Ten Principles of

Economics
Chapter 1
Copyright 2001 by Harcourt, Inc.
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Economy. . .
. . . The word economy comes from a
Greek word for one who manages a
household.

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A household and an economy

face many decisions:
Who

will work?
What goods and how many of them
should be produced?
What resources should be used in
production?
At what price should the goods be
sold?
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Society and Scarce Resources:

The management of societys
resources is important because
resources are scarce.

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Scarcity . . .
. . . means that society has limited
resources and therefore cannot
produce all the goods and services
people wish to have.

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Economics
Economics is the study of how
society manages its scarce
resources.

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Economists study. . .
How

people make decisions.

How

people interact with each other.

The

forces and trends that affect the

economy as a whole.

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Ten Principles of Economics

How People Make Decisions
1. People face tradeoffs.
2. The cost of something is what you give
up to get it.
3. Rational people think at the margin.
4. People respond to incentives.

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Ten Principles of Economics

How People Interact
5. Trade can make everyone better off.
6. Markets are usually a good way to
organize economic activity.
7. Governments can sometimes improve
economic outcomes.

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Ten Principles of Economics

How the Economy as a Whole Works
8. The standard of living depends on a
countrys production.
9. Prices rise when the government prints
too much money.
10. Society faces a short-run tradeoff
between inflation and unemployment.
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1. People face tradeoffs.

There is no such thing
as a free lunch!

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1. People face tradeoffs.

To get one thing, we usually
have to give up another thing.

Guns v. butter
Food v. clothing
Leisure time v. work
Efficiency v. equity
Making decisions requires trading
off one goal against another.

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1. People face tradeoffs.

Efficiency v. Equity
Efficiency means society gets the most
that it can from its scarce resources.
Equity means the benefits of those
resources are distributed fairly among
the members of society.

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2. The cost of something is

what you give up to get it.
Decisions require comparing costs and
benefits of alternatives.

Whether to go to college or to work?

Whether to study or go out on a date?
Whether to go to class or sleep in?

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2. The cost of something is

what you give up to get it.
The opportunity cost of an
item is what you give up to
obtain that item.

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3. Rational people think at the

margin.
Marginal changes are small, incremental
adjustments to an existing plan of action.

People make decisions by comparing

costs and benefits at the margin.

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4. People respond to incentives.

Marginal changes in costs or benefits
motivate people to respond.
The decision to choose one alternative
over another occurs when that
alternatives marginal benefits exceed its
marginal costs!

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4. People respond to incentives.

If someone offers you a job as manager you
might choose to skip college and go straight
to work.
or:
If the price of Coca Cola increases you might
decide to drink Pepsi Cola.

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5. Trade can make everyone

better off.
People

gain from their ability to

trade with one another.
Competition results in gains from
trading.
Trade allows people to specialize in
what they do best.
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6. Markets are usually a good

way to organize economic
activity.
In

a market economy, households

decide what to buy and who to work
for.
Firms decide who to hire and what
to produce.
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6. Markets are usually a good

way to organize economic
activity.
Adam Smith made the
observation that households
and firms interacting in
markets act as if guided by an
invisible hand.

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6. Markets are usually a good

way to organize economic
activity.
Because households and firms look at prices
when deciding what to buy and sell, they
unknowingly take into account the social
costs of their actions.
As a result, prices guide decision makers to
reach outcomes that tend to maximize the
welfare of society as a whole.

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7. Governments can
sometimes improve market
outcomes.
When the market fails (breaks
down) government can intervene to
promote efficiency and equity.

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7. Governments can
sometimes improve market
outcomes.
Market failure occurs when
the market fails to allocate
resources efficiently.

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7. Governments can
sometimes improve market
outcomes.
Market failure may be caused by an
externality, which is the impact of
one person or firms actions on the
well-being of a bystander.

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7. Governments can
sometimes improve market
outcomes.
Market failure may also be caused by
market power, which is the ability of
a single person or firm to unduly
influence market prices.

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8. The standard of living

depends on a countrys
production.
Standard of living may be measured in
different ways:
By comparing personal incomes.
By comparing the total market value of a
nations production.

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8. The standard of living

depends on a countrys
production.
Almost all variations in living
standards are explained by
differences in countries
productivities.

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8. The standard of living

depends on a countrys
production.
Productivity is the amount of goods
and services produced from each
hour of a workers time.
Higher productivity Higher standard of living
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9. Prices rise when the

government prints too much
money.
Inflation is an increase in the overall
level of prices in the economy.

One cause of inflation is the growth in the

quantity of money.
When the government creates large quantities
of money, the value of the money falls.

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10. Society faces a short-run

tradeoff between inflation and
unemployment.
The Phillips Curve illustrates the tradeoff
between inflation and unemployment:

Inflation Unemployment
Its a short-run tradeoff!

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Summary
When

individuals make decisions,

they face tradeoffs.
Rational people make decisions by
comparing marginal costs and
marginal benefits.

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Summary
People

can benefit by trading with

each other.
Markets are usually a good way of
coordinating trades.
Government can potentially improve
market outcomes.
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Summary
A countrys

productivity determines
its living standards.
Society faces a short-run tradeoff
between inflation and
unemployment.

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Review Question:

What are the opportunity cost of seeing a movie?

If you are thinking of going to the movie instead
of working at your part-time job, the cost
includes its monetary and time costs, plus the
opportunity cost of the wages you're giving up
by not working.
If the choice is between movie and going to the
library to study, then the cost of seeing the
movie is its monetary and time costs plus the
cost to you of getting a lower grade in your
course.

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Multiple Choice:

The word economy comes from the

Greek word for
a)
b)
c)
d)

environment.
one who participates in a market.
one who manages a household.
conservation.

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Multiple Choice:

Economics is defined as
a) the study of business.
b) the study of how society manages its
scarce resources.
c) the study of central planning.
d) the study of government regulation.

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Multiple Choice:

Which of the following is NOT a

major area of study for economists?
a) how people make decisions
b) how people interact with each other
c) how forces and trends affect the overall
economy
d) how countries choose national leaders

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Multiple Choice:

When society requires that firms

reduce pollution,
a) there is no tradeoff, since everyone benefits
from reduced pollution.
b) there is no tradeoff for society as a whole, since
the cost of reducing pollution falls only on the
firms affected by the requirements.
c) there is a tradeoff only if some firms are forced
to close.
d) there is a tradeoff because of reduced incomes
to the firms owners, workers, and customers.

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Multiple Choice:

In economics, the cost of something

is
a) the out-of-pocket expense of obtaining
it.
b) what you give up to get it.
c) always measured in units of time.
d) always higher than people think.

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Multiple Choice:

For most students, the largest single

cost of a college education is
a) transportation, parking, and
entertainment.
b) tuition, fees, and books.
c) room and board.
d) the wages given up to attend school.

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Multiple Choice:

Carolyn decides to spend an additional hour

working overtime rather than watching a video
with her friends. She earns $8 for her hours
work. Her opportunity cost of working is
a) the $8 she earns.
b) the enjoyment she would have received had she
watched the video.
c) the $8 minus the enjoyment she would have
received from watching the video.
d) nothing, since she would have received less than
$8 of enjoyment from the video.

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Multiple Choice:

A marginal change is
a)
b)
c)
d)

a long-term trend.
a large, significant adjustment.
a change for the worse.
a small incremental adjustment.

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Multiple Choice:

Which is the most accurate statement

about trade?
a) Trade makes some nations better off and others
worse off.
b) Trade can make every nation better off.
c) Trading for a good can make a nation better off
only if the nation cannot produce that good.
d) Trade helps rich nations and hurts poor
nations.

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