princ-ch01-presentation6e(2012).pptx

1
Ten Principles of
Economics
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Ron Cronovich
2012 UPDATE
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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N. Gregory Mankiw
Economics
Principles of
Sixth Edition

1
In this chapter,
look for the answers to these questions:
• 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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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, and other needs

The principles of
HOW PEOPLE
MAKE DECISIONS

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PRINCIPLE #1:
People Face Tradeoffs
All decisions involve tradeoffs. Examples:
 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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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,
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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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.

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PRINCIPLE #2:
The Cost of Something Is
What You Give Up to Get It
Examples:
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.
 make decisions by evaluating costs and benefits
of marginal changes, incremental adjustments
to an existing plan.

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PRINCIPLE #3:
Rational People Think at the 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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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.
Examples:
 When gas prices rise, consumers buy more
hybrid cars and fewer gas guzzling SUVs.
 When cigarette taxes increase,
teen smoking falls.

A C T I V E L E A R N I N G 1
Applying the principles
You are selling your 1996 Mustang. You have already
spent $1000 on repairs.
At the last minute, the transmission dies. You can
pay $600 to have it repaired, or sell the car “as is.”
In each of the following scenarios, should you have
the transmission repaired? Explain.
A. Blue book value (what you could get for the car) is
$6500 if transmission works, $5700 if it doesn’t
B. Blue book value is $6000 if transmission works,
$5500 if it doesn’t

Answers
Cost of fixing transmission = $600
A. Blue book value is $6500 if transmission works,
Benefit of fixing the transmission = $800
($6500 – 5700).
It’s worthwhile to have the transmission fixed.
B. Blue book value is $6000 if transmission works,
Benefit of fixing the transmission is only $500.
Paying $600 to fix transmission is not worthwhile.

Observations
 The $1000 you previously spent on repairs is
irrelevant. What matters is the cost and benefit
of the marginal repair (the transmission).
 The change in incentives from scenario A
to scenario B caused your decision to change.

Questions
 What is the number one problem in Economics .
 A buyer trying to choose between a hostel or
budget hotel is example of Trade-off or
opportunity cost?
 Would you sell a hotel room for $80 while normal
price for standard room is $120?
 How we make decision when we think at the
margin?
 When prices rise, people consume less – this
related to which principles of Economics?

Questions
 Which of the following statements is not true?
A. We conduct cost-benefit analysis for each available option
when we do trade-off.
B. For some economic activities, there is no opportunity cost.
C. Opportunity cost is related to the abundance of resources
D. People make trade-off due to resource abundance
 One of the following statements is false.
A. Concepts of Opportunity cost and trade-off helps us to be
aware of scarce resources
B. One traditional trade-off that a society is trade-off between
equality and specialty
C. People are rational
D. Incentives mean rewards or penalty for people.

The principles of
HOW PEOPLE
INTERACT

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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:
 Get a better price abroad for goods they
produce
 Buy other goods more cheaply from abroad
than could be produced at home

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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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PRINCIPLE #6:
 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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PRINCIPLE #6:
 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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PRINCIPLE #7:
Governments Can Sometimes
Improve Market Outcomes
 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.

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PRINCIPLE #7:
 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)
 Market power, a single buyer or seller has
substantial influence on market price
(e.g. monopoly)
 Public policy may promote efficiency.

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PRINCIPLE #7:
 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.

Discussion Question
In each of the following situations, what is the
government’s role? Does the government’s
intervention improve the outcome?
a. Public schools for K-12
b. Workplace safety regulations
c. Public highways
d. Patent laws, which allow drug companies to
charge high prices for life-saving drugs

The principles of
HOW THE
ECONOMY
AS A WHOLE
WORKS

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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.

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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 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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FYI: How to Read Your Textbook
1. Read before class.
You’ll get more out of class.
2. Summarize, don’t highlight.
Highlighting is a passive activity that won’t
improve your comprehension or retention.
Instead, summarize each section in your own
words. Then, compare your summary to the one
at the end of the chapter.

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3. Test yourself.
Try the “Quick Quiz” that follows each section
before moving on to the next section.
Write your answers down, compare them to the
answers in the back of the book. If your answers
are incorrect, review the section before moving on.
4. Practice, practice, practice.
Work through the end-of-chapter review questions
and problems. They are often good practice for
the exams. And the more you use your new
knowledge, the more solid it will become.

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5. Go online.
The book comes with excellent web resources,
including practice quizzes, tools to strengthen
your graphing skills, helpful video clips, and other
resources to help you learn the textbook material
more easily and effectively. Visit:
http://academic.cengage.com/economics/mankiw
6. Study in groups.
Get together with a few classmates to review each
chapter, quiz each other, and help each other
understand the material.

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7. Teach someone.
The best way to learn something is to teach it to
someone else, such as a study partner or friend.
8. Don’t skip the real world examples.
Read the Case Studies and “In The News” boxes
in each chapter. They will help you see how the
new terms, concepts, models, and graphs apply to
the real world. As you read the newspaper or
watch the evening news, see if you can find the
connections with what you’re learning in the
textbook.

S U M M A RY
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.

S U M M A RY
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.

Q u e s t i o n s
 Give three examples of important trade-offs that
you face in your life.
 What is the opportunity cost of seeing a movie?
 Water is necessary for life. Is the marginal bene-
fit of a glass of water large or small?
 Why should policymakers think about
incentives?
 Why is productivity important?
 What is inflation and what causes it?

Q u e s t i o n s
 What does the “invisible hand” of the marketplace
do?
 Explain 2 main causes of market failure and give
examples?
 How inflation and unemployment are related in the
short run?
 Describe some of the trade-offs faced by each of the
following:
a. a family deciding whether to buy a new car
b. a member of Congress deciding how much to
spend on national parks
c. a company president deciding whether to open a
new factory

Q u e s t i o n s
 Why isn’t trade among countries like a game with some
winners and some losers?
 You were planning to spend Saturday working at your
part-time job, but a friend asks you to go skiing. What is
the true cost of going skiing? Now suppose you had
been planning to spend the day studying at the library.
What is the cost of going skiing in this case? Explain.
 You win $100 in a basketball pool. You have
a choice between spending the money now or putting it
away for a year in a bank account that pays 5 percent
interest. What is the opportunity cost of spending the
$100 now?

Q u e s t i o n s
 You are trying to decide whether to take a vacation. Most
of the costs of the vacation (air- fare, hotel, and forgone
wages) are measured in dollars, but the benefits of the
vacation are psychological. How can you compare the
benefits to the costs?
 You were planning to spend Saturday working at your
part-time job, but a friend asks you to go skiing. What is
the true cost of going skiing? Now suppose you had
been planning to spend the day studying at the library.
What is the cost of going skiing in this case? Explain.

Q u e s t i o n s
 The company that you manage has invested
$5 million in developing a new product, but the
development is not quite finished. At a recent meeting,
your salespeople report that the intro- duction of
competing products has reduced
the expected sales of your new product to
$3 million. If it would cost $1 million to finish
development and make the product, should you go
ahead and do so? What is the most that you should pay
to complete development?

Q u e s t i o n s
 The Social Security system provides income for
people over age 65. If a recipient of Social Security
decides to work and earn some income, the amount
he or she receives in Social Security benefits is
typically reduced.
a. How does the provision of Social Security affect
people’s incentive to save while working?
b. How does the reduction in benefits associated
with higher earnings affect people’s incentive to
work past age 65?

Q u e s t i o n s
 A 1996 bill reforming the federal government’s
antipoverty programs limited many welfare recipients to
only two years of benefits.
a. How does this change affect the incentives for
working?
b. How might this change represent a trade-off between
equality and efficiency?

Q u e s t i o n s
 Your roommate is a better cook than you are, but you
can clean more quickly than your roommate can. If your
roommate did all the cooking and you did all the
cleaning, would your chores take you more or less time
than if you divided each task evenly? Give a similar
example of how specialization and trade can make two
countries both better off.

Q u e s t i o n s
 Explain whether each of the following government
activities is motivated by a concern about equality or a
concern about efficiency. In the case of efficiency,
discuss the type of market failure involved.
 a. regulating cable TV prices
b. providing some poor people with vouchers that can be
used to buy food
c. prohibiting smoking in public places
d. breaking up Standard Oil (which once owned 90
percent of all oil refineries) into several smaller
companies
e. imposing higher personal income tax rates on people
with higher incomes
f. instituting laws against driving while intoxicated

Q u e s t i o n s
 Discuss each of the following statements from the standpoints
of equality and efficiency.
a. “Everyone in society should be guaranteed the best
healthcare possible.”
b. “When workers are laid off, they should be able to collect
unemployment benefits until they find a new job.”
 In what ways is your standard of living different from that
of your parents or grandparents when they were your
age? Why have these changes occurred?

Q u e s t i o n s
 Suppose Americans decide to save more of their
incomes. If banks lend this extra saving to
businesses, which use the funds to build new
factories, how might this lead to faster growth in
productivity? Who do you suppose benefits from
the higher productivity? Is society getting a free
lunch?

Q u e s t i o n s
 During the Revolutionary War, the American
colonies could not raise enough tax revenue
to fully fund the war effort; to make up this
difference, the colonies decided to print more
money. Printing money to cover expenditures is
sometimes referred to as an “inflation tax.” Who do
you think is being “taxed” when more money is
printed? Why?

Q u e s t i o n s
 Imagine that you are a policymaker trying to decide whether
to reduce the rate of inflation. To make an intelligent decision,
what would you need to know about inflation, unemployment,
and the trade-off between them?
 A policymaker is deciding how to finance the construction of a
new airport. He can either pay for it by increasing citizens’
taxes or by printing more money. What are some of the short-
run and long-run consequences of each option?

Q u e s t i o n s
 In 2010, President Barack Obama and Congress enacted a
healthcare reform bill in the United States. Two goals of the bill
were to provide more Americans with health insurance (via
subsidies for lower-income households financed
 by taxes on higher-income households) and to reduce the cost of
healthcare (via various reforms in how healthcare is provided).
a. How do these goals relate to equality and efficiency?
b. How might healthcare reform increase productivity in the
United States?
 c. How might healthcare reform decrease productivity in the
United States?

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