1. Ten Principles of Economics
CHAPTER 1
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Notes about Chapter 1:
Most instructors try to cover this chapter in a single class session (especially those that are teaching the second of a two-semester sequence). If you are teaching principles of microeconomics, you might consider skipping Principles 8-10, which deal with macroeconomics.
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2. 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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3. Ten Principles of Economics
Resources are scarce
Scarcity: the limited nature of society’s resources
Society has limited resources
Cannot produce all the goods and services people wish to have
Economics
The study of how society manages its scarce resources
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4. Ten Principles of Economics
Economists study:
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
You might want to elaborate a bit on some of the points made here. Some examples:
“How do people decide how much to work?” Time is scarce resource—there’s just not enough time to do everything we’d like to do. How do we decide how much of our time to spend working? There’s a tradeoff: the more time we spend working, the higher our income, and therefore the more stuff we can buy. But, the more time we spend working, the less time we have for leisure—hanging out with friends, going hiking, watching movies, etc. (You might want to ask your students how THEY decide how much time to spend working. Some will say it depends on how many classes they are taking, or the time requirements of the available jobs. But probably at least a few will say the wage: the higher the wage, the more worthwhile to work.)
“How do firms decide what kind of labor to hire?” Firms can hire unskilled or skilled workers. The skilled workers are more productive, but cost more than the unskilled workers.
“How do firms decide how much to produce?” Ask your students, and see if any of them say, “It depends on the price of the product they sell.” (Probably some will say “it depends on whether there’s a lot of demand for the product”. To which you might respond “and if there’s a lot of demand for the product, what does that mean for the price that firms can get for the product?”)
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5. How People Make Decisions
Principle 1: People face trade-offs Principle 2: The cost of something is what you give up to get it Principle 3: Rational people think at the margin Principle 4: People respond to incentives
Decision-making is at the heart of economics. The individual must decide how much to save for retirement, how much to spend on different goods and services, how many hours a week to work. The firm must decide how much to produce, what kind of labor to hire. Society as a whole must decide how much to spend on national defense (“guns”) versus how much to spend on consumer goods (“butter”).
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6. Principle 1: People Face Trade-offs
To get something that we like, we have to give up something else that we also like
Going to a party the night before an exam
Less time for studying
Having more money to buy stuff
Working longer hours, less time for leisure
Protecting the environment
Resources could be used to produce consumer goods
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7. Principle 1: People Face Trade-offs
Society faces trade-offs:
The more it spends on national defense (guns) to protect its shores
The less it can spend on consumer goods (butter) to raise the standard of living at home
Pollution regulations: cleaner environment and improved health
But at the cost of reducing the incomes of the firms’ owners, workers, and customers
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8. Principle 1: People Face Trade-offs
Efficiency: society gets the most from its scarce resources
Equality: 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 economic “pie”
You may want to elaborate verbally on the last bullet to insure that the point is clear.
“Redistribute income from wealthy to poor.” This is accomplished through the progressive tax system, as well as social programs like food stamps and unemployment insurance that provide a safety net for people at the low end of the income distribution.
“But this reduces the incentive to work…” The reward for working hard is a high income. Taxes reduce this reward, and therefore reduce the incentive to work hard.
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9. Principle 2: The Cost of Something Is What You Give Up to Get It
Making decisions:
Compare costs with benefits of alternatives
Need to include opportunity costs
Opportunity cost
Whatever must be given up to obtain some item
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10. Principle 2: The Cost of Something Is What You Give Up to Get It
The opportunity cost of:
Going to college for a year
Tuition, books, and fees
PLUS foregone wages
Going to the movies
The price of the movie ticket
PLUS the value of the time you spend in the theater
Here’s a fun tangent if you have the class time and are so inclined:
Ask your students about the saying “The best things in life are free.” Ask them to name some of these things that supposedly are free. Ask them what “free” means in this context. The idea here is to get them to see that even things without an explicit monetary cost are not truly “free” because they have an opportunity cost.
For example, when you ask them to name the “best things” that are “free,” they will respond with answers like love, sitting at the top of a mountain you just climbed and enjoying an awesome view, or maybe witnessing the joy of a child who has just been given a new toy. In each case, there is no explicit monetary cost, but there’s an opportunity cost.
For example, a day spent climbing a mountain represents a day of foregone wages. And the fact that the mountain offers the incredible view probably means that land has been set aside for a national park that might otherwise have been used to produce industrial chemicals, or for a subdivision of million-dollar homes.
With love, it’s less obvious, but if prodded enough, your students will be able to think of non-monetary costs associated with love. For example, you might not want to see the latest “Scary Movie” or “Paranormal Activity” but someone you love might be DYING to see it and BEGGING you to take them. So you take them. That’s true love, don’t you think? And it’s certainly not free.
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11. Principle 3: Rational People Think at the Margin
Systematically and purposefully do the best they can to achieve their objectives
Given the available opportunities
Make decisions by evaluating costs and benefits of marginal changes
Small incremental adjustments to a plan of action
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12. Principle 3: Rational People Think at the Margin
Examples:
Cell phone users with unlimited minutes (the minutes are free at the margin)
Are often prone to making long/frivolous calls
Marginal benefit of the call > 0
A manager considers whether to increase output
Compares the cost of the needed labor and materials to the extra revenue
See the textbook for more examples:
The diamond-water paradox:
Water is a necessity for survival; low price
Diamonds are unnecessary; expensive
A person’s willingness to pay for a good is based on the marginal benefit that an extra unit of the good would yield.
The marginal benefit depends on how many units a person already has.
The near-zero marginal cost to an airline (the cost of peanuts and a can of soda) of taking an extra passenger on a flight that’s not full.
As long as the standby passenger pays more than the marginal cost, selling the ticket is profitable.
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13. Principle 4: People Respond to Incentives
Something that induces a person to act
Examples:
When gas prices rise, consumers buy more hybrid cars and fewer gas guzzling SUVs
When cigarette taxes increase, teen smoking falls
Seat belt law alters a driver’s cost–benefit calculation:
Seat belts make accidents less costly (reduce the likelihood of injury or death), and reduce the benefits of slow, careful driving
People will drive faster and less carefully, which leads to a larger number of accidents
1975 study, Sam Peltzman concluded that the net result is little change in the number of driver deaths and an increase in the number of pedestrian deaths
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14. Active Learning 1 Applying the principles
You are selling your 2007 Mustang. You have already spent $1,000 on repairs. At the last minute, the transmission dies. You can pay $900 to have it repaired, or sell the car “as is.”
In each of the following scenarios, should you have the transmission repaired? Explain.
Blue book value (what you could get for the car) is $7,500 if transmission works, $6,200 if it doesn’t.
Blue book value is $6,300 if transmission works, $5,500 if it doesn’t.
Most of these PowerPoint chapters have two or three Active Learning activities. They break up the lecture with short in-class activities for immediate reinforcement, application, or assessment of the material in the preceding slides. A good idea is to give students time to formulate their answers before asking for volunteers to share their answers with the class. When the questions or exercises are more complex, consider having them work in pairs.
Digression on class participation:
In general, it’s not a good idea to try to solicit participation by saying “Who can tell me the answer to X?” The invariable result is regular participation by very few students —the quick thinkers who have the confidence to answer spontaneously in front of the class—with little participation from anyone else. Better is to give students a quiet moment to think through their answers before requesting volunteers.
Better yet is a simple, time-tested activity called “THINK-PAIR-SHARE.” Pair students up. Pose a question or problem. Have students work on the problem individually for a couple minutes. Then, allow a couple minutes for pair work: each student tries to explain to the other why his or her answer is correct, and the other offers feedback. In many cases, students come up with better answers by working together. After this pair time, ask for volunteers. Students are much more likely to participate since they’ll have had the opportunity to test run answers by a classmate. And those who do not participate will at least have had the chance to share their answer with, and get feedback from, one other student.
Activities like these are useful to break up a lecture every minutes or so. They help maintain students’ attention spans and increase their comprehension of the material you cover. These activities are also useful for quick, informal assessment – often, they will alert you to problems in student understanding, which you can then correct before moving on to cover additional material.
End of digression.
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15. Active Learning 1 Answers
Cost of fixing the transmission = $900
A. Blue book value is $7,500 if transmission works, $6,200 if it doesn’t
Benefit of fixing transmission = $1,300
(= 7500 – 6200)
Get the transmission fixed
B. Blue book value is $6,300 if transmission works, $5,500 if it doesn’t
Benefit of fixing the transmission = $800
(= 6300 – 5500)
Do not pay $900 to fix it
In each scenario, we need to compare the marginal benefits with the marginal costs of fixing the transmission.
The $1000 you previously spent on repairs is irrelevant (sunk cost). 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.
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16. How People Interact
Principle 5: Trade can make everyone better off Principle 6: Markets are usually a good way to organize economic activity Principle 7: Governments can sometimes improve market outcomes
Whether we’re talking about the U.S. economy or the local economy, the term “economy” simply means a group of people interacting with each other.
These interactions play a critical role in the allocation of society’s scarce resources. For example, the interaction of buyers and sellers determines the prices of goods and the amounts produced and sold. These interactions are an important part of what economists study.
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17. Principle 5: Trade Can Make Everyone Better Off
People benefit from trade:
People can buy a greater variety of goods and services at lower cost
Countries 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
If each person had to grow his own food, make his own clothes, cut his own hair, we would have a world full of skinny, unfashionable, poor people having bad hair days every day of the week.
It’s far more efficient for each person to specialize in producing a good or service, and then exchanging it with other people for the things they produce.
The statement “trade can make everyone better off” should not be hard to understand, if you think about it for a moment: Each of two parties would not voluntarily enter into an exchange if it made either of them worse off, would they?
The same principles apply at the national and international level: International trade allows countries to sell their exports abroad and get a higher price, and to buy things from abroad more cheaply than they could produce at home.
In addition, trade gives a country’s consumers access to a greater variety of goods – including goods they might not be able to get at all. For example, U.S. consumers enjoy a variety of fresh produce year-round. This would not be possible without international trade.
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18. “Organize economic activity” means determining
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 and services to produce
How much of each to produce
Who produced and consumed these
A market economy is “decentralized,” meaning that there is no government committee that makes the decisions about what goods to produce and so forth. Instead, many households and firms make their own decisions:
* Each of many households decides who to work for and what goods to buy.
* Each of many firms decides whom to hire and what goods to produce.
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19. A market economy allocates resources
Principle 6: Markets Are Usually a Good Way to Organize Economic Activity
A market economy allocates resources
Decentralized decisions of many firms and households – 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
In all versions of this textbook except Brief Principles of Macroeconomics, market efficiency and the invisible hand are covered more thoroughly in Chapter 7.
Milton Friedman introduces these concepts using a very famous, simple, effective story. See it here:
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20. Prices: Invisible hand:
Principle 6: Markets Are Usually a Good Way to Organize Economic Activity
Prices:
Determined: interaction of buyers and sellers
Reflect the good’s value to buyers
Reflect the cost of producing the good
Invisible hand:
Prices guide self-interested households and firms to make decisions that maximize society’s economic well-being
The case study ‘Adam Smith would have loved Uber’ is a great example of the invisible hand at work.
It starts by discussing the strict controls in the market for taxis (limited number of taxi medallions or permits)
May determine the prices that taxis are allowed to charge
To keep unauthorized drivers off the streets and to prevent all drivers from charging unauthorized prices
Continues with information about Uber, launched in 2009
App for smartphones that connects passengers and drivers
Uber cars do not roam the streets looking for taxi-hailing
Not everyone is fond of Uber: Traditional taxi drivers (dislike additional competition)
Economists love Uber: Increase consumer well-being
Surge pricing
Increases the quantity of car services supplied when they are most needed
Allocate the services to those consumers who value them most highly
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21. Principle 7: Governments Can Sometimes Improve Market Outcomes
Government - enforce property rights
Enforce rules and maintain institutions that are key to a market economy
People are less inclined to work, produce, invest, or purchase if large risk of their property being stolen
Two examples of the idea in the second bullet point:
A restaurant won’t serve meals if customers do not pay before they leave.
A record company won’t produce CDs if too many people avoid paying by making illegal copies.
Many fledging market economies are struggling through the transition from central planning because they have not developed institutions that protect and enforce property rights. The British news magazine The Economist has lots of current examples of this. An older but still interesting example comes from a column that Mankiw wrote in the June 12, 2000, issue of Fortune magazine entitled “Ukraine: How Not To Run An Economy.”
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22. Principle 7: Governments Can Sometimes Improve Market Outcomes
Government - promote efficiency
Avoid market failures: market left on its own fails to allocate resources efficiently
Externality – source of market failure
Production or consumption of a good affects bystanders (e.g. pollution)
Market power – source of market failure
A single buyer or seller has substantial influence on market price (e.g. monopoly)
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23. Principle 7: Governments Can Sometimes Improve Market Outcomes
Government - promote equality
Avoid disparities in economic wellbeing
Use tax or welfare policies to change how the economic “pie” is divided
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24. Active Learning 2 Discussion Question
In each of the following situations, what is the government’s role?
Does the government’s intervention improve the outcome?
Public schools for K-12
Workplace safety regulations
Public highways
Patent laws, which allow drug companies to charge high prices for life-saving drugs
The items in this list are meant to get students thinking about Principles 6 and 7 in the context of specific examples, and to generate discussion rather than arrive at definitive answers.
NOTE: Discussing the entire list would consume a lot of class time (20-25 minutes). Two would suffice. Pick your favorite two and delete the others. Of course, you can skip this slide entirely if you wish to get through the chapter as quickly as possible. Here are some notes that might help guide the discussion:
a. Public schools. The alternative would be private schools. The cost of education would be concentrated among those with school-aged children, rather than spread over all taxpayers, so the price per child would likely be high. Some families would not be able to afford to enroll their children in schools, and would either home-school the children or raise them without education. Is the benefit to society of having an educated population large enough to justify making people without children share in the cost? Could the private sector provide education more efficiently (either at lower cost or higher quality) than the public sector?
b. Workplace safety regulations. Without such regulations, would firms provide a safe environment for their workers? Some students will say “no—look at how bad working conditions are in poor countries that have no safety regulations.” Another view is that dropping such regulations would make workers better off. Workers may view the safety of their work environment as part of their wage: the less safe the environment at a specific firm, the higher the wage the firm will have to offer to make workers willing to work there. If workers vary with respect to their tolerance for unsafe conditions, then workers with a high risk tolerance would be better off if given the option to work for higher wages in factories that aren’t as safe. Such workers would be worse off if the government required all firms to provide equally safe conditions.
c. Public highways. The alternative would be toll highways operated by the private sector. People who use highways more would pay more, and people who use them less would pay less, which seems fairer than having everyone pay equally for highways. (Actually, everyone does not pay equally - people who use public roads more buy more gas, and therefore pay more gas tax.) If there are external benefits to society of having a national highway system, then the private sector would under-provide this good.
d. Patent laws. I’ve kind of loaded the question with the wording on the slide. If you wish, change it to just “Patent laws.” Is it fair that drug companies charge such high prices for drugs that some people need to stay alive? If drug prices are regulated, how might pharmaceutical firms respond?
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25. How the economy as a whole works
Principle 8: A country’s standard of living depends on its ability to produce goods and services Principle 9: Prices rise when the government prints too much money Principle 10: Society faces a short-run trade-off between inflation and unemployment
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26. Huge variation in living standards
Principle 8: Country’s Standard of Living Depends on Its Ability to Produce Goods and 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
“Rich countries” refers to countries like the U.S. and Germany.
“Poor countries” refers to countries like India, Indonesia, and Nigeria.
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27. Productivity: most important determinant of living standards
Principle 8: Country’s Standard of Living Depends on Its Ability to Produce Goods and Services
Productivity: most important determinant of living standards
Quantity of goods and services produced from each unit of labor input
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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28. Principle 9: Prices Rise When the Government Prints Too Much Money
Inflation
An increase in the overall level of prices in the economy
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 government creates money, the greater the inflation rate
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29. Short-run trade-off between unemployment and inflation
Principle 10: Society Faces a Short-run Trade-off between Inflation and Unemployment
Short-run trade-off between unemployment and inflation
Over a period of a year or two, 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
While the long-run effect of increasing the quantity of money is inflation, the short-run effects are more complicated—and controversial.
However, most mainstream economists believe the following: An increase in the quantity of money causes spending to rise, which causes prices to rise, which induces firms to produce more goods and services, which requires that they hire more workers. Hence, in the short-run, increasing the quantity of money causes inflation to rise, but unemployment to fall.
Of course, REDUCING the quantity of money would have the opposite effects (inflation would fall, while unemployment would rise) in the short run.
Keep in mind, though, the lesson from Principle 9: In the long run, changing the quantity of money only affects inflation. We will learn in a later chapter what determines the rate of unemployment in the long run, and we will see that it has nothing to do with the quantity of money.
The second bullet addresses the following point: In som decades, due to factors outside of the control of policymakers, inflation and unemployment are both high (e.g. 1970s) or both low (e.g. 1990s). Yet, given these other factors, policymakers can always reduce unemployment temporarily by creating more inflation, or vice versa.
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30. Summary Fundamental lessons about individual decision making:
People face trade-offs among alternative goals
The cost of any action is measured in terms of forgone opportunities
Rational people make decisions by comparing marginal costs and marginal benefits
People change their behavior in response to the incentives they face
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31. Summary Fundamental lessons about interactions among people:
Trade and interdependence can be mutually beneficial
Markets are usually a good way of coordinating economic activity among people
The government can potentially improve market outcomes by remedying a market failure or by promoting greater economic equality
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, 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 or school-approved learning management system for classroom use.

32. Summary Fundamental lessons about the economy as a whole:
Productivity is the ultimate source of living standards
Growth in the quantity of money is the ultimate source of inflation
Society faces a short-run trade-off between inflation and unemployment
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, 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 or school-approved learning management system for classroom use.