PRINCIPLES OF

Economics
By N. Gregory Mankiw

Principles of Economics PowerPoint slides prepared by:

5e N. Gregory Mankiw Andreea Chiritescu
© 2009 Cengage Eastern Illinois University
 Chapter

Ten Principles of Economics

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Ten principles of economics
How People Make Decisions
1: People Face Trade-offs
2: The Cost of Something Is What You Give Up to Get It
3: Rational People Think at the Margin
4: People Respond to Incentives
How People Interact
5: Trade Can Make Everyone Better Off
6: Markets Are Usually a Good Way to Organize Economic Activity
7: Governments Can Sometimes Improve Market Outcomes
How the Economy as a Whole Works
8: A Country’s Standard of Living Depends on Its Ability to Produce
Goods and Services
9: Prices Rise When the Government Prints Too Much Money
10: Society Faces a Short-Run Trade-off between Inflation and
Unemployment
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 Ten Principles of Economics
• Economy – “oikonomos” (Greek)
– “One who manages a household”
• Economy is composed of households and
firms
• Economics is the study of how households
and firms make decisions under scarcity
– Scarcity – all resources are scarce (finite)
• Decisions about how to use them implies
tradeoffs are involved
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 1
The circular flow
This diagram is a
schematic representation
of the organization of the
economy. Decisions are
made by households and
firms. Households and
firms interact in the
markets for goods and
services (where
households are buyers and
firms are sellers) and in the
markets for the factors of
production (where firms are
buyers and households are
sellers). The outer set of
arrows shows the flow of
dollars, and the inner set of
arrows shows the
corresponding flow of
inputs and outputs.
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 Ten Principles of Economics
• Scarcity - limited nature of society’s resources
• Economics
– Study of how society manages its scarce
resources
• Economists study:
– How people make decisions
– How people interact with one another
– Analyze forces and trends that affect the
economy as a whole
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 How People Make Decisions
Principle 1: People face trade-offs
• Making decisions
– Trade off one goal against another
– Society
• National defense vs. consumer goods
• Clean environment vs. high level of income
• Efficiency vs. equality

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 How People Make Decisions
Principle 1: People face trade-offs
• Efficiency
– Society - maximum benefits from its scarce
resources
– Size of the economic pie
• Equality
– Benefits - uniformly distributed among
society’s members
– How the pie is divided into individual slices
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 2
The production possibilities frontier
Quantity of
Computers The production possibilities
Produced frontier shows the
combinations of output - in
C this case, cars and
3,000 F
computers - that the
Production
economy can possibly
A Possibilities
2,200 produce.
B Frontier
2,000 The economy can produce
any combination on or
inside the frontier.
D Points outside the frontier
1,000
are not feasible given the
E
economy’s resources.

0 300 600 700 1,000 Quantity of

Cars
Produced
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 The Economist as a Scientist
• Efficient levels of production
– Economy’s getting all it can
• From the scarce resources available
– Points on the production possibilities frontier
– Trade-off:
• The only way to get more of one good
• Is to get less of the other good
• Inefficient levels of production
– Points inside production possibilities frontier
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 How People Make Decisions
Principle 2: The cost of something is what you
give up to get it
• People face trade-offs
– Make decisions
• Compare cost with benefits of alternatives
– Opportunity cost
• Whatever most be given up to obtain one item
• PPF – Opportunity cost is what you give up as you
produce more of another good

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OPPORTUNITY COST

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 Opportunity cost of H.R.
• The opportunity cost of the time an
entrepreneur devotes to his own business is
the salary he could earn by seeking
employment elsewhere.
• The opportunity cost of using a machine to
produce one product is the earnings which
would have been possible from other
products.
• The opportunity cost of an Investment in a
business would be the amount of interest
received from the money deposited in a
bank
 How People Make Decisions
Principle 3: Rational people think at the margin
• Rational people
– Systematically & purposefully do the best
they can to achieve their objectives
• Marginal changes
– Small incremental adjustments to a plan of
action
• Rational decision maker – take action only if
– Marginal benefits > Marginal costs
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 Incremental Concepts
• The production capacity of a firm is 10000
units. It produces 5000 units and sells it to
Indian market at Rs.10 per unit.
• The expenses are:
• Land & Building - Rs. 20,000
• Raw Material - Rs. 5,000
• Labour - Rs. 5,000
• Administrative Expenses: Rs. 10,000
 Costs
• Total Cost - the sum of all costs incurred in
production
• TC = FC + VC
• Average Cost – the cost per unit
of output
• AC = TC/Output
• Marginal Cost – the cost of one more or one
fewer units of production
• MC = TCn – TCn-1 units
 Revenue
• Total revenue – the total amount received
from selling a given output
• TR = P x Q
• Average Revenue – the average amount
received from selling each unit
• AR = TR / Q
• Marginal revenue – the amount received
from selling one extra unit
of output
• MR = TRn – TR n-1 units
 Marginal Cost/Revenue
• The company receives an order from
Malaysia for 3000 units @ Rs.7 per unit.
• Should the company accepts the order??
• What is the Incremental Revenue and
Incremental Cost?
• What difference it makes in the total
profit/loss if the order is accepted?
• What should be the least price the
company accept so that the profit is
maximum?
 How People Make Decisions
Principle 4: People respond to incentives
• Incentive
– Something that induces a person to act
– Higher price
• Buyers - consume less
• Sellers - produce more
– Public policy
• Change costs or benefits
• Change people’s behavior

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 Incentives for Firms

• First Law of Supply:

• the higher the market price the greater the
quantity supplied by each firm
 Incentives - Consumers

• First Law of Demand

– The higher the price, the lower is quantity
demanded
 Can Economic Incentives Get You
Pregnant?
• http://freakonomics.blogs.nytimes.com/2008/01/16/can-economic-incentives-get-
you-pregnant/
• Can fertility rates be linked to financial incentives (or disincentives) to have
children? Alma Cohen, Rajeev Dehejia, and Dmitri Romanov, “Do Financial
Incentives Affect Fertility?”
– We find a significant positive effect on fertility, with the mean level of child
subsidies producing a 7.8 percent increase in fertility.
– we find that a large, unanticipated reduction in child subsidies that
occurred in 2003 had a substantial negative impact on fertility.
– Overall, our results support that fertility responds to financial
incentives and indicate that the child subsidy policies used in many
countries can have a significant influence on incremental fertility
decisions.
 How People Interact
Principle 5: Trade can make everyone better off
– Specialization
• Allows each person/country to specialize in the
activities he/she does best
– People/countries can buy a greater variety of
goods and services at lower cost.
– Team Work – understanding the team
members strengths and weaknesses and act.
– Learning Curve – Economies of scale due to
experience
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 A country
– Should specialize in production of and export products for which
it has absolute advantage; import other products
– Has absolute advantage when it is more productive than another
country in producing a particular product
 How People Interact
Principle 6: Markets are usually a good way to
organize economic activity
• Communist countries – central planning
– Government officials (central planners)
• Allocate economy’s scarce resources
– Decided
» What goods & services were produced
» How much was produced
» Who produced & consumed these goods & services
• Theory: only the government could organize
economic activity to promote economic well-
being for the country as a whole.
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 How People Interact
Principle 6: Markets are usually a good way to
organize economic activity
• Market economy - allocates resources
– Decentralized decisions of many firms and
households
– As they interact in markets for goods and
services
– Guided by prices and self interest
– Adam Smith’s “invisible hand”
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 Equilibrium Price Equilibrium Quantity
price at which the quantity output level that corresponds
demanded by consumers to the equilibrium price
and the quantity supplied
by producers are the same
P
S

(Qd=Qs)
E
Pe

Qe Q

http://www.cals.ncsu.edu/course/are012/readings/demand.html
 MARKET FOR YOYOS
Point Price Qd Qs

A 5 200 1,800

B 4 600 1,400
C 3 1,000 1,000
D 2 1,400 600
E 1 1,800 200
 EXCESS DEMAND
Shortage – an amount or extent of
deficiency due to excess demand

E
Pe

A B
P1
Shortage
Qd>Qs
D
QS Qe QD
 EXCESS SUPPLY
Surplus - an amount or a quantity in
excess of what is needed or demanded

Surplus S
Qd<Qs
A B
Pe

E
P1

D
QD Qe QS
 How People Interact
Principle 7: Governments can sometimes
improve market outcomes
• We need government
– Enforce the rules
– Maintain institutions - key to market economy
• Enforce property rights
• Property rights
– Ability of an individual to own and exercise
control over scarce resources
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 How People Interact
Principle 7: Governments can sometimes
improve market outcomes
• Government intervention
– Change allocation of resources
– To promote efficiency
• Avoid market failure
– To promote equality
• Avoid disparities in economic wellbeing

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 How People Interact
• Market failure
– Situation in which the market on its own fails
to produce an efficient allocation of resources
• Causes for market failure
– Externality
• Impact of one person’s actions on the well-being
of a bystander
– Market power
• Ability of a single person (or small group) to
unduly influence market prices
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 How People Interact
• Disparities in economic wellbeing
– Market economy
• Rewards people - ability to produce things that
other people are willing to pay for
– Government intervention
• Public policies
– May diminish inequality
– Process far from perfect

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 How Economy as a Whole Works
8. Country’s Standard of Living Depends on Ability to
Produce Goods and Services
– US average income
– Impacted by productivity
– Policymakers

9. Prices Rise When Government Prints Too Much

Money
– Inflation
– 1920s Germany

10. Society Faces a Short-Run Tradeoff between Inflation

and Unemployment
– Phillips curve
– Business cycle
 8. A Country’s Standard of Living
Depends on its Ability to Produce Goods
• 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.
• “A Country’s Standard of Living Depends on
its Ability to Produce Goods and Services.”

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 8. A Country’s Standard of Living
Depends on its Ability to Produce Goods

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9. Inflation – General rise in the level of
prices

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What should be an optimum level of
Inflation?

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10. Short-run Tradeoff between Inflation
and Unemployment.

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Economic Recession -2008

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