TEN PRINCIPLES OF ECONOMICS

HOW PEOPLE MAKE DECISIONS

Principle 1: People face trade-offs

 SOCIETY FACES TRADE-OFFS
• The more it spends on national defense (guns) to protect from foreign
aggressors, The less it can spend on consumer goods (butter) to raise
its standard of living

• Pollution regulations: cleaner environment and improved health, But at

the cost of reducing the well-being of the firms’ owners, workers, and
customers

• Efficiency versus Equality

 HOW PEOPLE MAKE DECISIONS

Principle 1: People face trade-offs

Principle 2: The cost of something is what you give up to get it

PRINCIPLE 2: THE COST OF SOMETHING IS WHAT
YOU GIVE UP TO GET IT

Making decisions:
o Compare costs with benefits of alternatives.
o Need to include opportunity costs.

Opportunity cost:
o Whatever must be given up to obtain some item.
 OPPORTUNITY COST

• What is the opportunity cost of going to college for a

year? What is the total cost?

• What is the opportunity cost of going to the movies?

What is the total cost?
 HOW PEOPLE MAKE DECISIONS

Principle 1: People face trade-offs

Principle 2: The cost of something is what you give up to get it

Principle 3: Rational People Think at the Margin

A. As the manager at the local mart, you are thinking
of hiring one more cashier that would increase
sales revenues by Rs. 4000 per week. The new
cashier would earn Rs. 3000 per week. Should you
hire the new cashier? Why?

B. You pay Rs. 120/month for access to Netflix,

regardless of how many movies or TV shows you
watch in a month. Should you watch one more
movie (or episode)? Why?
 HOW PEOPLE MAKE DECISIONS

Principle 1: People face trade-offs

Principle 2: The cost of something is what you give up to get it

Principle 3: Rational People Think at the Margin

Principle 4: People respond to incentives

THE GOVERNMENT INCREASES THE TAX ON PETROL BY
RS. 5 PER LITER.

• How do businesses respond?

• How do consumers respond?

 HOW PEOPLE INTERACT

Principle 5: Trade can make everyone better off.

 HOW PEOPLE INTERACT

Principle 5: Trade can make everyone better off.

Principle 6: Markets are usually a good way to organize economic activity.

 HOW PEOPLE INTERACT

Principle 5: Trade can make everyone better off.

Principle 6: Markets are usually a good way to organize economic activity.

Principle 7: Governments can sometimes improve market outcomes.

13
 THE GOVERNMENT

In each of the following situations, what is the government’s role?

Does the government’s intervention improve the outcome?

A. Government schools.

B. Workplace safety regulations

C. Public highways

D. Patent laws, which allow drug companies to charge high prices for life-saving drugs
 HOW THE ECONOMY AS A WHOLE
WORKS

Principle 8: A country’s standard of living depends on its ability to produce goods

and services.

Principle 9: Prices rise when the government prints too much money.

Principle 10: Society faces a short-run trade-off between inflation and

unemployment.
Principle 1: People face trade-offs

Principle 2: The cost of something is what you give up to get it

Principle 3: Rational People Think at the Margin

Principle 4: People respond to incentives

Principle 5: Trade can make everyone better off.

Principle 6: Markets are usually a good way to organize economic activity.

Principle 7: Governments can sometimes improve market outcomes.

Principle 8: A country’s standard of living depends on its ability to produce goods and services.

Principle 9: Prices rise when the government prints too much money.

Principle 10: Society faces a short-run trade-off between inflation and unemployment.
 MICRO- AND MACROECONOMICS

• Microeconomics
• The study of how households and firms make decisions and how they interact in
markets
• Macroeconomics
• The study of economy-wide phenomena, including inflation, unemployment, and
economic growth
 THINK-PAIR-SHARE

Your university decides to reduce the price of mess on

campus from Rs. 6000 per semester to Rs. 4000 per semester.

A. The number of students desiring to go to mess on

campus will _________.
B. The amount of time it would take to get a plate and fill it
will ___________.
C. Will the lower price of food necessarily lower the true
cost of food? (Hint: opportunity cost)
 ECONOMISTS STUDY: • Economists play two roles:
o Scientists: try to explain the world
o Policy advisors: try to improve it

• How people decide how much they work, what • As scientists, economists employ the scientific
they buy, how much they save, and how they method.
invest their savings o Dispassionate development and testing of
theories about how the world works
o Devise theories, collect data, and analyze these
• How firms decide how much to produce and data to verify or refute their theories
how many workers to hire

• How society decides how to divide its • Economists make assumptions. (simplification)
resources between national defense, consumer
goods, protecting the environment, and other
needs
• Economists use models to study economic issues.
(simplification)
 ECONOMISTS IN GOVERNANCE

• Chief Economic Advisor

• Advises the prime minister
• Writes the annual Economic Survey

• Ministry of Finance
• Helps formulate spending plans and regulatory policies

• Reserve Bank of India

THE CIRCULAR-FLOW DIAGRAM
 THE CIRCULAR FLOW – 1

Households:
▪ Own the factors of production,
sell/rent them to firms for income
▪ Buy and consume goods and
services
Firms Households

Firms:
▪ Buy/hire factors of production,
use them to produce goods
and services
▪ Sell goods and services
 THE CIRCULAR FLOW – 2

Markets for
Goods and
Services
▪ Goods and services
are bought and sold.
▪ Sellers: firms
▪ Inputs are bought ▪ Buyers: households
and sold.
▪ Sellers: households
▪ Buyers: firms Markets for
Factors of
Production
 THE CIRCULAR FLOW – 3
Revenue Spending
Markets for
G&S Goods &
G&S
sold Services bought

Firms Households

Factors of Labor, land,

production Markets for capital
Factors of
Wages, rent, Production Income
profit
 THE PPF

Production possibilities frontier (PPF)

A graph that shows various combinations of outputs that the economy can
possibly produce, given the available factors of production and the available
production technology.
 EXAMPLE: THE PPF

• Assume the following:

• A country produces only two goods: airplanes and soybeans.
• It has a fixed amount of resources (labor).
• And it has a fixed amount and quality of technology.
• The available resources and technology can be used to produce:

• Only soybeans (5,000 tons)

• Only airplanes (100 airplanes)
• Or a combination of soybeans and airplanes
EXAMPLE : THE PPF AND OUTPUT COMBINATIONS

Airplanes Tons of Soybeans

A 0 5,000
B 20 3,000
C 50 2,500
D 80 1,000
E 100 0
• These are just a few of the possible production
combinations.
• To increase the production of airplanes from 0 to 20,
how many tons of soybeans do we have to give up?
 EXAMPLE 1: DRAWING THE PPF
Airplanes
100 E
Airplanes Tons of D
Soybeans 80
A 0 5,000 C
50
B 20 4,000
C 50 2,500 B
20
D 80 1,000 A
E 100 0 0 1,000 2,500 4,000 5,000
Soybeans (tons)
• Efficient: the economy is getting all it can from the scarce
resources available – points on the PPF (A, B, C, D, E)
• Inefficient levels of production: points inside the PPF
• Not feasible: points outside the PPF
 POINTS OFF THE PPF

Use the graph from the previous example.

Would it be possible for the economy to produce the following combinations of
the two goods?

• Point F: 80 airplanes and 4,000 tons of soybeans

• Point G: 30 airplanes and 2,500 tons of soybeans
 MOVING ALONG THE PPF

• Moving along a PPF

• Involves shifting resources from the production of one good to the other
• Society faces a tradeoff.
• Getting more of one good requires sacrificing some of the other.
• The slope of the PPF
• The opportunity cost of one good in terms of the other
 THE PPF AND OPPORTUNITY COST

Airplanes
E
100 To produce the first 1,000 tons of
D soybeans: give up 20 airplanes
80 • Opportunity cost of 1 airplane =
______
C
50
• Opportunity cost of 1 ton of
B soybeans = _______
20
A

0 1,000 2,500 4,000 5,000

Soybeans (tons)
 ECONOMIC GROWTH AND THE PPF

Airplanes
• With additional resources
120
or an improvement in
Economic growth technology, the economy
100 shifts the PPF
outward. can produce:
80
• more soybeans,
50
• more airplanes,
• or any combination in
20
between.
0 1,000 2,500 4,000 5,000 6,000

Soybeans (tons)
 THE SHAPE OF THE PPF

• Shape of the PPF

• Straight line: constant opportunity cost
• Previous example: the opportunity cost of 1 airplane is 50 tons of soybeans
• Bowed outward: increasing opportunity cost
• As more units of a good are produced, we need to give up increasing amounts of
the other good produced.
WHY THE PPF MIGHT BE BOWED OUTWARD – 1

• As the economy shifts

Beer
resources from beer to
mountain bikes:
• PPF becomes steeper
• and the opportunity
cost of mountain bikes
increases.

Mountain
Bikes
WHY THE PPF MIGHT BE BOWED OUTWARD – 2

At A, opportunity cost of • At point A, most workers

Beer
A mountain bikes is low. are producing beer, even
those who are better
suited to building bikes.
B
• At B, most workers are
At B, opportunity producing bikes.
cost of mountain
bikes is high. The few left in beer
production are the best
Mountain brewers.
Bikes
 WHY THE PPF MIGHT BE BOWED
OUTWARD

• The PPF is bowed outward when:

• Different workers have different skills
• There are different opportunity costs of producing one good in terms of the other
• There is some other resource, or mix of resources, with varying opportunity costs
• E.g., different types of land suited for different uses
 THE ECONOMIST AS POLICY ADVISER

• Positive statements: descriptive

• Attempt to describe the world as it is
• Confirm or refute by examining evidence: “Minimum-wage laws
cause unemployment.”
• Normative statements: prescriptive
• Attempt to prescribe how the world should be: “The government
should raise the minimum wage.”

• Note: A statement need not be true to be positive.

 POSITIVE OR NORMATIVE?

Which of these statements are “positive” and which are “normative”? How can you tell the
difference?

A. Prices rise when the government increases the quantity of money.

B. The government should print less money.
C. A tax cut is needed to stimulate the economy.
D. An increase in the price of burritos will cause an increase in consumer demand
for movie streaming.
 PROPOSITIONS

a. A ceiling on rents reduces the quantity and quality of housing

available.
b. Tariffs and import quotas usually reduce general economic welfare.
c. Cash payments increase the welfare of recipients to a greater degree
than do transfers in-kind of equal cash value.
d. A large federal budget deficit has an adverse effect on the economy.
e. A minimum wage increases unemployment among young and
unskilled workers.
 PROPOSITIONS

• A ceiling on rents reduces the quantity and quality of housing

available. (93%)
• Tariffs and import quotas usually reduce general economic welfare.
(93%)
• Cash payments increase the welfare of recipients to a greater degree
than do transfers in-kind of equal cash value. (84%)
• A large federal budget deficit has an adverse effect on the economy.
(83%)
• A minimum wage increases unemployment among young and unskilled
workers. (79%)