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10PrinciplesofEconomicsWikiversity

10PrinciplesofEconomics
FromWikiversity
GregoryMankiw
inhisPrinciples
ofEconomics
outlinesTen
Principlesof
Economicsthat
wewillreplicate
here,theyare:

Contents
1 HowPeopleMakeDecisions
1.1 Peoplefacetradeoffs
1.2 Thecostofsomethingiswhatyougiveuptogetit
1.3 Rationalpeoplethinkatthemargin
1.4 Peoplerespondtoincentives
2 HowPeopleInteractWithEachOther
2.1 Tradecanmakeeveryonebetteroff
2.2 Marketsareusuallyagoodwaytoorganizeeconomicactivity
2.3 Governmentscansometimesimprovemarketoutcomes
3 TheForcesandTrendsThatAffectHowTheEconomyasaWholeWorks
3.1 Thestandardoflivingdependsonacountrysproduction
3.2 Pricesrisewhenthegovernmentprintstoomuchmoney
3.3 Societyfacesashortruntradeoffbetweeninflationandunemployment

1.Peopleface
tradeoffs
2.Thecostof
something
iswhatyou
giveupto
getit
3.Rational
people
thinkatthe
margin
4.Peoplerespondtoincentives
5.Tradecanmakeeveryonebetteroff
6.Marketsareusuallyagoodwaytoorganizeeconomicactivity
7.Governmentscansometimesimprovemarketoutcomes
8.Acountry'sstandardoflivingdependsonitsabilitytoproducegoodsandservices
9.Pricesrisewhenthegovernmentprintstoomuchmoney
10.SocietyfacesashortruntradeoffbetweenInflationandunemployment.

HowPeopleMakeDecisions
Peoplefacetradeoffs
Thereisnothingsuchasafreelunch.Togetonethingthatwelike,weusuallyhavetogiveupanother
thingthatwelike.Makingdecisionsrequirestradingonegoalforanother.
Examplesincludehowstudentsspendtheirtime,howafamilydecidestospenditsincome,howthe
governmentspendsrevenue,andhowregulationsmayprotecttheenvironmentatacosttofirmowners.
Aspecialexampleofatradeoffisthetradeoffbetweenefficiencyandequity.
Definitionofefficiency:thepropertyofsocietygettingthemaximumbenefitsfromitsscarce
resources.
Definitionofequity:thepropertyofdistributingeconomicprosperityfairlyamongthe
membersofsociety.
Forexample,taxpaidbywealthypeopleandthendistributedtopoormayimproveequitybut
lowertheincentiveforhardworkandthereforereducethelevelofoutputproducedbyour
resources.
Thisimpliesthatthecostofthisincreasedequalityisareductionintheefficientuseofour
resources.
AnotherExampleisgunsandbutter:Themorewespendonnationaldefense(guns)toprotectour
borders,thelesswecanspendonconsumergoods(butter)toraiseourstandardoflivingathome.
Recognizingthattradeoffsexistdoesnotindicatewhatdecisionsshouldorwillbemade.
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Thecostofsomethingiswhatyougiveuptogetit
Becausepeoplefacetradeoff,makingdecisionsrequirescomparingthecostsandbenefitsofalternative
coursesofaction.
Thecostof
goingtocollegeforayearisnotjustthetuition,books,andfees,butalsotheforegonewages.
seeingamovieisnotjustthepriceoftheticket,butthevalueofthetimeyouspendinthe
theater
Thisiscalledopportunitycostofaresource
Definitionofopportunitycost:whatevermustbegivenupinordertoobtainsomeitem.
Whenmakinganydecision,decisionmakersshouldconsidertheopportunitycostsofeachpossible
action.

Rationalpeoplethinkatthemargin
Economistsgenerallyassumethatpeoplearerational.
Definitionofrational:systematicallyandpurposefullydoingthebestyoucantoachieveyour
objectives.
Consumerswanttopurchasethebundleofgoodsandservicesthatallowsthemthegreatestlevelof
satisfactiongiventheirincomesandthepricestheyface.
Firmswanttoproducethelevelofoutputthatmaximizestheprofits.
Manydecisionsinlifeinvolveincrementaldecisions:ShouldIremaininschoolthissemester?ShouldI
takeanothercoursethissemester?ShouldIstudyanadditionalhourfortomorrowsexam?
Rationalpeopleoftenmakedecisionsbycomparingmarginalbenefitsandmarginalcosts.
Example:Supposethatflyinga200seatplaneacrossthecountrycoststheairline1,000,000,
whichmeansthattheaveragecostofeachseatis5000.Supposethattheplaneisminutesaway
fromdepartureandapassengeriswillingtopay3000foraseat.Shouldtheairlineselltheseat
for3000?Inthiscase,themarginalcostofanadditionalpassengerisverysmall.
Anotherexample:Whyiswatersocheapwhilediamondsareexpensive?Becausewateris
plentiful,themarginalbenefitofanadditionalcupissmall.Becausediamondsarerare,the
marginalbenefitofanextradiamondishigh.

Peoplerespondtoincentives
Peoplewillmakedecisionsbasedonbenefitordetriment.
Anythingthatbringsoutadesiretodowork.
Incentivesmaypossesanegativeorapositiveintention.Itmaybeinapositveoranegativeway.

HowPeopleInteractWithEachOther
Tradecanmakeeveryonebetteroff
Tradeisnotlikeasportscompetition,whereonesidegainsandtheothersideloses.
Considertradethattakesplaceinsideyourhome.Yourfamilyislikelytobeinvolvedintradewithother
familiesonadailybasis.Mostfamiliesdonotbuildtheirownhomes,maketheirownclothes,orgrow
theirownfood.
Countriesbenefitfromtradingwithoneanotheraswell.
Tradeallowsforspecializationinproductsthatbenefitscountries(orfamilies)

Marketsareusuallyagoodwaytoorganizeeconomicactivity
Manycountriesthatoncehadcentrallyplannedeconomieshaveabandonedthissystemandaretryingto
developmarketeconomies.

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Definitionofmarketeconomy:aneconomythatallocatesresourcesthroughthedecentralized
decisionsofmanyfirmsandhouseholdsastheyinteractinmarketsforgoodsandservices.
Marketpricesreflectboththevalueofaproducttoconsumersandthecostoftheresourcesusedto
produceit.
Centrallyplannedeconomieshavefailedbecausetheydidnotallowthemarkettowork.
AdamSmithandtheInvisibleHand
AdamSmiths1776worksuggestedthatalthoughindividualsaremotivatedbyselfinterest,an
invisiblehandguidesthisselfinterestintopromotingsocietyseconomicwellbeing.

Governmentscansometimesimprovemarketoutcomes
Therearetwobroadreasonsforthegovernmenttointerferewiththeeconomy:thepromotionofefficiencyand
equity.
Governmentpolicycanbemostusefulwhenthereismarketfailure.
Definitionofmarketfailure:asituationinwhichamarketleftonitsownfailstoallocate
resourcesefficiently.
ExamplesofMarketFailure
Definitionofexternality:theimpactofonepersonsactionsonthewellbeingofabystander.
(Ex.:Pollution)
Definitionofmarketpower:theabilityofasingleeconomicactor(orsmallgroupofactors)to
haveasubstantialinfluenceonmarketprices.
Becauseamarketeconomyrewardspeoplefortheirabilitytoproducethingsthatotherpeopleare
willingtopayfor,therewillbeanunequaldistributionofeconomicprosperity.
Notethattheprinciplestatesthatthegovernmentcanimprovemarketoutcomes.Thisisnotsayingthat
thegovernmentalwaysdoesimprovemarketoutcomes.

TheForcesandTrendsThatAffectHowTheEconomyasaWhole
Works
Thestandardoflivingdependsonacountrysproduction
Differencesinthestandardoflivingfromonecountrytoanotherarequitelarge.
Changesinlivingstandardsovertimearealsoquitelarge.
Theexplanationfordifferencesinlivingstandardsliesindifferencesinproductivity.
Definitionofproductivity:thequantityofgoodsandservicesproducedfromeachhourofa
workerstime.
Highproductivityimpliesahighstandardofliving.
Thus,policymakersmustunderstandtheimpactofanypolicyonourabilitytoproducegoodsand
services.
Toboostlivingstandardsthepolicymakersneedtoraiseproductivitybyensuringthatworkersarewell
educated,havethetoolsneededtoproducegoodsandservices,andhaveaccesstothebestavailable
technology.

Pricesrisewhenthegovernmentprintstoomuchmoney
Definitionofinflation:anincreaseintheoveralllevelofpricesintheeconomy.
Whenthegovernmentcreatesalargeamountofmoney,thevalueofmoneyfalls.
Examples:GermanyafterWorldWarI(intheearly1920s)andtheUnitedStatesinthe1970s

Societyfacesashortruntradeoffbetweeninflationandunemployment
Mosteconomistsbelievethattheshortruneffectofamonetaryinjection(injecting/addingmoneyinto
theeconomy)islowerunemploymentandhigherprices.
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Anincreaseintheamountofmoneyintheeconomystimulatesspendingandincreasesthedemand
ofgoodsandservicesintheeconomy.
Higherdemandmayovertimecausefirmstoraisetheirpricesbutinthemeantime,italso
encouragesthemtoincreasethequantityofgoodsandservicestheyproduceandtohiremore
workerstoproducethosegoodsandservices.Morehiringmeanslowerunemployment.
Someeconomistsquestionwhetherthisrelationshipstillexists.
Theshortruntradeoffbetweeninflationandunemploymentplaysakeyroleinanalysisofthebusiness
cycle.
Definitionofbusinesscycle:fluctuationsineconomicactivity,suchasemploymentandproduction.
Policymakerscanexploitthistradeoffbyusingvariouspolicyinstruments,buttheextentand
desirabilityoftheseinterventionsisasubjectofcontinuingdebate..

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