Ten Principles of Economics
* The management of society’s resources is important because resources are scarce. * Scarcity refers to the limited nature of society’s resources. * Economics involves the study of how society manages its scarce resources * In most societies, resources are allocated through the combined decisions and actions of millions of households and firms. * Hence, economists must study:
1) How people make decisions
2) How they interact with one another
3) Forces and trends that affect the economy as a whole
10 Principles of economics
The behavior of an economy reflects the behavior of individuals that make up the economy. Hence, we begin our study of economics with the four principles of individual decision-making.
Princple 1: People face trade offs
* Making decisions require trading off one goal against another. * Example: For every hour a student studies one subject, she gives up an hour she could have used studying the other. * One of the main trade-off that society faces is between efficiency and Equality. * Efficiency refers to the property of society getting the most out of its scarce resources. * Equality refers to the property of distributing economic prosperity uniformly among the members of the society. * Example: Welfare systems or unemployment insurance-policies designed to improve equality but end up reducing efficiency.
Principle 2: Opportunity costs
* Because people face trade offs, making decisions require comparing the costs and benefits of alternative courses of actions. Hence, opportunity costs comes in. * Opportunity cost by definition is the next best alternative forgone when a choice is made. I.e. it is whatever that must be given up to obtain some item. * E.g. Lebron james going to school instead of NBA.
Principle 3: Rational People think at the margin
* Rational People are people who systematically and purposefully do the best they can to achieve their objectives.
* Economists assume that people are rational
* A rational decision maker takes an action if and only the marginal benefit of the action exceeds the marginal cost.
* Example flight seats: ($100000/200 seats = $500 but sells tickets at $300 to standby passenger)
Principle 4: People respond to incentives
* Incentive is something that induces a person to act. * Because rational people make decisions by comparing costs and benefits, they respond to incentives. * Example: a higher price in the market provides an incentive for buyers to consume less and an incentive for sellers to produce more. * Incentives consideration is important to public policymakers. When policy makers fail to consider how policies affect incentives, they will end up with unintended consequences. * Example: Car seat belts
* When analyzing any policy, we must consider not only the direct effects but also the less obvious indirect effects that work through incentives. If the policy changes incentives, it will cause people to alter their behavior.
The next three principles concern how people interact with one another.
Principle 5: trade can make everyone better off.
* People are easily misled that trade is a zero sum activity. * Despite the competition that people face during trade, trade allows each person to specialize in activities they have a comparative advantage in. By trading with others, people can buy a greater variety of goods and services at a lower cost.
Principle 6: Markets are usually a good way to organize economic activity. * Market economy is an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services. * Centrally planned economy is an economy whereby central planners decide what goods to produce, who to produce, how much to produce and who to consume these goods and services. * Economist Adam smith made a famous observation in all economics: Households and firms interacting in the markets act as if they are guided by an “invisible hand” that leads them to desirable market outcomes. The invisible hand uses price as the instrument to direct economic activity. * Buyers look at prices to determine how much to demand
* Sellers look at the price to determine how much to supply * Prices will then adjust to guide the buyers and sellers to reach outcomes, in many cases, maximize the well-being of society as a whole. * Central planners failed as they lacked the necessary information about consumers’ tastes and producers’ costs, which in the market economy is reflected in prices. Hence, by determining prices instead of leaving it to the natural interactions in the market place. The well being of the society is not maximized.
Principle 7: Governments can sometimes improve market outcomes
Property rights refers to the ability of an individual to own and exercise control over scarce resources.
* The invisible hand counts on the ability of institutions/ government to enforce our property rights over the things we produce. Also, the invisible hand is nor omnipotent. There are two broad reasons why government intervention is required. * Reason1: To promote Efficiency
-The market is not socially efficient in the case of market failure. -Market failure refers to a situation in which the market fails to allocate resources efficiently. – Market failure may be due to externality or a monopoly.
-Example: Use monopoly.
* Reason 2: To promote Equality
-The invisible hand does not ensure that everyone has sufficient food, decent clothing and adequate healthcare. Hence, government intervention is required. -Example: Income tax and welfare system with the aim to achieve a more equal distribution of economic well being.
The last three principles concern the workings of the economy as a whole.
Principle 8: A country’s Standard of Living depends on it’s ability to produce Goods and Services.
Principle 9: Price rises when the government prints too much money
Principle 10: Society faces a short- run trade off between inflation and unemployment.