review the section before moving on.
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3. Practice, practice, practice. Work through the end-of-chapter review questions and problems. They are often good practice for the exams. And the more you use your new knowledge, the more solid it will become. 4. Go online. The book comes with excellent web resources, including practice quizzes, tools to strengthen your graphing skills, helpful video clips, and other resources to help you learn the textbook material more easily and effectively.
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5. Study in groups. Get together with a few of your classmates to review each chapter, quiz each other, and help each other understand the material in the chapter.
6. Dont forget the real world. Read the Case Studies and In The News boxes in each chapter. They will help you see how the new terms, concepts, models, and graphs apply to the real world. As you read the newspaper or watch the evening news, see if you can find the connections with what youre learning in the textbook.
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CONCLUSION
Economics offers many insights about the
behavior of people, markets, and economies.
It is based on a few ideas that can be applied

in many situations.
Whenever we refer back to one of the

Ten Principles from this chapter, you will see an icon like this one:
CHAPTER 1
40
CHAPTER SUMMARY The principles of decision making are:
People face tradeoffs. The cost of any action is measured in terms of

foregone opportunities.
Rational people make decisions by comparing

marginal costs and marginal benefits.
People respond to incentives.
CHAPTER 1
41
CHAPTER SUMMARY The principles of interactions among people are:
Trade can be mutually beneficial. Markets are usually a good way of

coordinating trade.
Govt can potentially improve market

outcomes if there is a market failure or if the market outcome is inequitable.
CHAPTER 1
42
CHAPTER SUMMARY The principles of the economy as a whole are:
Productivity is the ultimate source of living

standards.
Money growth is the ultimate source of

inflation.
Society faces a short-run tradeoff between

inflation and unemployment.
CHAPTER 1
43

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Microeconomics

2009 Cengage Learning

Many of the worlds most pressing problems are

Climate change: how can reduce greenhouse gas emissions?

In this chapter, look for the answers to these questions:

What kinds of questions does economics

What are the principles of how people make

TEN PRINCIPLES OF ECONOMICS

What Economics Is All About

Economics is the study of how society manages

HOW PEOPLE MAKE DECISIONS

The first four

TEN PRINCIPLES OF ECONOMICS

HOW PEOPLE MAKE DECISIONS

Principle #1: People Face Tradeoffs

Going to a party the night before your midterm

Having more money to buy stuff requires working

Protecting the environment requires resources

HOW PEOPLE MAKE DECISIONS

Principle #1: People Face Tradeoffs

TEN PRINCIPLES OF ECONOMICS

HOW PEOPLE MAKE DECISIONS

Principle #1: People Face Tradeoffs

The cost of increased equality is a reduction in

Tradeoff: To increase equity, can redistribute

But this reduces the incentive to work and produce,

Principle #1: People Face Tradeoffs

1. What should be produced?

Producing one thing requires to giving up another

2. How should goods & services (G&S) be produced?

HOW PEOPLE MAKE DECISIONS

Principle #2: The Cost of Something Is What You Give Up to Get It

Making decisions requires comparing the costs

It is the relevant cost for decision making.

It is not always as obvious as they might appear

TEN PRINCIPLES OF ECONOMICS

HOW PEOPLE MAKE DECISIONS

Principle #2: The Cost of Something Is What You Give Up to Get It

HOW PEOPLE MAKE DECISIONS

The accounting cost of an item is the total monetary

HOW PEOPLE MAKE DECISIONS

Principle #3: Rational People Think at the Margin

A person is rational if she systematically and

Many decisions are not all or nothing,

Evaluating the costs and benefits of marginal

HOW PEOPLE MAKE DECISIONS

Principle #3: Rational People Think at the Margin

HOW PEOPLE MAKE DECISIONS

Principle #3: Rational People Think at the Margin

A student considers whether to go to college

A firm considers whether to increase output,

Principle #3: Rational People Think at the Margin

As an individual, a person tries to be as `happy' as

Principle #3: Rational People Think at the Margin

The marginal cost (i.e. the cost of the next Pho) is

However, the marginal benefit (i.e. the `happiness'

So, after eating a three Phos, the `happiness' you'll

You'll keep buying and eating Phos as long as

HOW PEOPLE MAKE DECISIONS

Principle #4: People Respond to Incentives

incentive: something that induces a person to act,

Rational people respond to incentives because they

Cost of fixing transmission = $600