Ten Principles of Economics

Although the study of economics is complex, the field is unified by several

central ideas. The famous Ten Principles of Economics by
Gregory Mankiw are the principles of how the global economy works. These
principles also include basic concepts used by economists around the world.

Principle 1: People face trade-offs.

Economists often say, “There ain’t no such thing as a free lunch.” This means
that there are always trade-offs: To get one thing, you have to give up
something else. For example, if you spend money on a new computer, you
won’t be able to spend it on a new television. This principle also works for
nations. There is the classic trade-off between “guns and butter”: if society
spends more on national defense (guns), then it will have less to spend on
social programs (butter). Recognizing that trade-offs exist does not indicate
what decisions should be made.

Principle 2: The cost of something is what you give up to get it.

Making decisions requires comparing the costs and benefits of alternative

courses of action. For instance, if a firm spends $100 on electrical power,
they can’t use that money to buy new office equipment. Economists say the
firm’s opportunity cost is $100. The opportunity cost of an item is whatever
you give up to get that item. Thus, opportunity costs are not restricted to
financial costs: By seeing a movie in a cinema, your opportunity cost is not
just the price of the ticket, but the value of the time you spend in the theater.
Put another way, opportunity costs are the benefits you could have received
by taking an alternative action. When making decisions, managers should
always consider the opportunity costs of each possible action.
Principle 3: Rational people think at the margin.

Economists generally assume that people are rational – that means, their
decisions are based on facts and reasons. Rational people make decisions
by comparing marginal benefits and marginal costs. For example, you should
only attend college for another year if the benefits from that year of schooling
exceed the cost of attending that year. Furthermore, a car company should
only produce more cars if the benefit exceeds the cost of producing them.

Principle 4: People respond to incentives.

Because rational people weigh marginal costs and marginal benefits of

activities, they will respond when these costs or benefits change. For
example, when the price of cars rises, buyers have an incentive to buy fewer
cars. Public policy can alter the costs or benefits of activities. Some policies
have unintended consequences because they alter behavior in a manner
that was not predicted.

Principle 5: Trade can make everyone better off.

Trade is not a contest in which one side wins and one side loses. Trade can
make each trader better off. Trade allows each trader to specialize in the
activities he or she does best, whether it be farming, building, engineering or
manufacturing. By trading with others, people can buy a greater variety of
goods or services. This is true for both individuals and countries. You are
likely to be involved in trade with other individuals and companies on a daily
basis: Most people do not make their own clothes or grow their own food –
but by trading you are able to get all those products.
Principle 6: Markets are usually a good way to organize economic
activity.

In a market economy, the decisions about what goods and services to

produce and how much to produce are made by millions of firms and
households in the marketplace. Political economist Adam Smith made the
famous observation that although individuals are motivated by self-interest,
an invisible hand guides this self-interest into promoting society’s economic
well-being. Consequently, centrally planned economies have mostly failed
because they did not allow the market to work.

Principle 7: Governments can sometimes improve market outcomes.

When a market fails to allocate resources efficiently, the government can

change the outcome through public policy. One kind of market failure
is externality – it occurs when the actions of one person affect the well-being
of other people. The second kind of market failure is market power – when
a single actor has so much power, that he can influence the price. In these
cases, the government may be able to intervene. Examples are regulations
against monopolies. The government may also intervene to improve equality
with income taxes and welfare.

Principle 8: A country’s standard of living depends on its ability to

produce goods and services.

There is great variation in living standards across countries today as well as

within the same country over time. These are largely attributable to
differences in productivity. Productivity is the amount of goods and services
produced from each unit in a specific time period. As a result, public policy
should improve education and improve access to the best available
technology.
Principle 9: Prices rice when the government prints too much money.

When a government creates large quantities of the nation’s money, the value
of the money falls. In this process, called inflation, prices increase and
consumers require more of the same money to buy goods and services. High
inflation is costly to the economy. Policymakers wishing to keep inflation low
should maintain slow growth in the quantity of money.

Principle 10: Society faces a short-run trade-off between inflation and

unemployment.

In the short run, an increase in the quantity of money (inflation) stimulates

spending, which raises production. The increase in production requires more
hiring, which reduces unemployment. The result is a temporary trade-off
between inflation and unemployment. Understanding this trade-off is crucial
for understanding the short-run effects of changes in taxes, government
spending and monetary policy.