Principles of Microeconomics Chapter 1 Ten Principles of Economics 

Ch.1 - Ten Principles of Economics 

• Scarcity: society has limited resources and cannot produce all goods and services people want

• Economics: the study of how society manages its scarce resources

  • How people make decisions

  • How people interact with one another

  • The forces and trends that affect the economy as a whole

1-1 How People Make Decisions

• Principle 1: People face trade-offs

  • Guns and butter (national defense vs. consumer goods) 

  • Efficiency and equality: the balance between whether society gets maximum benefits or benefits are distributed uniformly among society’s members.

    • Increasing equality usually means sacrificing efficiency 

  • Efficiency: absent of waste 

    • On the production side, this means producers are producing at the lowest cost possible. On the consumption side, this means the good is being consumed by those who value it the highest. 

  • No such thing as “free lunch”

    • Building factories means decreasing consumption now because resources are going into building capital rather than producing goods and services.

• Principle 2: Cost of something is what you give up to get it

  • Compare costs and benefits of alternative courses of action

  • Opportunity cost: what you give up to get that item. 

    • Best alternative use of those resources (which is subjectively defined) 

• Principle 3: Rational people think at the margin

  • Rational people: people who systematically and purposefully do the best they can to achieve their goals given the opportunities 

  • Marginal change: a small incremental adjustment to an existing plan of action

  • Marginal cost: the price of adding one additional unit

  • Rational people make decisions by comparing marginal benefits and marginal costs

  • Marginal benefit of RARE items is large 

  • Rational decision maker takes action only if the action’s marginal benefit > marginal cost 

• Principle 4: People respond to incentives

  • Incentive: something that induces a person to act, such as a reward or punishment

  • If the policy changes incentives, it will cause people to alter their behavior 

1-2 How People Interact

• Principle 5: Trade can make everyone better off

  • Trade allows each person to specialize in what he/she does best, so people can buy a greater variety of goods and services at lower cost. 

  • Same applies to countries (partners AND competitors) 

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

  • Central planning: only the government can organize economic activity that promotes everyone’s well-being 

  • Market economy: the decisions are made by millions of firms and households who interact in the marketplace. Money and self-interest guide their decisions. 

  • “Invisible hand”: prices adjust to guide buyers and sellers to outcomes that maximize society’s well-being

  • Government intervention in prices prevents the invisible hand from coordinating the decisions to improve wellbeing (ex. TAXES distort prices and thus decisions)

  • Surge pricing allocates services to consumers who value them the most 

• Principle 7: Governments can sometimes improve market outcomes

  • Invisible hand only works if government enforces rules to maintain market economy

  • Need to enforce property rights so individuals can own and control scarce resources

  • Government is not omnipotent, need them to promote efficiency/equality

  • [Efficiency] Market failure: market on its own fails to produce efficient allocation of resources

  • [Efficiency] Externality: a cause for market failure; the impact of one person’s actions on a bystander/outsider

    • Externalities can be an unpriced benefit or cost (ex. Pollution is negative, education is positive)

  • [Efficiency] Market power: another cause for market failure; ability of a single person/firm to unduly influence market prices

  • [Equality] Public policies aim to achieve more equal distribution of economic well-being

  • [Equality] government can sometimes be corrupt; designed to only reward the powerful 

1-3 How the Economy as a Whole Works

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

  • Variations in average income are reflected in quality of life

  • Variation in living standards is attributed to countries’ PRODUCTIVITY (the amount of goods and services produced by each unit of labor input); higher productivity → higher growth in income

  • Productivity → income → living standards

  • Must consider productivity when thinking about public policy 

• Principle 9: Prices rise when the government prints too much $$$

  • Inflation: an increase in the overall levels of prices in the economy

  • CAUSES: mainly growth in quantity of money; large quantities of money → value of money drops 

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

  • Increasing quantity of money → rise in level of spending → higher demand for goods/services

  • Higher demand may later cause firms to raise prices, but also makes them hire more workers and produce more goods/services

  • More hiring → lower unemployment (which leads to inflation/unemployment short-run trade-off)

  • Business cycle: the irregular and unpredictable fluctuations in economic activity, measured by production of goods/services OR # people employed

  • Economic policy can determine amount government spends/taxes/quantity of money → influence demand for goods/services → affect inflation/unemployment

  • INVERSE RELATIONSHIP between inflation/unemployment short-run