1 ten principles of economics premium powerpoint slides by ron cronovich 2012 cengage learning. all...

1Ten Principles of Economics Premium

PowerPoint Slides by

Ron Cronovich

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, 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 for classroom use.

N. Gregory Mankiw

EconomicsPrinciples of

Sixth Edition

2© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, 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 for classroom use.

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?


What Economics Is All About The word economy comes from the Greek word oikonomos, which means

“one who manages a household.” At first, this origin might seem peculiar. But in fact, households and economies have much in common.

A household faces many decisions. It must decide which members of the household do which tasks and what each member gets in return: Who cooks dinner? Who does the laundry? Who gets the extra dessert at dinner? Who gets to choose what TV show to watch? In short, the household must allocate its scarce resources among its various members, taking into account each member’s abilities, efforts, and desires.

Like a household, a society faces many decisions. A society must find some way to decide what jobs will be done and who will do them. It needs some people to grow food, other people to make clothing, and still others to design computer software. Once society has allocated people (as well as land, buildings, and machines) to various jobs, it must also allocate the output of goods and services


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

DECISIONSDecision-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”).


PRINCIPLE #1: People Face Tradeoffs“There ain’t no such thing as a free lunch.” To get one thing that we like, we usually have to give up

another thing that we like. Making decisions requires trading off one goal against another.

Consider a student who must decide how to allocate her most valuable resource—her time. She can spend all her time studying economics, spend all of it studying psychology, or divide it between the two fields. For every hour she studies one subject, she gives up an hour she could have used studying the other. And for every hour she spends studying, she gives up an hour that she could have spent napping, bike riding, watching TV, or working at her part-time job for some extra spending money.


PRINCIPLE #1: People Face Tradeoffs When people are grouped into societies, they face different kinds

of trade-offs. One classic trade-off is between “guns and butter.” The more a society spends on national defense (guns) to protect its shores from foreign aggressors, the less it can spend on consumer goods (butter) to raise the standard of living at home.

Also important in modern society is the trade-off between a clean environment and a high level of income. Laws that require firms to reduce pollution raise the cost of producing goods and services. Because of the higher costs, these firms end up earning smaller profits, paying lower wages, charging higher prices, or some combination of these three. Thus, while pollution regulations yield the benefit of a cleaner environment and the improved health that comes with it, the regulations come at the cost of reducing the incomes of the regulated firms’ owners, workers, and customers.


PRINCIPLE #1: People Face TradeoffsAll 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.


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.”


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.


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.


PRINCIPLE #2: The Cost of Something Is What You Give Up to Get It “The best things in life are free.” Name some of these things that

supposedly are free. 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.


PRINCIPLE #3: Rational People Think at the MarginRational 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.


PRINCIPLE #3: Rational People Think at the MarginExamples: 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.


PRINCIPLE #3: Rational People Think at the Margin For example, consider an airline deciding how much to charge

passengers who fly standby. Suppose that flying a 200-seat plane across the United States costs the airline $100,000. In this case, the average cost of each seat is $100,000/200, which is $500.

One might be tempted to conclude that the airline should never sell a ticket for less than $500. Actually, a rational airline can often find ways to raise its profits by thinking at the margin. Imagine that a plane is about to take off with ten empty seats, and a standby passenger waiting at the gate will pay $300 for a seat.

Should the airline sell the ticket? Of course it should. If the plane has empty seats, the cost of adding one more passenger is tiny.

Although the average cost of flying a passenger is $500, the marginal cost is merely the cost of the bag of peanuts and can of soda that the extra passenger will consume. As long as the standby passenger pays more than the marginal cost, selling the ticket is profitable.


PRINCIPLE #3: Rational People Think at the Margin Why is water so cheap, while diamonds are so expensive? Humans need water to survive, while diamonds are

unnecessary; but for some reason, people are willing to pay much more for a diamond than for a cup of water.

The reason is that 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, in turn, depends on how many units a person already has. Water is essential, but the marginal benefit of an extra cup is small because water is plentiful. By contrast, no one needs diamonds to survive, but because diamonds are so rare, people consider the marginal benefit of an extra diamond to be large.


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. That is one reason people drive smaller cars in Europe, where gasoline taxes are high, than in the United States, where gasoline taxes are low. TURKEY?

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, $5700 if it doesn’tBenefit of fixing the transmission = $800($6500 – 5700). It’s worthwhile to have the transmission fixed.

B. Blue book value is $6000 if transmission works, $5500 if it doesn’tBenefit 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.


The principles of HOW PEOPLE

INTERACT


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


PRINCIPLE #5: Trade Can Make Everyone Better Off 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.


PRINCIPLE #6: Markets Are Usually A Good Way toOrganize 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


PRINCIPLE #6: Markets Are Usually A Good Way toOrganize Economic Activity 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.


PRINCIPLE #6: Markets Are Usually A Good Way toOrganize Economic Activity 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.


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.


PRINCIPLE #7: Governments Can Sometimes Improve Market Outcomes

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.


PRINCIPLE #7: Governments Can Sometimes Improve Market Outcomes 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


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.


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.


PRINCIPLE #9: Prices Rise When the Government Prints Too Much Money Inflation: increases in the general level of prices. In January 1921, a daily newspaper in Germany cost

0.30 marks. Less than two years later, in November 1922, the same newspaper cost 70,000,000 marks.

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.


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.


PRINCIPLE #10: Society Faces a Short-run Tradeoff Between Inflation and Unemployment Most economists describe the short-run effects of

monetary injections as follows:

• Increasing the amount of money in the economy stimulates the overall level of spending and thus the demand for goods and services.

• Higher demand may over time cause firms to raise their prices, but in the meantime, it also encourages them to hire more workers and produce a larger quantity of goods and services.

• More hiring means lower unemployment.


FYI: How to Read Your Textbook1. 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.


FYI: How to Read Your Textbook3. 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.


FYI: How to Read Your Textbook5. 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.

http://academic.cengage.com/economics/mankiw


FYI: How to Read Your Textbook7. 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.


S U M M A RY

The principles of the economy as a whole are:

• Productivity is the ultimate source of living standards.

• Money growth is the ultimate source of inflation.

• Society faces a short-run tradeoff between inflation and unemployment.


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