Burgess Principles of Macro Economics: Econ 1010 1

Econ 1010-1

Topic 1: Ten Principles of Economics

1. Introduction

2. How People Make Decisions: Principles 1- 4

3. How People Interact: Principles 5 – 7

4. How the Economy as a Whole Works: Principles 8 – 10

5. Summary

1. Introduction

The word economy comes from a Greek word for “one who manages a household.”

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?

Economics is the study of how society manages its scarce resources.

Economists study:

How people make decisions.

How people interact with each other.

The forces and trends that affect the economy as a whole

Ten Principles of Economics

2. How People Make Decisions

P1: People face tradeoffs.
P2: The cost of something is what you give up to get it.
P3: Rational people think at the margin.
P4: People respond to incentives.

3. How People Interact

P5: Trade can make everyone better off.
P6: Markets are usually a good way to organize economic activity.
P7: Governments can sometimes improve economic outcomes.

4. How the Economy as a Whole Works

P8: The standard of living depends on a country’s production.
P9: Prices rise when the government prints too much money.
P10: Society faces a short-run tradeoff between inflation and unemployment.
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2. How People Make Decisions: Principles 1- 4

2.1 Principle 1. People face tradeoffs.

“There is no such thing as a free lunch!”

To get one thing, we usually have to give up another thing:

Food v. clothing

Leisure time v. work

Efficiency v. equity

2.2 Principle 2. The cost of something is what you give up to get it, i.e. the
opportunity cost.

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?

2.3 Principle 3. Rational people think at the margin.

Marginal changes are small, incremental adjustments to an existing plan of action.

If deciding on whether to spend an additional year at school you would compare:

the additional benefits of an extra year in school (i.e. higher lifetime wages and joy
of learning);

and the additional costs incurred (i.e. tutition and foregone wages earned whilst at
school).

By comparing the marginal costs and benefits, you can evaluate whether an extra
year is worthwhile.

2.4 Principle 4. People respond to incentives.

Marginal changes in costs or benefits motivate people to respond.

The decision to choose one alternative over another occurs when that alternative’s
marginal benefits exceed its marginal costs!

3. How People Interact

3.1 Principle 5. Trade can make everyone better off.

People gain from their ability to trade with one another.

Competition results in gains from trading.

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Trade allows people to specialize in what they do best.

3.2 Principle 6. Markets are usually a good way to organize economic

activity.

In a market economy, households decide what to buy and who to work for.

Firms decide who to hire and what to produce.

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.

Principle 7: Governments can sometimes improve market outcomes.

Market failure occurs when the market fails to allocate resources efficiently.

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.

Market failure may also be caused by market power, which is the ability of a single
person or firm to unduly influence market prices.

When the market fails (breaks down) government can sometimes intervene to
promote efficiency and equity.

4. How the Economy as a Whole Works

4.1 Principle 8. The standard of living depends on a country’s production.

Standard of living may be measured in different ways:

By comparing personal incomes.

By comparing the total market value of a nation’s production.

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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4.2 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.

4.3 Principle 10. Society faces a short-run tradeoff between inflation and
unemployment.

The Phillips Curve illustrates the tradeoff between inflation and unemployment in the
short run.

Reducing inflation may cause a temporary rise in unemployment.

5. Summary: Ten Principles of Economics

How People Make Decisions

P1: People face tradeoffs.
P2: The cost of something is what you give up to get it.
P3: Rational people think at the margin.
P4: People respond to incentives.

How People Interact

P5: Trade can make everyone better off.
P6: Markets are usually a good way to organize economic activity.
P7: Governments can sometimes improve economic outcomes.

How the Economy as a Whole Works

P8: The standard of living depends on a country’s production.
P9: Prices rise when the government prints too much money.
P10: Society faces a short-run tradeoff between inflation and unemployment.
Burgess Principles of Macro Economics: Econ 1010 5

Mankiw's "Ten Principles of Economics" -

.
How People Make Decisions

• People Face Tradeoffs. To get one thing, you have to give up something
else. Making decisions requires trading off one goal against another.
• The Cost of Something is What You Give Up to Get It. Decision-makers
have to consider both the obvious and implicit costs of their actions.
• Rational People Think at the Margin. A rational decision-maker takes
action if and only if the marginal benefit of the action exceeds the marginal
cost.
• People Respond to Incentives. Behavior changes when costs or benefits
change.

How the Economy Works as A Whole

• Trade Can Make Everyone Better Off. Trade allows each person to
specialize in the activities he or she does best. By trading with others, people
can buy a greater variety of goods or services.
• Markets Are Usually a Good Way to Organize Economic Activity.
Households and firms that interact in market economies act as if they are
guided by an "invisible hand" that leads the market to allocate resources
efficiently. The opposite of this is economic activity that is organized by a
central planner within the government.
• Governments Can Sometimes Improve Market Outcomes. When a
market fails to allocate resources efficiently, the government can change the
outcome through public policy. Examples are regulations against monopolies
and pollution.

How People Interact

• A Country's Standard of Living Depends on Its Ability to Produce

Goods and Services. Countries whose workers produce a large quantity of
goods and services per unit of time enjoy a high standard of living. Similarly,
as a nation's productivity grows, so does its average income.
• Prices Rise When the Government Prints Too Much Money. When a
government creates large quantities of the nation's money, the value of the
money falls. As a result, prices increase, requiring more of the same money to
buy goods and services.
• Society Faces a Short-Run Tradeoff Between Inflation and
Unemployment. Reducing inflation often causes a temporary rise in
unemployment. This tradeoff is crucial for understanding the short-run effects
of changes in taxes, government spending and monetary policy.
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Scarcity is taking over the world. “There just isn’t enough of anything”; there is not
sufficient money and time. Due to this we have to decide how to distribute these
scarcities. “Decision making is the essence of economics” states Gregory Mankiw,
everyday we make decisions and choices that help us allocate our scarcities.
“Economics is the study of mankind, in the ordinary business of life” was said almost
a century old by Alfred Marshall. Gregory Mankiw says that quote “captures
economics perfectly” and it does, it studies the decisions we make in order to deal
with this scarcities, we make decisions and choices everyday, when we go shopping
and choose what to buy, since there is an scarcity of money, when we go to work and
choose how many hours to work because there is an scarcity of life and etc. We
impact and shape our economy with every decision we make.

1. Tradeoffs
As we make decisions we make tradeoffs, which mean we choose something over
something else, or we have to give up something in order to have something else.
Decisions such as having a child involve a tradeoff between money for yourself, and
money to buy the child his necessities; it also involves trading off time, since you are
giving up your personal or free time, for the time to give to the baby. In the movie a
very good example of tradeoff is shown. It shows a college student that wants to
move to Washington when he finishes college, and gives up some of the time he uses
to study for tests or exams, for time to look for jobs in Washington. Choosing his
priorities over other ones makes him face a tradeoff. Society as a whole also involves
tradeoffs; the government has to choose how much money to use in certain aspects
of the country. One example is how we face tradeoffs even in the environment, “We
all want cleaner air but the tradeoff can mean loss of income or even the loss of jobs
for some Americans”. Like a coal company in Ohio that had to be shut down because
it was being harmful to the environment, the consequences? More than a thousand
persons lost their jobs, the community decided to have a cleaner environment, but
the tradeoff was the losing of the jobs of all those people.

2. Opportunity Cost
What you sacrifice in order to get something is its cost. Gregory Mankiw explain this
principle with a college student. By choosing to go four years to college the student’s
costs are many. There is the cost of the money she is spending in books and tuition,
and also the “opportunity costs” as said by Mankiw because since she decided to go
to college she is giving up the opportunity of getting a job and the wages of the job
she would’ve taken. “Nothing comes for free, our time is worth something” that
makes you realize that a cost of something is not always involved with money; the
cost of something you do can be as simple as spending time with loved ones. An
example is how the opportunity cost of a college student is reasonably low, since the
student is giving up low paying jobs, but the opportunity cost for a very talented high
school athlete offered to go straight to professional is very high, because if he
decides to go to college he is giving up the millions of dollars he would earn being a
professional athlete.
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3. Marginal Thinking
A rational person like the college student thinks at the margin, when given too much
college work instead of quitting the job that earns her money for her personal
spending, she simply cuts back a little on the work hours. She is not radical; she is
adjusting instead of finishing, she is thinking at the margin. Another good example is
that of a Broadway that sometimes faces empty seats. So thinking at the margin they
decide to bargain with the public and sell them the seats at half the price some hours
before the show instead of having empty seats in the show. Adjusting the ticket’s
price actually gains the theater more revenues because even if it’s earning them
50% of the original cost, that’s more than zero, if the seats would’ve stayed empty.
By being rational and thinking at the margin better decisions and choices can be
made.

4. Incentives
When the cost and the advantages of something vary or change, our decisions
change too. “If I want my son to wash my car I’ll say if you was my car you can use it
tonight, that’s an incentive”. The incentive is that he can use the car that night, in
other words he benefits from saying yes, but if they weren’t any incentives, he’ll
probably doubt it. A very good example they give on how we respond to incentives,
and applies to today’s situation, is that of how we response to the prices of gasoline.
In Europe the price of gasoline is very high, this incentive makes people buy smaller
and more economic cars, in contrast to America where the price is still relatively low,
and people buy vans and big cars. That is because people are responding to
incentives, incentives that benefit them; obviously you’ll do more shopping if you are
not going to be taxed. When President Clinton was in office, he asked for the
cigarettes prices to go up by a dollar and a half, because it was demonstrated that
young people would not buy cigarettes and smoke. This is a perfect example of a
disincentive since this discourages the youth from smoking. Another point explained
is the behavior some people take with incentives. Nowadays safety belts are required
because is proven to save lives but in the other hand “there is evidence that
behavior does change in response to these safety belts” states Mr. Gregory, since
some people exceed speed limits because they feel more secure.

5. Trade
Since we are not self-sufficient we trade. “People specialize; people do particular
tasks and rely on other people to do other tasks for them”. A hairstylist for example
trades her service (that is cutting hair) for money, and the other person relies on her
the hairstylist to get her hair cut. “The idea of: I have something and you have
something and if we exchange it we are both going to be better off, is fundamentally
what economics is all about. We as humans and to be able to survive we trade, we
exchange, we rely. We rely in a group of specialized farmers to grow the food for us,
we both benefit since we get the food and they are paid for producing the food.
Countries also trade between them when they sell each other products that they are
good at making cheaper. We trade every day in order to survive.

6. Markets
In markets agreements are made, and prices are settled, which then are
communicated to the world. In the food market farmers sell their goods, and
supermarket owners buy them to then sell it. Another type of market is the Stamp
Market. Mark Easter a stamp dealer explains that it is like the stock market where the
dealers go for the highest price offered. How can buyers and sellers interact to each
other and not create chaos? Adam Smith said “that markets are guided as if by an
invisible hand at least to a desirable allocation of resources.” We all have interests,
and if we all try to achieve them, we are all going to be happy. An example is if I
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have a $25 dollars and you have a good and you want to sell it to me, we both win,
you wanted the $25 dollars more than the good, and I wanted the good more than
$25 dollars. The key of the invisible hand are prices, the sellers and consumers
depend on them. When communism fell in Russia and Eastern Europe it showed that
free market is the best way to operate, since people know what they want, how they
want it, at how much they want to buy it and etc.

7. Government
Sometimes the government gets involved in developing better outcomes. This
happens when any of two situations happens. First if the market outcome is not
efficient, and second if it fails to distribute the income efficiently. In many cases,
externality is the cause of failure. “Externality is when a company or an individual
creates something that has an impact beyond the immediate buyers and sellers of
that product. Electricity plants are obviously benefiting the users and buyers of
electricity but it also has an externality since the smoke produced by them can harm
the health of a person. Market power can also lead to market failures, since a certain
firm or person’s services is outsized and can control and influence prices. When the
market is not being fair the government also intervenes. Some people get paid for
their services more than other; this is something that cannot be controlled by the
invisible hand. When the government gets involved is because the situation is very
complicated, the more complicated it gets, the harder it gets for the government to
fix it.

8. Productivity
Statistics show that in 1998 the average American had a yearly income of $31,500,
the average Mexican of $8,300 and the average Indian of $1700. You can notice that
their quality of life is not the same for example Americans live better than Indians.
Productivity explains it all; a rich country produces more than a poor one. And
productivity depends on skills, capital and etc. If a country has a well educated work
force, productivity will rise. Economic freedom and liberty means more productivity.
An ideal example is the US and Hong Kong, where people are free to use their brains
to create goods, services, or ideas that can be taken to the market where consumers
take advantage of them.

9. Inflation
This basically means inflation which means that prices rise in order to mirror all the
money that is being print out. The printing of money is something that needs to be
controlled because even though it might “temporarily make the people feel
wealthier”, at some point prices will start going up, and inflation will come in play,
and it will be very hard to take back under control. Stability between goods and
money is the best way to keep inflation away.

10. The Phillips Curve

The Federal Reserve Chairman is supposed to maintain unemployment low, and
inflation under control. Mankiw states that you can’t achieve both goals at the same
time and that the policy instrument is money supply. When one goes up the other
one goes down and vice versa, this is called The Phillips Curve. This is a short run
tradeoff, you have to choose one over the other one. But nowadays this tradeoff does
not really exist because in the past year both inflation and unemployment has gone
down. This doesn’t mean that The Phillips Curve would not come in play again, some
economists say it will.
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Understanding these 10 principles is the key to understanding the whole concept of

economics.