Economics is about decision making in situations of scarcity
ECONOMICS is the study of how individuals, firms and government make decisions to manage scarce resources. What does this mean exactly?
Professor Greg Mankiw teaches economics at Harvard University and is the author of a popular economics text book called Principles of Economics which is used at many Ivy League schools. Mankiw’s status within the economics profession makes him uniquely well placed to help us understand the basic principles of economics.
Set out below are Mankiw’s 10 Principles of Economics:
How People Make Decisions
1. People face tradeoffs: To get one thing, you have to give up something else. You may have heard economists say “there is no such thing as a free lunch”. What they mean by this is that, for example, you might get a free bowl of soup at the student co-op, but the soup is not free because you have to give up 35-minutes waiting in line to be served.
2. The cost of something is what you give up to get it: Making a decision requires comparing the costs and benefits of alternative courses of action. The cost of one option is not how much it will cost in dollar terms, but rather the value of your second best alternative. For more explanation, see understanding the cost benefit analysis.
3. Rational people think at the margin: People make decisions by comparing the marginal benefit with the marginal cost. For example, you might buy one cup of coffee in the morning because it helps you start the day, but you might not buy a second cup because this gives you no extra benefit (and costs another $3).
4. People respond to incentives: Behaviour changes when costs or benefits change. For example, if your hourly wage increases then you are likely to work more (unless of course your income is already too high).
How People Interact
5. Trade can make everyone better off: Trade allows people to specialise in what they do best. By trading, each person can then buy a variety of goods or services. For example, you may be a skilled management consultant. Money you earn through your consulting work might be used to build a house even though you may not have the skills to build the house yourself.
6. Markets are usually a good way to organise economic activity: Individuals and firms that operate in a market economy respond to prices and thereby act as if guided by an “invisible hand” which leads the market to allocate resources efficiently. For example, if there is an oversupply of wheat on the world market then individual farmers will lower the price they charge until they can sell all of their wheat. Lower wheat prices will also likely reduce the total quantity of wheat that farmers decide to produce. Market prices are able to adjust to equate supply and demand without the need for any central planning.
7. Governments can sometimes improve market outcomes: Sometimes a market may fail to allocate resources efficiently, and government regulation can be used to improve the outcome. Market failures can occur due to the existence of public goods, monopolies and externalities. For example, an electricity supplier might have a monopoly. Government regulation may be required to ensure that the supplier does not abuse its market power.
How the Economy Works
8. A country’s standard of living depends on its ability to produce goods and services: A country whose workers produce a large number of goods and services per unit of time will enjoy a high standard of living.
9. Prices rise when the government prints too much money: Printing money causes inflation. When a government prints money, the quantity of money increases and each unit of money therefore becomes less valuable. As a result, more money is required to buy goods and services. For more explanation, see quantitative easing.
10. Society faces a short-run tradeoff between inflation and unemployment: Reducing inflation often causes a temporary rise in unemployment. This tradeoff is the key to understanding the short-run effects of changes in taxes, government spending and monetary policy. For more explanation, see the Phillips curve.