The 10 Principles of Economics

Breaking down the 10 Principles:Even though economists might not agree

on how the economy will operate best, some things we can rely on to be certain: the 10 principles of economics can be broken down into 3 categories:

1. How people make decisions2. How people interact3. How the economy works as a whole

How People Make DecisionsPrinciple 1: People Face Tradeoffs•Making decisions requires trading off one

goal against another•Examples:

-Personal: You have 2 exams tomorrow (Math and English), but only 3 hours to study before then- when you use some of that time to study English, you are giving up time studying Math.-National: A nation must decide how to spend its money- some possibilities: national defense or consumer goods…whatever they spend on national defense is lost from what they could have spent on consumer goods.-Societal: efficiency versus equity

Efficiency vs. EquityEfficiency: society is getting the most it

can from scarce resourcesEquity: the benefits of those resources are

distributed fairly among society’s members

Example: government policies aimed at achieving greater equity in society (like Welfare and Income Tax) reduce efficiency overall

How People Make DecisionsPrinciple 2: The cost of something

is what you give up to get it

• Because people face tradeoffs, making decisions requires comparing the costs and benefits of different courses of action.

• Opportunity Cost: whatever must be given up to obtain some item

• Example: college athletes going professional- what is the opportunity cost of going pro? What is

the opportunity cost of not going pro?

How People Make DecisionsPrinciple 3: Rational People Think at

the Margin•Economists use the term Marginal Changes to

describe small adjustments to an existing plan of action

•Margin means edge, so marginal changes are changes just on the edge of what you are doing

•People can make better decisions by thinking at the margin- comparing marginal benefits and marginal costs of a decision- example: is it worth it for airlines to sell standby seats when the plane is not full?

How People Make DecisionsPrinciple 4:People Respond to

Incentives•Because people make decisions by comparing

costs and benefits, their behavior may change if those costs and benefits change.

•People respond to incentives! (something that encourages a person to do something or to work harder)

•Think of one example when you have responded to an incentive. Write it down!

How People InteractPrinciple 5: Trade Can Make

Everyone Better Off• Trading- whether it is between two people or

between two countries- can make each party better off

-Trade allows countries to specialize in what they do best and enjoy a greater variety of goods and services.

• Any examples of when you made a trade with someone that made both parties better off? Write in your notebook!

How People InteractPrinciple 6: Markets are Usually a Good Way to Organize Economic

Activities A market economy allocates resources through

the decentralized decisions of many households and firms as they interact in markets.

•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.

How People InteractPrinciple 6: Markets are Usually a Good Way to Organize Economic

Activities•The invisible hand works through the price

system:▫The interaction of buyers and sellers

determines prices. ▫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 InteractPrinciple 7:Governments can Sometimes Improve Market

Outcomes• Two broad reasons for gov. to intervene in the economy: to

increase efficiency or equity• 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 promote efficiency

How People InteractPrinciple 7:Governments can Sometimes Improve Market

Outcomes• Gov. 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 market operates and its outcomes.

How The Economy Works as a WholePrinciple 8: A Country’s Standard of

Living Depends on its Ability to Produce Gods and 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 Works as a WholePrinciple 8: A Country’s Standard of

Living Depends on its Ability to Produce Gods and 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.

How The Economy Works as a WholePrinciple 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 Works as a WholePrinciple 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.