Empowering Economic Minds
Ten Principles of Economics
Principles of Economics
The following are the 10 principles of economics as indicated by Mankiw.
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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
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
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
Principles 1 to 4 focus on how individuals make decisions, considering trade-offs, opportunity costs, rational decision-making, and the incentives that drive their choices. Meanwhile, Principles 5 to 7 explain how people interact with one another, highlighting the benefits of trade, how buyers and sellers organize market activity, and the role of government in improving market outcomes through public policies.
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Moreover, Principles 8 to 10 examine how the decisions of individuals (as discussed in Principles 1 to 4) and the interactions between economic agents (as discussed in Principles 5 to 7) influence the economy as a whole. These principles delve into macroeconomic concepts, including a country’s standard of living, the relationship between inflation and money supply, and the short-run trade-off between inflation and unemployment.
Principle 1: People Face Trade-offs
Every decision involves trade-offs, where choosing one option requires forgoing another. The following are examples of situations where people face trade-offs.
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Going to a party the night before an exam means sacrificing your time for studying.
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When you want to earn more income often requires working longer hours, which sacrifices time for doing leisure things or even resting.
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A firm or company may need to decide between investing in new technology to increase productivity or expanding its workforce to boost production capacity.
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Societal decisions also involve trade-offs, such as balancing efficiency—achieving the maximum benefits from limited resources—with equality, which aims to distribute these benefits evenly among all members of society.
Principle 2: The Cost of Something Is What You Give Up to Get It
When making decisions, individuals must consider the opportunity cost, which is the value of what you sacrifice when you choose one option over another.
The following are examples of opportunity cost:
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The true cost of attending college for a year goes beyond just tuition, books, and other fees; it also includes the income you forgo by choosing to study instead of working during that time.
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The cost of watching a movie involves not only the price of the ticket but also the value of the time spent.
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The opportunity cost for a firm is choosing to invest in new machinery instead of launching a new product, thereby forgoing potential revenue from the new product.
Principle 3: Rational People Think at the Margin
A rational person is someone who makes decisions logically and systematically to achieve their objectives or goals, considering all available information, potential outcomes, and possible alternatives. When we say “thinking at the margin”, this involves making decisions based on small, incremental changes to a plan of action rather than taking into account larger or more significant changes. This entails weighing the additional benefits costs of having a bit more or less of something.
The following are examples of a rational person thinking at the margin.
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A student deciding whether to continue their education for another year will weigh the additional tuition costs and lost wages against the potential higher income they could earn with further education.
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A manager evaluating whether to increase production will compare the additional costs of labor and materials with the expected additional revenue.
Principle 4: People Respond to Incentives
Incentives, whether they are rewards or punishments, influence people's behavior. Rational individuals adjust their actions in response to these incentives.
The following are the examples on how people respond to incentives.
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A student who maintains a good GPA may be eligible for a scholarship. This financial incentive encourages the student to study more and get higher scores, since they react favorably to the reward of lower tuition prices.
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Companies may give performance-based incentives to their staff. This incentive motivates workers to boost their productivity and contribute more effectively to the company's objectives by offering a cash reward.
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A telecommunication company imposes late fees on consumers who do not pay their bills on or before the due date. This fee encourages consumers to pay their internet bills on time to avoid the additional cost.
Principle 5: Trade Can Make Everyone Better Off
Trade refers to the exchange of goods, services or resources. All parties involved in the trade can benefit. When people or countries specialize in producing what they are best at and then trade with others, they can access a wider variety of goods and services at lower costs than if they tried to produce everything on their own. This specialization and exchange can have better outcome. It can create more efficient production and greater overall wealth, making everyone involved better off than they would be without trade.
The following are examples where trade can make everyone better off.
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Japan trades apples to the Philippines in exchange for bananas. Japan benefits by gaining access to bananas, which are more efficiently produced in the Philippines, while the Philippines gains access to high-quality apples from Japan.
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A local farmer sells fresh vegetables to a grocery store. The farmer earns income, and the store gets fresh produce to sell to customers, benefiting both parties.
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Countries can benefit by exporting goods they produce efficiently and importing goods that are less expensive to buy from other nations than to produce at home.
Principle 6: Markets Are Usually a Good Way to Organize Economic Activity
A market is a place where buyers and sellers interact, either in a physical location or online. When we say organize economic activity, this means identifying the following:
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What goods to produce?
This question asks which products should be made based on what people want to buy (demand) and how easily those products can be made (supply). If there's high demand for a product and it can be produced efficiently, and this makes sense to focus on making that product.
How to produce them?
This refers to deciding the best way to make goods, considering the resources, technology, and methods available. This involves choosing the most efficient production techniques or methods. For example, you consider a decision whether to use more labor or machines, and how to minimize costs while maintaining quality.
How much of each to produce?
This involves determining the quantity of each good or service to be made. This decision is based on the demand for the product, the cost of production, and the availability of resources.
Who gets them?
This refers to deciding how the goods and services produced are distributed among people or groups like consumers, sellers, and government sectors. This decision impacts how resources and wealth are shared within a society or economy.
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Moreover, this principle relates to Adam Smith’s concept of the invisible hand, which suggests that individuals pursuing their self-interest in competitive markets inadvertently contribute to the efficient allocation of resources, thereby maximizing society’s economic well-being. The invisible hand theory is also closely linked to the concept of supply and demand, guiding the market toward equilibrium, where the quantity of goods or services supplied aligns with the quantity demanded.
Principle 7: Governments Can Sometimes Improve Market Outcomes
Market outcomes refer to the results of interactions between buyers and sellers in a market, including the determination of prices, the quantities of goods and services exchanged, and how resources are allocated. While markets typically allocate resources efficiently, there are instances of market failure, which occur when resources are not optimally distributed or are wasted. Pollution is an example of market failure.
For instance, a factory may produce goods at a low cost but releases pollutants into the air or water as a byproduct. This pollution harms the environment and public health, creating costs that are not included in the price of the goods produced. This situation represents a negative externality, where the market fails to account for the full social cost of production, leading to overproduction and detrimental effects on society.
In this such situations, governments can play a crucial role in improving market outcomes by enforcing property rights, addressing externalities, and regulating market power to ensure more efficient and equitable resource allocation.
The following are examples of situations on how governments can sometimes improve market outcomes.
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Public policy can correct the inefficiencies caused by pollution.
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A government could ensure a more equitable distribution of wealth through taxation and welfare policies.
Principle 8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services
The standard of living refers to how well people live in terms of wealth, comfort, and access to essentials like healthcare, education, and other basic needs. It reflects the level of wealth and material comfort available to individuals or communities. A higher standard of living means better access to these resources, resulting in an improved quality of life.
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A country’s standard of living is primarily determined by its productivity, which is the amount of goods and services produced per unit of labor. For example, after World War II, Germany was in a very poor state with a low standard of living. By focusing on improving its industries and worker skills, Germany became very productive in manufacturing high-quality goods. This increase in productivity led to higher wages and a much better standard of living for its people. Now, Germany is one of the most developed countries in the world, where people earn higher incomes and enjoy a better standard of living.
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Increased production, driven by better equipment, skills, and technology, leads to higher living standards. When individuals produce more, they can earn higher incomes, which allows them to afford a better standard of living and consume more goods and services that enhance their quality of life. Other factors, like labor unions and international competitiveness, have a much smaller impact on living standards compared to productivity.
Principle 9: Prices Rise When the Government Prints Too Much Money
Inflation refers to the the increase in the general level of prices. This is often caused by excessive growth in the money supply. When the government issues more money, the value of money falls, resulting in higher prices. Inflation tends to rise when the money supply increases rapidly. This can lead to hyperinflation, a situation where prices soar quickly due to an excessive money supply. Typically, when the inflation rate reaches 50% or more per month, it is considered hyperinflation.
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A strong real-life example of this principle is what happened in Venezuela, where hyperinflation began in 2016. To cover its expenses, the government printed large amounts of money, which caused the value of the Venezuelan bolívar to plummet. As a result, prices skyrocketed, making basic items like food and medicine unaffordable for most people. By 2018, Venezuela's inflation rate had exceeded 1,000,000%, marking it as one of the worst cases of hyperinflation in modern history. The economic situation continued to deteriorate, severely impacting the population's ability to afford basic goods and services, and making life much harder for Venezuelans.
Principle 10: Society Faces a Short-Run Trade-off Between Inflation and Unemployment
Inflation refers to the general rise in the prices of goods and services, while unemployment describes the situation where individuals are actively seeking work but are unable to find jobs. In the short run, there is a trade-off between inflation and unemployment, often influenced by the business cycle. The business cycle refers to the natural rise and fall of economic activity over time, characterized by periods of expansion (growth) and contraction (recession).
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A short-run trade-off between inflation and unemployment often occurs during the prosperity phase of a business cycle. In this phase, there is an increase in aggregate demand, or the overall demand within the economy. As aggregate demand rises, firms tend to increase production to meet this higher demand, which often requires them to hire more labor and acquire additional resources. This leads to higher employment, which in turn reduces unemployment. However, as firms hire more workers and purchase more resources, their production costs can rise. These higher production costs typically result in increased prices for goods and services, signaling inflation.
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The scenario presents a short-run trade-off: unemployment decreases, but inflation increases. However, this trade-off is temporary. Over time, if prices continue to rise persistently, aggregate demand may begin to fall. Reduced demand leads to lower economic activity and, subsequently, to decreased production. As a result, firms may lay off workers, leading to higher unemployment. This situation, known as stagflation, is characterized by the simultaneous occurrence of inflation and rising unemployment.
References
Mankiw, N. G. (2013). Macroeconomics (8th ed.). Worth Publishers.
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Smith, A. (1776). An inquiry into the nature and causes of the wealth of nations. W. Strahan and T. Cadell.