10 Principles of Economics Economics Economy- comes from th

1
10 Principles of Economics
2
Economics

• Economy- comes from the Greek word for one who
  manages a household
• Households and economies have a lot in common
• Households face many decisions
• Society must decided what jobs will be done and
  who will do them
• Once society has allocated people to various jobs
  it must also allocate the output of goods and
  services that they produce.

3
Economics

• The management of societys resources is
  important because resources are scarce.
• Scarcitya concept that means a society has a
  limited amount of resources (inputs-labor/capital
  ) and therefore cannot produce all the goods and
  services people wish to have.

4
Economics

• Economics is the study of how societies manage
  its scarce resources.
• Economists study how people make decisions
• How people interact with one another
• Economists analyze forces and trends that affect
  the economy as a whole.

5
Ten Principles of economics

• Individual decision making
• The behavior of an economy reflects the behavior
  of the individuals that make up an economy, we
  start our focus on the four principles of
  individual decision making

6
Principle 1 People face tradeoffs

• TINSTAAFL to get something you want, you will
  have to give up another things that we like.
• Example a student has to decide how to allocate
  her scare amount of time.
• For every hour studying, you give up an hour of
  another activity that you value

7
Principle 1 People face tradeoffs

• Modern society has been forced to decide between
  a clean environment or a higher level of income

8
Principle 1 People face tradeoffs

• Classic trade-off is between guns and butter

9
Principle 1 People face tradeoffs

• Another tradeoff that society faces is between
  efficiency and equity.
• Efficiencymeans that society is getting the most
  that it can from its resources
• Equitymeans that the benefits of those resources
  are distributed fairly among societys members

10
Principle 1 People face tradeoffs

• Equity
• Welfare system
• Unemployment insurance
• Individual income tax
• When a government redistributes income from the
  rich to the poor, it reduces the reward for
  working hard
• As a result people work less and produce fewer
  goods and services

11
Principle 1 People face tradeoffs

• Acknowledging lifes tradeoffs is important
  because people are more likely to make good
  decisions only if they understand the options
  that they have available.

12
Principle 2 The cost of something is what has
to be given up to get it

• Making decisions requires comparing the costs and
  benefits of alternative courses of action.

13
Principle 2 The cost of something is what has
to be given up to get it

• Consider the costs incurred from going to college
• Cost/Benefit analysis
• First problem, is separating the true costs of
  going to college
• Do not forget the value of your time, and lost
  work experience
• Opportunity costs the cost of an item is what
  you give up to get that item.

14
Principle 3 Rational people think in the margin

• At dinner time the decision you face is not
  between fasting or eating like a pig
• But whether you take that extra spoonful of
  mashed potatoes
• The decision is not between blowing off studying
  or studying for 24 straight hours
• But will you spend that extra hour studying your
  notes or watching television.

15
Principle 3 Rational people think in the margin

• Economists use the term marginal changes to
  describe small incremental adjustments to an
  existing plan of action
• In many situations people make the best decisions
  by thinking at the margin

16
Principle 3 Rational people think in the margin

• Lets return to our example of going to college
• To make this decision, you need to know the
  additional benefits that an extra year in school
  would offer.
• And the additional costs that you would incur.
• By comparing these marginal benefits and marginal
  costs you can evaluate whether the extra year in
  school is worthwhile.

17
Principle 3 Rational people think in the margin

• Airline example
• Suppose an airline is deciding how much it should
  charge a passenger who flies standby
• Assume that flying a 200 seat plane across
  country costs an airline 100,000.
• In this case the average price per seat
  (100,000/200 seats) 500

18
Principle 3 Rational people think in the margin

• Should an airline sell a ticket to a passenger on
  standby for 300?
• Of course it should
• While the average cost per seat is 500, the
  marginal cost is merely the cost of the bag of
  peanut and a can of soda the extra passenger will
  consume

19
Principle 3 Rational people think in the margin

• As long as the standby passenger is willing to
  pay more than the marginal cost , selling the
  ticket is profitable
• A rational decision maker takes an action if and
  only if the marginal benefits of an action
  exceeds the marginal costs of that action

20
Principle 4 People respond to incentives

• The effects of price on behavior of buyers and
  sellers in a market are crucial for understanding
  how the economy works

21
Principle 4 People respond to incentives

• Public policymakers should never forget about
  incentives,
• Many policies change the costs and benefits
  people face, and therefore change alters
  behavior.
• Examples
• Gasoline prices / public transit
• Sin taxes

22
Principle 4 People respond to incentives

• When analyzing any policy we must consider not
  only the direct effects but also the indirect
  effects that work through incentives.
• Primary v. secondary markets

23
Quick Quiz

• List and briefly explain the four principles of
  individual decision making, and how they apply to
  your own experiences.

24
How people interact

• The next three principles concern how people
  interact with one another

25
Principle 5 Trade makes everyone better off

• Trade between the US Japan is not a sports
  contest
• Where one side wins and the other looses
• (zero-sum game)
• In fact, trade between the two countries can make
  each country better off
• (increase wealth/incomes)

26
Principle 5 Trade makes everyone better off

• Trade allows countries to specialize in what they
  do best to enjoy a greater variety of goods and
  services

27
Principle 6 Markets are usually a good way to
organize economic activity

• The collapse of the Soviet Union and Eastern
  Europe in the 1980s may be the most important
  change in the world in the last 50 years
• Communist countries used central planners to
  guide economic activity

28
Principle 6 Markets are usually a good way to
organize economic activity

• Planners decided
• What goods and services to produce
• How much is produced
• and Who produces these goods and services

29
Principle 6 Markets are usually a good way to
organize economic activity

• The theory behind central planning believes that
  only the government can organize economic activity

30
Principle 6 Markets are usually a good way to
organize economic activity

• Today most countries have market economies
• In a market economy the decision of a central
  planner are replaced by the decisions of millions
  of firms and households

31
Is the success of market economies puzzling?

• No one is looking out for the economic well being
  of society as a whole
• Most individuals only look out for themselves
• Despite decentralized decision making and self
  interested decision makers
• Market economies have been remarkably successful

32
Key to success

• Prices
• Prices guide these individual decision makers to
  reach market outcomes that in many cases maximize
  the welfare of society as a whole.
• http//www.gametheory.net/applets/prisoners.html

33
Principle 6

• When the government prevents prices from
  adjusting naturally through supply demand,
• It impedes the invisible hands ability to
  coordinate the economy
• This explains why taxes distort prices and thus
  the decisions of households and firms

34
Principle 6

• This also helps to explain the failure of
  communism
• Prices were not determined in the market place
  but were directed by central planners

35
Principle 7 Governments can sometimes improve
market outcomes

• Why do we need governments?
• One answer is that the invisible hand needs
  government to protect it
• Farmers would not grow crops if they will just
  get stolen
• Restaurants would not being you a meal if they
  thought they were not going to get paid for it

36
Two broad ways a government could intervene

• To promote efficiency
• The invisible hand usually leads to markets to
  allocate resources efficiently
• When it does not we say there was a market failure

37
Two broad ways a government could intervene

• Or, to promote Equity
• Market economies reward people according to their
  ability to produce things that other people are
  willing to pay for
• The invisible hand does not ensure that everyone
  had sufficient food, decent clothing, or adequate
  health care

38
Equity

• Public policies, such as income taxes the
  welfare system, aim to achieve a more equitable
  distribution of economic well being
• Most policies aim either to enlarge the economic
  pie or to change how the pie is divided

39
The goal

• One goal of the study of economics is to help you
  judge
• When a government policy is justifiable and when
  it is not
• e.g. promoting efficiency or equity

40
Quick Quiz

• Which form of government would you use and why?
• How would you improve our current market
  economy/democratic system?

41
How the economy works as a whole

• The last three principles concern the workings of
  the economy of a whole

42
Principle 8 A countrys standard of living
depends on its ability to produce goods and
service
43
Principle 8

• The difference in the standard of living around
  the world is staggering

• Average annual income
• US 34,100
• Mexico 8,790
• Nigeria 800

44
Principle 8

• Citizens of high income countries have more TVs,
  more technology, more cars, better nutrition,
  better healthcare, and longer life expectancies
• It does not take much thought to understand why
  terrorism is so rabid in poverty stricken
  countries

45
Principle 8

• The US standard of living has historically grown
  2 per year
• At this rate the average income doubles every 35
  years
• Over the past century, the average income has
  risen 8 fold

46
Principle 8

• Almost all of the variation in the standard of
  living between countries can be attributed to
  differences in a countries productivity
• Productivity refers to the amount of goods and
  services produced from each hour of a workers
  time (marginal)
• The growth of a nations productivity determines
  the growth rate of average incomes

47
Principle 8

• You may be tempted to credit labor unions or
  minimum wage laws for the rise in the standard of
  living in America
• Yet the real hero is the rising productivity of
  the US worker
• e.g. women during WWII

48
Principle 8

• What caused a slow down in the growth of the
  American economy during the 1970s and 80s?
• Increased competition from Japan and other
  countries?
• The real villain was not competition but
  declining productivity growth in the US economy

49
Principle 8

• To boost the standard of living, policymakers
  need to raise productivity by ensuring that
  workers are
• Well educated
• Have the tools needed to produce goods and
  services
• And have access to the best available technology

50
Principle 8

• A lot of growth in an economy is spurred by
  continued research and development
• US has only been a world power for the last 75
  years mostly due to the development of atomic
  sciences and the space race

51
Principle 8

• The next frontier will come from stem cell
  research and other medical research
• If the US does not pursue this research another
  country will and they will reap the benefits
  and probably become the next world power

52
Principle 9

• Prices rise when the government prints too much
  money

53
Principle 9

• In Germany in January 1921, daily newspapers cost
  .30 marks less than two years later, in November
  1922, the same newspaper cost 70,000,000 marks.
• This is a spectacular example of inflation

54
Principle 9

• In the US during the 1970s the overall price
  level more than doubled
• President Ford said inflation was public enemy
  number one
• By contrast, inflation during the 1990s was
  about 3 per year
• At this rate the price level would take more than
  20 years to double.

55
Principle 9

• What causes inflation?
• Growth in the quantity of money
• When a government creates large quantities of the
  nations money, the value of that money falls

56
Principle 10

• Society faces a short-run trade off between
  inflation and unemployment

57
Principle 10

• When a government increases the money supply, one
  result is inflation
• Another result, at least in the short-run, is a
  lower level of unemployment

58
Principle 10

• The curve that illustrates the short-run trade
  off between inflation and unemployment is called
  the Phillips Curve

59
Principle 10

• A controversial topic for many years, but today
  most economists agree in the validity of this
  relationship

60
Principle 10

• This simply means that over a period of a year or
  two, many economic policies push inflation and
  unemployment in opposite directions.

61
Principle 10

• Trade off between inflation and unemployment is
  only temporary
• But the Phillips curve is crucial for
  understanding many developments in the economy

62
Principle 10

• Particularly its important to understand the
  business cycle
• Business cycles irregular and largely
  unpredictable fluctuations in economic activity,
  as measured by the number of people employed or
  in the level of production of goods and services

63
Quick Quiz

• Briefly describe how these three principles
  describe how the economy works