Chapter 1 Ten Principles of Economics

PowerPoint Slides prepared by:
Andreea CHIRITESCU
Eastern Illinois University
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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Ten Principles of Economics
PowerPoint Slides prepared by:

Andreea CHIRITESCU
Eastern Illinois University
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 2
• Economy, “oikonomos” (Greek)
– “One who manages a household”
– Households and economies have much in
common
• Households face many decisions
– Allocate scarce resources
• Ability, effort, and desire
• Society faces many decisions
– Allocate resources and output
• Resources are scarce
• Scarcity
– The limited nature of society’s resources
– Society has limited resources and
therefore cannot produce all the goods
and services people wish to have
• Economics
– How society manages its scarce resources
– How people make decisions
• Economists study:
– How people make decisions
• Work, buy, save, invest
– How people interact with one another
– Analyze forces and trends that affect the
economy as a whole
• Growth in average income
• Fraction of the population that cannot find
work
• Rate at which prices are rising
• 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
How People Make Decisions, #1
Principle 1: People face trade-offs
• “There ain’t no such thing as a free lunch”
– To get something that we like, we usually
have to give up something else that we
also like
• Making decisions
– Trade off one goal against another
• Trade offs
– Students: time
– Parents: income
– Society
• National defense vs. consumer goods (guns
vs. butter)
• Clean environment vs. high level of income
• Efficiency vs. equality
• Efficiency
– Society getting the maximum benefits
from its scarce resources
– Size of the economic pie
• Equality
– Distributing economic prosperity uniformly
among the members of society
– How the pie is divided into individual slices
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 must be given up to obtain
some item
Principle 3: Rational people think at the
margin
•Rational people
– Systematically and purposefully do the
best they can to achieve their objectives
•Marginal changes
– Small incremental adjustments to a plan of
action
• Rational decision maker
– Make decisions by
comparing marginal
benefits and marginal
costs
– Take action only if:
• Marginal benefits >
Marginal costs
“Is the marginal benefit
of this call greater than
the marginal cost?”
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
The Incentive Effects of Gasoline Prices
• 2005 to 2008, price of oil in world oil
markets skyrocketed
– Limited supplies
– Surging demand from robust world
growth
– Price of gasoline in the United States
rose from about $2 to about $4 a gallon
The Incentive Effects of Gasoline Prices
• Increased incentive to conserve gas
– Smaller cars, scooters, bicycles, mass
transit
– Camels (India)
– New, more fuel-efficient aircraft
• Airbus A320 and Boeing 737
– Moving near an Amtrak station
– Online courses
– Sean “Diddy” Combs - flying on
commercial airlines
How People Interact, #5
Principle 5: Trade can make
everyone better off
•Trade
– Allows each person to
specialize in the activities he
or she does best
“For $5 a week
– Enjoy a greater variety of you can watch
goods and services at lower baseball without
being nagged to
cost cut the grass!”
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
– What goods and services were produced
– How much was produced
– Who produced and consumed these goods and
services
• Market economy, allocation of resources
– Through 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”
– Households and firms interacting in
markets
• Act as if they are guided by an “invisible
hand”
• Leads them to desirable market outcomes
– Corollary: Government intervention
• Prevents the invisible hand’s ability to
coordinate the decisions of the households
and firms that make up the economy
Principle 7: Governments can sometimes
improve market outcomes
•We need government
– Enforce rules and maintain institutions that
are key to a market economy
– Enforce property rights
– Promote efficiency, avoid market failure
– Promote equality, avoid disparities in
economic wellbeing
• Property rights
– Ability of an individual to own and exercise
control over scarce resources
• Market failure
– Situation in which the market left on its
own fails to allocate resources efficiently
– Externalities
– Market power
• Externality
– Impact of one person’s actions on the
well-being of a bystander
– Pollution
• Market power
– Ability of a single economic actor (or small
group of actors) to have a substantial
influence on market prices
• Disparities in economic wellbeing
– Market economy rewards people
• According to their ability to produce things
that other people are willing to pay for
– Government intervention, public policies
• Aim to achieve a more equal distribution of
economic well-being
• May diminish inequality
• Process far from perfect
How the Economy as a Whole Works, #8
Principle 8: A country’s standard of living

depends on its ability to produce goods and
services
•Large differences in living standards
– Among countries
– Over time
•Average annual income, 2011
– $48,000 (U.S.); $9,000 (Mexico)
– $5,000 (China); $1,200 (Nigeria)
• Explanation: differences in productivity

• Productivity
– Quantity of goods and services produced
from each unit of labor input
– Higher productivity
• Higher standard of living
– Growth rate of nation’s productivity
• Determines growth rate of its average income
Principle 9: Prices rise when the

government prints too much
money
•Inflation
– An increase in the overall level “Well it may
of prices in the economy have been 68
cents when you
•Causes for large or persistent got in line, but
it’s 74 cents
inflation now!”
– Growth in quantity of money
– Value of money falls
Principle 10: Society faces a short-run

trade-off between inflation and
unemployment
•Short-run effects of monetary injections:
– Stimulates the overall level of spending
• Higher demand for goods and services
– Firms – raise prices; hire more workers;
produce more goods and services
– Lower unemployment
• Short-run trade-off between

unemployment and inflation
– Key role – analysis of business cycle
• Business cycle
– Fluctuations in economic activity
• Employment
• Production
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Principle 8: A country’s standard of living

• Explanation: differences in productivity

Principle 9: Prices rise when the

Principle 10: Society faces a short-run

• Short-run trade-off between

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