Chapter 1 KTVM

9/30/22
CHAPTER 1
TEN PRINCIPLES OF ECONOMICS
CHAPTER 1
TEN PRINCIPLES OF ECONOMICS
1.1 What is Economics?
1.2 Ten principles of economics
In this chapter,
look for the answers to these questions:
§ What is Economics?
§ What kinds of questions does economics address?
§ What are the principles of how people make
decisions?
§ What are the principles of how people interact?
§ What are the principles of how the economy as a
whole works?
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1.1 What is Economics
TEN PRINCIPLES OF ECONOMICS 3
What Economics Is All About

§ “economy” comes from the Greek word “oikonomos” -
one who manages a household.
§ A household faces many decisions - allocate its
scarce resources among its various members, taking
into account each member’s abilities, efforts, and
desires.
§ Like a household, a society faces many decisions -
allocate people (as well as land, buildings, and
machines) to various jobs - allocate the output of
goods and services that they produce

§ 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: the study of how society manages its
scarce resources, e.g.
§ how people decide what to buy,
how much to work, save, and spend
§ how firms decide how much to produce,
how many workers to hire
§ how society decides how to divide its resources
between national defense, consumer goods,
protecting the environment, and other needs
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“Economics is the study of how society

manages its scarce resources”

§ Economics is a social science that studies the
way economic agents make choices on the
allocation of resources, with alternate uses, to
satisfy their needs and wants in order to
maximize their output.
§ Economics is concerned mainly with the
production, distribution, and consumption of
goods and services.
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1.2 Ten principles of Economics
The principles of
HOW PEOPLE
MAKE DECISIONS
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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
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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
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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
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HOW PEOPLE MAKE DECISIONS

Principle #1: People Face Tradeoffs
§ “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
§ All decisions involve tradeoffs.
§ Ex: a student allocate her most valuable
resource—her time.
§ For every hour she studies one subject, she gives
up an hour she could have used studying the
other.
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§ Parents deciding how to spend their family income

§ When they choose to spend an extra dollar on one
of these goods, they have one less dollar to spend
on some other good.
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§ Going to a party the night before your midterm

leaves less time for studying.
§ Having more money to buy stuff requires working
longer hours, which leaves less time for leisure.
§ Protecting the environment requires resources
that could otherwise be used to produce
consumer goods.
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§ Society faces an important tradeoff:
efficiency vs. equality
§ Efficiency: when society gets the most from its
scarce resources
§ Equality: when prosperity is distributed uniformly
among society’s members
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§ Efficiency refers to the size of the economic pie,
and equality refers to how the pie is divided into
individual slices.
§ Tradeoff: To achieve greater equality,
could redistribute income from wealthy to poor.
But this reduces incentive to work and produce,
shrinks the size of the economic “pie.”
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§ Modern society: trade-off between a clean environment
and a high level of income.
§ Laws that require firms to reduce pollution raise the cost
of producing goods and services => smaller profits,
paying lower wages, charging higher prices,…
§ Pollution regulations yield the benefit of a cleaner
environment and the improved health, they come at the
cost of reducing the incomes of the regulated firms’
owners, workers, and customers.
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Principle #2: The Cost of Something Is
What You Give Up to Get It
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§ Making decisions requires comparing the costs

and benefits of alternative choices.
§ The opportunity cost of any item is
whatever must be given up to obtain it.
§ It is the relevant cost for decision making.
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§ Getting into UEL:
§ Benefits: intellectual enrichment and a lifetime of better job
opportunities
§ Cost: spend a year listening to lectures, reading textbooks, and

writing papers, you cannot spend that time working at a job.
§ The opportunity cost of an item is what you give up to get that
item.
§ When making any decision, decision makers should be aware
of the opportunity costs that accompany each possible action.
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The opportunity cost of…

…going to college for a year is not just the tuition,
books, and fees, but also the foregone wages.
…seeing a movie is not just the price of the ticket,
but the value of the time you spend in the theater.
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Principle #3: Rational People Think at the
Margin
§ Rational people systematically and purposefully do the best

they can to achieve their objectives, given the available
opportunities .
§ Marginal change to describe a small incremental adjustment to
an existing plan of action.
§ Rational people often make decisions by comparing marginal
benefits and marginal costs.
§ A rational decision maker takes an action if and only if the
marginal benefit of the action exceeds the marginal cost.
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Margin
§ Consider American Airline deciding how much to charge

passengers who fly standby.
§ Suppose that flying a 200-seat plane of American Airline
from New York to Ohio costs the airline $100,000.
§ Imagine that a plane is about to take off with 10 empty
seats and a standby passenger waiting at the gate is willing to
pay $300 for a seat.
§ Should the airline sell the ticket?
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Margin
§ Average cost of each seat is $500 ($100,000/200). One

might be tempted to conclude that the Airline should never
sell a ticket for less than $500. But a rational airline can
increase its profits by thinking at the margin.
§ If the plane has empty seats, the cost of adding one more
passenger is tiny. The average cost of flying a passenger is
$500, but the marginal cost is merely the cost of the can of
soda that the extra passenger will consume.
§ As long as the standby passenger pays more than the
marginal cost, selling the ticket is profitable.
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Margin
Examples:
§ When a student considers whether to go to
college for an additional year, he compares the
fees & foregone wages to the extra income
he could earn with the extra year of education.
§ When a manager considers whether to increase
output, she compares the cost of the needed
labor and materials to the extra revenue.
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#4: People Respond to Incentives
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Principle #4: People Respond to Incentives
§ Incentive: something that induces a person to act, i.e. the
prospect of a reward or punishment.
§ Rational people respond to incentives.
§ Rational people make decisions by comparing costs and
benefits, they respond to incentives
§ Ex: a higher price in a market provides an incentive for buyers
to consume less and an incentive for sellers to produce more.
§ The influence of prices on the behavior of consumers and
producers is crucial to how a market economy allocates scarce
resources.
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The principles of
HOW PEOPLE
INTERACT
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HOW PEOPLE INTERACT

Principle #5: Trade Can Make Everyone
Better Off
§ Trade between two countries is not like a sports contest in
which one side wins and the other side loses.
§ Trade between 2 countries can make each country better off.
§ Trade allows each person to specialize in the activities she
does best.
§ Countries also benefit from the ability to trade with one another.
§ Trade allows countries to specialize in what they do best and to
enjoy a greater variety of goods and services.
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HOW PEOPLE INTERACT

Principle #6: Markets Are Usually A Good Way
to Organize Economic Activity
§ Market: a group of buyers and sellers

(need not be in a single location)
§ “Organize economic activity” means determining
§ what goods to produce
§ how to produce them
§ how much of each to produce
§ who gets them
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HOW PEOPLE INTERACT

§ 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.
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HOW PEOPLE INTERACT

§ 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.
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HOW PEOPLE INTERACT

§ Prices are the instrument with which the invisible

hand directs economic activity.
§ In any market, buyers look at the price when
determining how much to demand, and sellers look at
the price when deciding how much to supply.
§ As a result of the decisions that buyers and sellers
make, market prices reflect both the value of a good
to society and the cost to society of making the good.
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HOW PEOPLE INTERACT

Principle #7: Governments Can Sometimes
Improve Market Outcomes
§ The invisible hand can work its magic only if the
government enforces the rules and maintains the
institutions that are key to a market economy.
§ Market economies need institutions to enforce property
rights so individuals can own and control scarce
resources.
§ Important role for govt: enforce property rights
(with police, courts)
§ People are less inclined to work, produce, invest, or
purchase if large risk of their property being stolen. 37
37TEN PRINCIPLES OF ECONOMICS
HOW PEOPLE INTERACT

• Government intervene in the economy and change the

allocation of resources that people would choose on
their own: to promote efficiency or to promote equality
• The market on its own fails to produce an efficient

allocation of resources: market failure: externality,
§ market power
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HOW PEOPLE INTERACT

§ 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.
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HOW PEOPLE INTERACT

§ Govt 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 economic “pie” is divided.
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The principles of
HOW THE
ECONOMY
AS A WHOLE
WORKS
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HOW THE ECONOMY AS A WHOLE WORKS

Principle #8: A country’s standard of living
depends on its ability to produce goods &
services.
§ Almost all variation in living standards is attributable to
differences in countries’ productivity - the amount of
goods and services produced by each unit of labor
input.
§ In nations where workers can produce a large quantity
of goods and services per hour, most people enjoy a
high standard of living;
§ In nations where workers are less productive, most
people endure a more meager existence. 42
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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.
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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.
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Principle #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.
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Principle #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.
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CHAPTER SUMMARY
The principles of decision making are:

§ People face tradeoffs.
§ The cost of any action is measured in terms of
foregone opportunities.
§ Rational people make decisions by comparing
marginal costs and marginal benefits.
§ People respond to incentives.
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CHAPTER SUMMARY
The principles of interactions among people are:

§ Trade can be mutually beneficial.
§ Markets are usually a good way of coordinating
trade.
§ Govt can potentially improve market outcomes if
there is a market failure or if the market outcome
is inequitable.
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CHAPTER SUMMARY
The principles of the economy as a whole are:

§ Productivity is the ultimate source of living
standards.
§ Money growth is the ultimate source of inflation.
§ Society faces a short-run tradeoff between
inflation and unemployment.
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9/30/22

1.1 What is Economics?

1.2 Ten principles of economics

1.1 What is Economics

TEN PRINCIPLES OF ECONOMICS 3

What Economics Is All About

TEN PRINCIPLES OF ECONOMICS 4

What Economics Is All About

“Economics is the study of how society

What Economics Is All About

TEN PRINCIPLES OF ECONOMICS 8

1.2 Ten principles of Economics

How People Make Decisions

Principle 1: People face trade-offs

How People Interact

Principle 5: Trade can make everyone better off

How the economy as a whole works

Principle 8: A country’s standard of living depends

HOW PEOPLE MAKE DECISIONS

§ “There ain’t no such thing as a free lunch.”

HOW PEOPLE MAKE DECISIONS

§ Parents deciding how to spend their family income

TEN PRINCIPLES OF ECONOMICS 15

HOW PEOPLE MAKE DECISIONS

§ Going to a party the night before your midterm

TEN PRINCIPLES OF ECONOMICS 16

HOW PEOPLE MAKE DECISIONS

TEN PRINCIPLES OF ECONOMICS 17

HOW PEOPLE MAKE DECISIONS

TEN PRINCIPLES OF ECONOMICS 18

HOW PEOPLE MAKE DECISIONS

TEN PRINCIPLES OF ECONOMICS 20

HOW PEOPLE MAKE DECISIONS

TEN PRINCIPLES OF ECONOMICS 21

HOW PEOPLE MAKE DECISIONS

§ Making decisions requires comparing the costs

TEN PRINCIPLES OF ECONOMICS 22

HOW PEOPLE MAKE DECISIONS

§ Cost: spend a year listening to lectures, reading textbooks, and

HOW PEOPLE MAKE DECISIONS

The opportunity cost of…

TEN PRINCIPLES OF ECONOMICS 24

HOW PEOPLE MAKE DECISIONS

§ Rational people systematically and purposefully do the best

TEN PRINCIPLES OF ECONOMICS 25

HOW PEOPLE MAKE DECISIONS

§ Consider American Airline deciding how much to charge

TEN PRINCIPLES OF ECONOMICS 26

HOW PEOPLE MAKE DECISIONS

§ Average cost of each seat is $500 ($100,000/200). One

HOW PEOPLE MAKE DECISIONS

TEN PRINCIPLES OF ECONOMICS 28

#4: People Respond to Incentives

HOW PEOPLE MAKE DECISIONS

TEN PRINCIPLES OF ECONOMICS 30

HOW PEOPLE INTERACT

TEN PRINCIPLES OF ECONOMICS 32

HOW PEOPLE INTERACT

§ Market: a group of buyers and sellers