Chapter 1 - Ten Principles of Economics PDF

N. Gregory Mankiw & Mohamed H. Rashwan Principles of Macroeconomics Chapter 1 Ten Principles of Economics © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a li...

N. Gregory Mankiw & Mohamed H. Rashwan Principles of Macroeconomics Chapter 1 Ten Principles of Economics © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  In this chapter, look for the answers to these questions: What kinds of questions does economics address? Three pitfalls in reasoning 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? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 1 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  What Economics Is All About § Scarcity: the limited nature of society’s resources § 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, etc. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 2 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Three Pitfalls in Reasoning 1. Measuring costs and benefits as proportions instead of as dollar or dirhams amounts 2. Ignoring implicit costs 3. Failing to weigh costs and benefits at the margin. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 3 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The principles of HOW PEOPLE MAKE DECISIONS  PRINCIPLE #1: People Face Tradeoffs All decisions involve tradeoffs. Examples: § Going out with friends the night before your exam leaves less time for studying. § Having more money to buy things requires working longer hours, which leaves less time for leisure. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 5 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  PRINCIPLE #1: People Face Tradeoffs § 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 § Tradeoff: To achieve greater equality, income could be redistribute from the wealthy to the poor via higher taxation on the wealthy. But this reduces incentive to work thus reduces the size of the economic “pie.” © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 6 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  PRINCIPLE #2: The Cost of Something Is What You Give Up to Get It § 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. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 7 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  PRINCIPLE #2: The Cost of Something Is What You Give Up to Get It Examples: The opportunity cost of… …going to university 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. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 8 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  PRINCIPLE #3: Rational People Think at the Margin Rational people § systematically and purposefully do the best they can to achieve their objectives. § make decisions by evaluating costs and benefits at the margin (marginal analysis). § In economics, margin means “small” so a marginal change refers to a small incremental change. Rational decisions are based on the comparison of small incremental benefits to small incremental costs. This may include decisions to engage in illegal activities. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 9 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  PRINCIPLE #3: Rational People Think at the Margin Examples: § When a student considers whether to go to university 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, they compare the cost of the needed labor and materials to the extra revenue. § When a mugger decides to steal a purse, he is comparing the potential valuables inside the purse and the probability of getting arrested. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 10 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  PRINCIPLE #4: People Respond to Incentives § Incentive: something that induces a person to act or not to act (i.e., the prospect of a reward or punishment). § Rational people respond to incentives. Examples: § The high number of unfinished houses in Cairo § Jail for criminals. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 11 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The principles of HOW PEOPLE INTERACT  PRINCIPLE #5: Trade Can Make Everyone Better Off § Rather than being self-sufficient, people can specialize in producing one good or service and exchange it for other goods. § Countries also benefit from trade and specialization: short-run versus long-run § Imports § Exports © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 13 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  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 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 14 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  PRINCIPLE #6: Markets Are Usually A Good Way to Organize Economic Activity § A market economy allocates resources through the decentralized decisions of many households and firms as they interact in markets. Different that a command economy where decisions are centralized by a central authority or government. § 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. 15 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  PRINCIPLE #6: Markets Are Usually A Good Way to Organize Economic Activity § 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 production to the seller. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 16 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  PRINCIPLE #7: Governments Can Sometimes Improve Market Outcomes § Important role for government: enforce property rights (with police, courts) § People are less inclined to work, produce, and invest if their property, both physical and intellectual, is not respected. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 17 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  PRINCIPLE #7: Governments Can Sometimes Improve Market Outcomes § Market failure: when the market fails to allocate society’s resources efficiently § Causes of market failure: § Externalities, when the production or consumption of a good affects bystanders (e.g. pollution). An externality is an unintended consequence of the production process. § Market power, a single buyer or seller has substantial influence on market price (e.g. monopoly or monopsony) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 18 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The principles of HOW THE ECONOMY AS A WHOLE WORKS  PRINCIPLE #8: A Country’s Standard of Living Depends on Its Ability to Produce Goods & 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. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 20 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  PRINCIPLE #8: A Country’s Standard of Living Depends on Its Ability to Produce Goods & Services § The most important determinant of living standards: productivity, the amount of goods and services produced per unit of labor. § Productivity depends on education, skills, and equipment and technology available to workers. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 21 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  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 in circulation, which causes the value of money to fall. § The faster the government creates money, the greater the inflation rate. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 22 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  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. § The Phillips Curve: The short-run inverse relationship between inflation and unemployment. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 23 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.