Principles of Microeconomics, N.

Gregory Mankiw (7th Edition)

Chapter One: Ten Principles of Macroeconomics

I.

II.

Opening Vignette
a. Etymology of economy: from the Greek word oikonomos, which means one
who manages a household
b. Once society has allocated resources (as well as land, buildings, and machines) to
various jobs, it must then allocate the goods and services that have been produced.
c. The aforementioned manages of resources proves important as resources are
scarce; scarcity refers to the limited nature of societys resources.
d. Economics is the study of how society manages its scarce resources
i. In most societies, resources are allocated through the combined choices of
millions of households and firms.
ii. Economists, therefore, study (1) how people make decisions, (2) how
people interact with one another, and (3) the forces and trends that affect
the economy as a whole.
How People Make Decisions
a. Principle 1: People Face Trade-Offs
i. Making decisions requires trading off one goal against another.
1. One classic trade-off is between guns and butter: the more a
society spends on national defense (guns) to protect its shores from
foreign aggressors, the less it can spend on consumer goods
(butter) to raise the standard of living at home.
ii. Another trade-off society faces is between efficiency and equality.
1. Efficiency is the property of society getting the most it can from its
scarce resources.
2. Equality is the property of distributing economic prosperity
uniformly among the members of society.
a. For example, the welfare system versus individual income
tax on the financially successful
iii. Though these equity-centered systems such as welfare programs achieve
greater equality, these policies reduce efficiency.
1. When the government redistributes income from the rich to the
poor, it reduces the reward for working hard; as a result, work
incentives are distorted, motivating people to work less and
product fewer goods and services.
b. Principle 2: The Cost of Something Is What You Give Up to Get It
i. Because people face trade-offs, making decisions necessitates comparing
the costs and benefits of alternative courses of action.
ii. The opportunity cost of an item is what you give up to get that item.
1. e.g. college athletes who can earn millions if they drop out of
school and play professionally are well aware that the opportunity
cost of their opting to instead attend college is very high
c. Principle 3: Rational People Think at the Margin
i. Rational people systematically and purposefully do the best they can to
achieve their objectives, given the available opportunities.

Principles of Microeconomics, N. Gregory Mankiw (7th Edition)

III.

ii. Economists use the term marginal change to describe a small incremental
adjustment to an existing plan of action.
1. Decisions between marginal costs and marginal benefits, e.g.
the cellphone example (p. 7), Why is water so cheap, while
diamonds are so expensive? Because water is plentiful, the
marginal benefit of an additional cup is small. Because diamonds
are rare, the marginal benefit of an extra diamond is high. (p.7);
when shopping for organic versus conventional groceries, the
marginal cost is how much more organics cost and the marginal
benefits are healthier food, decreased environmental impact, etc.
d. Principle 4: People Respond to Incentives
i. An incentive is something (such a prospect of a punishment or reward)
that induces a person to react).
ii. Incentives are crucial to analyzing how markets work.
1. For example, when the price of an apple rises, people decide to eat
fewer apples. Meanwhile, apple orchards decide to hire more
workers ad harvest more apples.
a. A higher price in market incentivizes buyers to consume
less and sellers to product more.
2. As further instance, high petrol taxes provide an incentive for
European drivers to purchase smaller and more fuel-efficient cars
compared to their American counterparts.
3. Consider how a seat belt law alters a drivers cost-benefit
calculation.
a. Seat belts reduce the benefits of slow and careful driving,
resulting in a larger number of accidents. See: Sam
Peltzmans 1975 study
How People Interact
a. Principle 5: Trade Can Make Everyone Better Off
b. Principle 6: Markets Are Usually a Good Way to Organize Economic Activity
i. In a market economy, the decisions of a central planner are replaced by the
decision of millions of firms and households.
1. Inherently decentralized; prices and self-interest guide decisions
ii. In his 1776 book An Inquiry into the Nature and Causes of the Wealth of
Nations, Adam Smith observes that market economies perform as if
guided by an invisible hand.
1. Prices adjust to guide individual buyers and sellers to reach
outcomes that, in many cases, maximize the well-being of society
as a whole.
2. Smiths insights have an important corollary: when a government
impedes prices from adjusting naturally to supply and demand, it
undermines the invisible hands ability to coordinate the decisions
of the constituents of an economy.
c. Principle 7: Governments Can Sometimes Improve Market Outcomes

Principles of Microeconomics, N. Gregory Mankiw (7th Edition)

IV.

i. One reason that we need government is that the invisible hand can work
its magic only if the government enforces the rules and maintains the
institutions that are key to a market economy.
ii. Market economies need institutions to enforce property rights: the ability
of an individual to own and exercise control over scarce resources.
1. e.g. a farmer wont grow crops if they believe their product will
just be stolen
iii. Governments promote efficiency and equality.
1. Efficiency
a. Market failure: a situation in which a market left on its own
fails to allocate resources efficiently
i. One possible cause of market failure is an
externality, which is the impact of one persons
actions on the well-being of a bystander (e.g.
pollution).
ii. Another possible cause of market failure is market
power, which refers to the ability of a single person
or firm (or a small group) to unduly market prices.
1. As in, circumstances with limited resources;
consider a town with only one, privately
owned well
2. Equality
a. The invisible hand does not ensure that everyone has
sufficient resources (e.g. healthcare, food, shelter).
How the Economy Works
a. Principle 8: A Countrys Standard of Living Depends On Its Ability to Produce
Goods and Services
i. Almost all variation in living standards is attributable to differences in
countries productivity, that is, the amount of goods and services
produced by each labor input.
1. Similarly, the growth rate of a nations productivity determines the
growth rate of its average income.
b. Principle 9: Prices Rise When the Government Prints Too Much Money
i. Inflation: the increase in the overall levels of the prices of an economy;
e.g. Weimar Germany, Fords presidency (1970s)
c. Principle 10: Society Faces a Short-Run Trade-Off between Inflation and
Unemployment
i. Most economists describe the short-run effects of monetary injections as
follows:
1. Increasing the amount of money in the economy stimulates the
overall level of spending and thus the demand for goods and
services,
2. Higher demand may over time cause firms to raise their prices, but
in the meantime, it also encourages them to hire more workers and
produce a larger quantity of goods and services,

Principles of Microeconomics, N. Gregory Mankiw (7th Edition)

3. More hiring means lower unemployment.

ii. This short-run trade-off plays a key role in the analysis of the business
cycle the irregular and largely unpredictable fluctuations in economic
activity, as measured by the production of goods and services or the
number of people employed.
iii. Policymakers can influence the overall demand for goods and services;
e.g. Barack Obamas 2009 stimulus package to reduce unemployment

Principles of Microeconomics, N. Gregory Mankiw (7th Edition)

Excerpts from Parkins Microeconomics, 11th Edition

Economics is the social science that studies the choices that individuals, businesses,
governments, and entire societies make as they cope with scarcity and the incentives that
influence and reconcile those choices.
An incentive is a reward that encourages an action or a penalty that discourages one.
Microeconomics is the study of the choices that individuals and businesses make, the way
these choices interact in markets, and the influence of governments.
o Some examples of microeconomic questions are: Why are people downloading
more movies? How would tax on e-commerce affect eBay?
Macroeconomics is the study of the performance of the national economy and the global
economy.
o Some examples of macroeconomic questions are: Why is the U.S. unemployment
rate so high? Can the Federal Reserve make our economy expand by recurring
interest rates?
Goods and services are the objects that people value and produce to satisfy wants.
o Goods are physical objects such as cell phones and automobiles. Services are
tasks performed for people such as cell-phone service and auto-repair service.
The resources used to product goods and services are called factors of production, which
are grouped into four categories:
o Land: natural resources, including land, minerals, oil gas, coal, water, air, forests,
and fish
o Labor: the work time and work effort that people devote to producing goods and
services; includes physical and mental efforts
o Capital: the tools instruments, machines, buildings, and other constructions that
businesses use to produce goods and services
Human capital: the knowledge and skill that people obtain from education,
training, and experience; expands over time.
Financial capital: money, stocks, and bonds; financial capital is not used to
produce goods and services and is not a factor of production
o Entrepreneurship: The human resource that organizes labor, land, and capital;
entrepreneurs are the drivers of economic progress as they develop new ideas,
make business decisions, and bear the risks that arise from these decisions
People earn their incomes by selling the services of the factors of production they own:
o Land earns rent;
o Labor earns wages;
o Capital earns interest;
o Entrepreneurship earns profit.
Labor earns the most income.
The 20 percent of people with the lowest incomes earn about 5 percent of total income,
while the richest 20 percent earn close to 50 percent of total income.

Principles of Microeconomics, N. Gregory Mankiw (7th Edition)

All the choices that people make about how to use their time and other resources are
made in the pursuit of self-interest; an outcome is in the social interest if it is best for
society as a whole.
Resource use is efficient if it is not possible to make someone better off without making
someone else worse off.
Four issues in todays world put some flesh on questions about social interest, namely:
o Globalization
o Information-age monopolies
o Climate change
o Economic instability
Globalization is the expansion of international trade, borrowing and lending, and
investment.
o Globalization is in the self-interest of those consumers who buy low-cost goods
and services produced in other counties; and it is in the self-interest of the
multinational firms that produce in low-cost regions and self in high-price
regions. However, is it in the social interest?
Consider the low-wage worker in Malaysia and the displaced cobbler in
Seattle.
The technological change of the past forty years has been called the Information
Revolution.
The years between 1993 and 2007 brought remarkable economic stability, so much so
that they have been called the Great Moderation.
o Banks went on a lending spree to homebuyers; home loans were bundles into
securities that were sold and resold to banks around the world. In 2006, as interest
rates began to rise and the rate and which home prices were rising slowed,
borrowers defaulted on their loans. As more people defaulted, banks took losses
that totaled billions of dollars by the summer of 2007. This led to bail outs backed
by taxpayer dollars to be doled out by the Federal Reserve.
o Banks take in deposits and get more funds by borrowing from each other and
from other firms. Banks use these funds to make loans.
Market capitalism is an economic system in which individuals own all the land and
capital and are free to buy and sell land, capital, and goods and services in markets.
o Adam Smith held that an invisible hand leads decisions made in pursuit of selfinterest to unintentionally promote the social interest
Centrally planned socialism is an economic system in which the government owns all the
land and capital, directs workers to jobs, and decides what, how, and for whom to
produce.
o e.g. Karl Marx; Occupy Wall Street: arguments include that big corporations have
too much power and influence on governments, more regulation in social interest
is needed by democratically elected governments, human need, not corporate
greed
Our economy today is a mixed economy, which is market capitalism which government
regulation.

Principles of Microeconomics, N. Gregory Mankiw (7th Edition)

The economic way of thinking is defined by six key ideas:

o A choice is a trade-off,
o People make rational choices by comparing benefits and costs.
o Benefit is what one gains from something,
o Cost is what one must give up to get something
o Most choices are made at the margin, and
o Choices respond to incentives.
A positive statement is about what is; a normative statement is what ought to be. (e.g.
global warming is an issue versus we out to cut coal usage)
An economic model is a description of some aspect of the economic world that includes
only those features that are needed for the purpose at hand.
o For example, an economic model of a cell-phone network might include features
such as the prices of calls, the number of cell-phones, and the volume of calls.
This model would ignore cell-phone colors and ringtones.
o A model is tested by comparing its predictions with the facts.
The phases of the business cycle are expansion, peak, recession, and trough.