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

 1
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 Countrys 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
3
 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
4
 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.
5
 Ten Principles of Economics
Scarcity - limited nature of societys 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
6
 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

7
 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
societys members
How the pie is divided into individual slices
8
 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
economys resources.

0 300 600 700 1,000 Quantity of

Cars
Produced
9
 The Economist as a Scientist
Efficient levels of production
Economys 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
10
 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

11
 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
12
 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 peoples behavior

13
 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
Trade
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

17
 How People Interact
Principle 6: Markets are usually a good way to
organize economic activity
Communist countries central planning
Government officials (central planners)
Allocate economys 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 18
 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 Smiths invisible hand
19
 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
20
 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

21
 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 persons actions on the well-being
of a bystander
Market power
Ability of a single person (or small group) to
unduly influence market prices
22
 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

23