PRINCIPLES

Microeconomics
OF

By N. Gregory Mankiw

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CHAPTER 1

TEN PRINCIPLES
OF ECONOMICS
WHAT
ECONOMICS
IS ALLrefers to
Scarcity
the limited nature of
ABOUT
society’s resources.
What Economics Is All About

Economics is the study of how socie

manages its scarce resources, inclu
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
 HOW PEOPLE MAKE DECISIONS 0

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.
 HOW PEOPLE MAKE DECISIONS

Principle #1: People Face Tradeoffs

• Society faces an important trade off: efficiency vs. equality

• 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

• Equality:
⚬ Benefits are uniformly distributed among members of a
society
⚬ Refers to “how the economic pie is slided”
⚬ Example: Every household in the country has the same
level of income
 0

HOW PEOPLE MAKE DECISIONS

Principle #1: People Face Tradeoffs

• The “cost” of increased equality is a reduction in

the efficient use of our scare resources

• Tradeoff: To increase equality, 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.”
 HOW PEOPLE MAKE
DECISIONS
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
 HOW PEOPLE MAKE DECISIONS

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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 HOW PEOPLE MAKE DECISIONS
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
 HOW PEOPLE MAKE DECISIONS

Principle #2: The Cost of Something Is

What You Give Up to Get It

• Opportunity costs of
going college
⚬Tuition and fees
⚬Books
⚬Without wages
 HOW PEOPLE MAKE DECISIONS

Principle #3: Rational People Think at

the Margin
• A person is rational if he systematically and
purposefully does the best she can achieve his
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.
 HOW PEOPLE MAKE DECISIONS

Principle #3: Rational People Think at

the Margin

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.
 HOW PEOPLE MAKE DECISIONS

Principle #3: Rational People Think at

the Margin

Examples:
• A firm considers
whether to increase
output, comparing the
cost of the needed
labor and materials to
the extra revenue.
 HOW PEOPLE MAKE DECISIONS
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.
 HOW PEOPLE MAKE DECISIONS
Principle #4: People Respond to
Incentives

• Examples:
⚬In response to higher gas
prices,
sales of “hybrid” cars, e-cars 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.
 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
 Principle #5: Trade Can Make
Everyone Better Off
Gains From Trade
Examples:
• Vietnam 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
 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
 HOW PEOPLE INTERACT

Principle #6: Markets Are Usually

A Good Way to Organize Economic
Activity
• 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.
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 HOW PEOPLE INTERACT
Principle #6: Markets Are Usually
A Good Way to Organize Economic
Activity
• The invisible hand works through the price system:
⚬The interaction of buyers and sellers
determines prices of goods and services.
⚬Each price reflects the good’s 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
society’s economic well-being.
 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 won’t serve meals if customers
do not pay before they leave.
⚬A music company won’t produce CDs if too many
people avoid paying by making illegal copies.

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 HOW PEOPLE INTERACT

Principle #7: Governments Can

Sometimes Improve Market
Outcomes
• Govt may alter market outcome to promote
efficiency
• Market failure, when the market fails to
allocate society’s 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

Principle #7: Governments Can

Sometimes Improve Market Outcomes
• Govt may alter market outcome to promote equity
• If the market’s distribution of economic well-being
is not desirable, tax or welfare policies can change how the
economic “pie” is divided.
 HOW THE ECONOMY AS A WHOLE
WORKS
Principle #8: A country’s 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.
 HOW THE ECONOMY AS A WHOLE
WORKS
Principle #8: A country’s 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. <nu
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 HOW THE ECONOMY AS A WHOLE WORKS

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.
 HOW THE ECONOMY AS A WHOLE WORK

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.
 C O N C LU S I O N

• 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.