Ten Principles of Economics (N. Gregory Mankiw: 7th Edition)

Ten Principles of Economics was introduced by N. Gregory Mankiw, Professor of Economics at Harvard University, in his book “Principles of Microeconomics“. He beautifully summarized his book mainly in Ten Principles of Economics in the first chapter of his book. He divided Ten Principles of Economics into 3 main divisions:-

  1. How People Make Decisions
  2. How People Interact (Trade, Markets, Government Intervention)
  3. How the Economy as a Whole works

Ten Principles of Economics

Ten Principles of Economics
Ten Principles of Economics (N. Gregory Mankiw)

A: How People Make Decisions

As an economy is a group of people dealing with each other in their lives, hence their behavior reflects the behavior of an economy (because individuals make up the economy). The first four principles of economics relate to individual decision-making.

Principle 1: People Face Trade-Off (Broader Concept)

There is no such thing as “Free Lunch”. There are usually many alternatives available against our choices and making decisions regarding our choices requires trading off between the alternatives.

For example, a student has 1 hour and he is facing the following choices

  • spend all time on studying Economics
  • spend all time on studying English
  • spend all time on watching movie
  • spend all time on watching TV
  • spend all time on playing game

OR

  • spend half of the times on one choice and half on another choice, etc.

For every choice, there are a lot of trade-offs that a student may face.

Similarly, society also faces trade-offs. One trade-off that society faces is between efficiency and equality. Efficiency is the property of society getting the most it can from its scarce resources while Equality is the distribution of benefits uniformly among society’s members.

Principle 2: The Cost of Something is What You Give Up to Get It (Opportunity Cost, Narrower Concept)

Making decisions among trade-offs requires comparing the costs and benefits of alternative choices. Forgoing the next best alternative is the opportunity cost of deciding on any one choice. College athletes who can earn millions if they drop out of school and play professional sports are well aware that their opportunity cost of college is very high. It is not surprising that they often decide that the benefit of a college education is not worth the cost.

Principle 3: Rational People Think at the Margin (Marginal Benefit>Marginal Cost)

Economists normally assume that people are rational. Rational people systematically and purposefully do the best they can to achieve their objectives, given the available opportunities.

Economists also use the term Marginal Change to describe a small incremental adjustment to an existing plan of action. Keeping the mind the Margin means “Edge” so marginal changes are adjustments around the edge of what you are doing. Rational people often make decisions by comparing marginal benefits and marginal costs.

Marginal decision-making also helps to explain some otherwise puzzling economic phenomena that why is water so cheap while diamonds are so expensive? 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. A rational decision-maker takes an action if and only if the marginal benefits of the action exceed the marginal cost.

Principle 4: People Respond to Incentives

An incentive is something that induces a person to act, such as the prospect of a punishment or a reward. Calling Principle 3, because rational people make decisions by comparing costs and benefits, they respond to incentives.

Incentives play a central role in the study of economics. A higher price in a market provides an incentive for buyers to consume less and an incentive for sellers to produce more. It is the basis for the allocation of scarce resources and important for a policymaker as well to formulate the policies.

B: How People Interact

Principle 5: Trade Can Make Everyone Better Off

Trade can make everyone better off and trade between two countries can make each country better off. Despite the competition, no family can better off isolating itself from all other families. If it did, she would need to grow her own food, make her own clothes and build her own home which may compromise efficiency and result in waste of scarce resources.

Trade Ten Principles of Economics
Trade Can Make Everyone Better Off (Ten Principles of Economics)

Trade allows two families, two individuals, and two countries to specialize in what they do best and to enjoy a greater variety of goods and services.

Principle 6: Markets Are Usually a Good Way to Organize Economics Activity

One of the Ten Principles of Economics, Principle no. 6 focuses on the Market Economy, an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services.

Households and firms interacting in markets act as if they are guided by an “Invisible Hand” that leads them to desirable market outcomes. (An Inquiry into the Nature and Causes of the Wealth of Nations, Adam Smith: 1776)

Market Economy Ten Principles of Economics
Market Economy (Ten Principles of Economics)

Principle 7: Governments Can Sometimes Improve Market Outcomes

This principle votes for government intervention in the market (Mixed Economy). The invisible hand can work its magic only if the government enforces the rules and maintains the institutions that are key to a market economy, especially to enforce property rights so individuals can own and control scarce resources. The government also provides police and courts to enforce rights over the things the individual produces and the invisible hand counts on the ability to enforce rights.

In the absence of government intervention:-

  • economy can face market failure, a situation in which a market left on its own fails to allocate resources.
  • economy can’t address the externality, the impact (positive or negative) of one person’s action on the well-being of a bystander.
  • economy can lead to Market Power, an ability of a single person or small group to unduly influence market prices.

Besides the above, the government can improve on market outcomes at times does not mean that it always will. Sometimes, public policies may worsen the economic situation.

externality
Externality (Ten Principles of Economics)

C: How the Economy as a Whole works

Principle 8: A Country’s Standard of Living Depends on its Ability to Produce Goods and Services (Production Possibility Curve)

The fundamental relationship between productivity (the quantity of goods and services produced from each unit of labor input) and living standards is simple, but its implications are far-reaching. An increase in productivity means an increase in Living Standard. This relationship also has profound implications for public policy. To boost living standards, policymakers need to raise productivity by ensuring that workers are well educated, have the tools needed to produce goods and services, and have access to the best available technology.

Principle 9: Prices Rise When the Government Prints Too Much Money

When a government creates large quantities of the nation’s money, the value of the money falls. In almost all cases of large or persistent inflation, the reason is growth in the quantity of money. In Germany in the early 1920s, when prices were on average tripling every month, the quantity of money was also tripling every month.

money inflation
Fall of Money Value (Ten Principles of Economics)

Principle 10: Society Faces a Short-Run Trade-off between Inflation and Unemployment (Philips Curve)

Although a higher level of prices is, in the long run, the primary effect of increasing the quantity of money, the short-run story is more complex and controversial. Most economics describes 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
Inflation vs Unemployement
Inflation vs Unemployment (Ten Principles of Economics)

This is the reasoning for one final economy-wide short-run trade-off between inflation and unemployment. This short-run trade-off plays a key role in the analysis of the business cycle, the irregular and largely unpredictable fluctuations in economic activity such as employment and production.

Quiz with Answers – Ten Principles of Economics

  1. Efficiency is the property of society getting the most it can from its
    1. society’s members
    2. scarce resources
    3. workforce
    4. technology
  2. Equality is the distribution of benefits among society’s members
    1. distinctly
    2. on work basis
    3. uniformly
    4. any of the above
  3. Forgoing the next best alternative is
    1. the trade-off
    2. the opportunity cost
    3. a choice
    4. a decision
  4. Trade allows two countries
    1. to specialize in what they do best
    2. to enjoy a greater variety of goods and services
    3. to exchange products with each others
    4. all of the above
  5. A situation in which a market left on its own fails to allocate resources is called
    1. externality
    2. market power
    3. market failure
    4. government intervention
0

Ten Principles of Economics

1 / 5

Efficiency is the property of society getting the most it can from its

2 / 5

Equality is the distribution of benefits among society’s members

3 / 5

Forgoing the next best alternative is

4 / 5

Trade allows two countries

5 / 5

A situation in which a market left on its own fails to allocate resources is called

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