Ch01 Ten Principles

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Ten Principles of
Economics
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?
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TEN PRINCIPLES OF ECONOMICS
What Economics Is All About

Scarcity refers to the limited nature of societys
resources.
Economics is the study of how society manages

its scarce resources, including
how people decide how much to work, save,
and spend, and what to buy
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
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HOW PEOPLE MAKE DECISIONS

Decision making is
at the heart of
economics.
The first four

principles deal with
how people make
decisions.
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Mini Case
Pioneer automobiles Ltd. projected an increasing
demand for their cars in the country by 20% per annum.
Currently all their plants are fully in operation up to in
maximum capacity. The firm intend to expand its output
with an objective of earning more profit.
The
management has TWO option to choose for expanding
output:
Strategy I: construct two new additional plants
Strategy II: The rival firm is in financial trouble and

wishes to sell out its two plants in the vicinity of the
pioneer. Buy this and modify.
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Answer
Decision Process:
Objective: to increase profit(P)
Analysis: Check relative cost and profit in case
of these two strategies i.e. PS1 and PS2
Decision rule:
PS1 > PS2 choose S1
PS1 = PS2 Indifferent
PS1 < PS2 choose S2
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Principle #1: People Face Tradeoffs

All 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 might otherwise be used to produce
consumer goods.
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Principle #1: People Face Tradeoffs
Society faces an important tradeoff:

efficiency vs. equity
efficiency: getting the most out of scarce

resources
equity: distributing prosperity fairly among

societys members
Tradeoff: To increase equity, can redistribute

income from the well-off to the poor.
But this reduces the incentive to work and produce,
and shrinks the size of the economic pie.
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Describe some of the trade offs:
A family deciding to buy new car

Decide whether to take vacation
Member of congress deciding how much to
spend on national parks

A company president deciding whether to open
a new factory
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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.
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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.
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Questions
You were planning to spend Saturday working at
your part time job, but a friend ask you to go for
party. What is the true cost of going party?
Now suppose you had plan to spend the day

studying in library. What is the cost of going
skiing in this case?
You have choice between spending the Rs.

1,00,000 now or putting it for a year in
bank/stock market/mutual fund/ lottery. What is
the opportunity cost of spending rupees?
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Principle #3: Rational People Think at the

Margin
A person is rational if she systematically and

purposefully does the best she can to achieve
her objectives.
Many decisions are not all or nothing,

but involve marginal changes incremental
adjustments to an existing plan.
Evaluating the costs and benefits of marginal

changes is an important part of decision making.
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Principle #3: Rational People Think at the

Margin
Examples:
A student considers whether to go to college

for an additional year, comparing the fees & foregone
wages to the extra income he could earn with an extra
year of education.
Cost of Flight or train

A firm considers whether to increase output, comparing
the cost of the needed labor and materials to the extra
revenue.
Why water is so cheap and diamond are so expensive?

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Example
During a year of operation, firm collects Rs.
1,75,000 in revenue & spends Rs. 80,000 on
raw material, labour, utilities. The owner of the
firm have provided Rs. 5,00,000 of their own
money to the firm instead of investing the money
& earning a 14% annual rate of return.
Calculate
Explicit cost
Implicit cost
Accounting profit
Economic Profit
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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 because

they make decisions by comparing costs and
benefits. Examples:
In response to higher petrol prices, sales of CNG
kits rise.
Students specialization respond to availability of
jobs
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Many public policies change the costs and

benefits that people face. Sometimes
policymakers fail to understand how policies alter
incentives and behavior.
Example: Seat belt laws increase the use of seat

belts and lower the incentives of individuals to
drive safely. This leads to an increase in the
number of car accidents.
Example: Helmet cases
Example: Sun Film in Vehicles

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Exercise
You are selling your 1996 Mercedes. 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?
A. Book value is $6500 if transmission works,
$5700 if it doesnt
B. book value is $6000 if transmission works,
$5500 if it doesnt
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Answers
Cost of fixing transmission = $600
A. Book value is $6500 if transmission works,
$5700 if it doesnt
Benefit of fixing the transmission = $800

($6500 5700).
Its worthwhile to have the transmission fixed.
B. Book value is $6000 if transmission works,
$5500 if it doesnt
Benefit of fixing the transmission is only $500.

Paying $600 to fix transmission is not worthwhile.
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Answers
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.
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Company that you manage has invested $5

million in developing a new product, but the
development is not quite finished. At a recent
meeting, your sales people report that the
introduction of competing products has reduced
the expected sales of your new product to $3mi.
If it would cost $1mi. to finish development &
make the product, should you go ahead & do
so? What is the most you should pay to
complete development?
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HOW PEOPLE INTERACT

An economy is just
a group of people
interacting with
each other.
The next
three principles
deal with how people
interact.
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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 & specialization:
get a better price abroad for goods they
produce
buy other goods more cheaply from abroad
than could be produced at home
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The Reserve Bank of India (RBI) moved to

tighten gold imports, making them dependent on
export volumes with an eye to reducing a record
current account deficit- (Reuters, Jul 13)
RBI had ruled out any credit transactions for

imports unless they were intended to make
jewellery for export, as current account deficit
are high.
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Questions
Your roommate is better cook than you are, but
you can clean more quickly than your roommate
can. If your roommate did all the cooking & you
did all the cleaning, would it take less or more
time if you divide each task evenly? Give similar
example of how specialization and trade can
make two countries better off.
Nation with corrupt police and court system

typically have lower standards of living than
nation with less corruption. Why might that be
the case?
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HOW PEOPLE INTERACT
Principle #6: Markets Are Usually A Good Way

to Organize Economic Activity
A market is a group of buyers and sellers.

(They 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
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HOW PEOPLE INTERACT

In a market economy, these decisions result from

the interactions of many households and firms.
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.
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HOW PEOPLE INTERACT

The invisible hand works through the price system:
The interaction of buyers and sellers

determines prices of goods and services.
Each price reflects the goods 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 societys economic well-being.
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HOW PEOPLE INTERACT
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.
A restaurant wont serve meals if customers

do not pay before they leave.
A music company wont produce CDs if too many

people avoid paying by making illegal copies.
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HOW PEOPLE INTERACT

Govt may alter market outcome to promote efficiency

market failure, when the market fails to allocate
societys resources efficiently. Causes:
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)
In such cases, public policy may increase efficiency.

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HOW PEOPLE INTERACT

Govt may alter market outcome to promote equity

If the markets distribution of economic well-being
is not desirable, tax or welfare policies can change
how the economic pie is divided.
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HOW THE ECONOMY AS A WHOLE WORKS
The last three

principles deal with
the economy as a
whole.
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Principle #8: A countrys 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.
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Principle #8: A countrys 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.
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Per Capita Income

Low PCI compared to western countries
In 1952-53 : PCI was 1/13th of USA
1/9th of Japan, thus used to come among the category of
underdeveloped economy
50-51- 3687.4 Rs p.a

70-71 5002.3 Rs p.a
90-91 9064
Rs p.a
97-98 17325 Rs p.a

04-05 27457 Rs p.a
05-06 - 29000 Rs p.a
11-12 - 55000 Rs p.a
1213 68478 Rs p.a
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PPP growth ( in $)
Country 2011 2012
2013
2014
Australia 40,816
China
8,288
Denmark 37,585
42,291
43,801
45,327
9,157
10,103
11,172
38,778
40,002
41,323
India
3,608
Mauritius 14,746
3,892
4,213
4,571
16,257
17,119
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15,483
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Question
In what ways your std. of living different from
that of your parents or grandparents when they
were your age? Why have these changes
occurred?
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Principle #9: Prices rise when the

government prints too much money.
Inflation: increases in the general level of prices.

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.
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ZIMBABWE INFLATION
One 200,000 dollar note equals less than US $0.10
cents.
December 22nd 2007, a new note of 500,000 dollars

introduced to the market!
Next - 750,000 dollars.

January 2008 a new note of 10 million dollars.
This US $10 dollar note is 10 times worth more than the
10 million dollars Zimbabwe note.
This guy is going to a supermarket. The exchange rate is

25 million Zimbabwe dollars for 1 US dollar.
This mountain of cash is worth 100 US Dollars.

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The wholesale price index (WPI),

quickened to 4.86 percent in June
The average inflation(CPI) of India in

2013: 11.18 %
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Inflation in India
The rising prices of food products, manufacturing products, and essential
commodities have pushed inflation rate further in India.
This is how food prices have risen since 2007:

Food articles: 7.02% (in 2007) to 17.41% in January 2010.
Food products: 3.43% (in 2007) to 22.55% in January 2010.
Food commodities: 5.60% (in 2007) to 19.42% in January 2010.
Foodgrains: 6.27% (in 2007) to 17.89% in January 2010.

Cereals: 6.27% (in 2007) to 13.69% in January 2010.
Pulses: 2.14% (in 2007) to 45.62% in 2007 in January 2010.
Rice: 6.05% (in 2007) to 12.02% in January 2010.
Wheat: 6.77% (in 2007) to 14.86% in January 2010.
Dairy products: 6.08% (in 2007) to 12.87% in January 2010.
Eggs, fish and meat: 6.38% (in 2007) to 30.71% in January 2010.
Sugar: (-)14.69% (in 2007) to 58.94% in January 2010.
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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.
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Imagine that you are a policy maker trying to

decide whether to reduce the rate of inflation.
To make an intelligent decision, what would you
need to know about inflation, unemployment and
trade off between them?
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CONCLUSION
Economics offers many insights about the
behavior of people, markets, and economies.
It is based on a few ideas that can be applied

in many situations.
Whenever we refer back to one of the

Ten Principles from this chapter,
you will see an icon like this one:
CHAPTER 1
44

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1

In this chapter, look for the answers to

What kinds of questions does economics

What are the principles of how people make

What are the principles of how people interact?

TEN PRINCIPLES OF ECONOMICS

What Economics Is All About

Economics is the study of how society manages

TEN PRINCIPLES OF ECONOMICS

HOW PEOPLE MAKE DECISIONS

The first four

TEN PRINCIPLES OF ECONOMICS

Strategy I: construct two new additional plants

Strategy II: The rival firm is in financial trouble and

TEN PRINCIPLES OF ECONOMICS

TEN PRINCIPLES OF ECONOMICS

HOW PEOPLE MAKE DECISIONS

Principle #1: People Face Tradeoffs

Going to a party the night before your midterm

Having more money to buy stuff requires working

Protecting the environment requires resources

TEN PRINCIPLES OF ECONOMICS

HOW PEOPLE MAKE DECISIONS

Principle #1: People Face Tradeoffs

Society faces an important tradeoff:

efficiency: getting the most out of scarce

equity: distributing prosperity fairly among

Tradeoff: To increase equity, can redistribute

TEN PRINCIPLES OF ECONOMICS

Describe some of the trade offs:

A family deciding to buy new car

spend on national parks

TEN PRINCIPLES OF ECONOMICS

HOW PEOPLE MAKE DECISIONS

Principle #2: The Cost of Something Is What

Making decisions requires comparing the costs

The opportunity cost of any item is whatever

It is the relevant cost for decision making.

TEN PRINCIPLES OF ECONOMICS

HOW PEOPLE MAKE DECISIONS

Principle #2: The Cost of Something Is What

TEN PRINCIPLES OF ECONOMICS

Now suppose you had plan to spend the day

You have choice between spending the Rs.

TEN PRINCIPLES OF ECONOMICS

HOW PEOPLE MAKE DECISIONS

Principle #3: Rational People Think at the

A person is rational if she systematically and

Many decisions are not all or nothing,

Evaluating the costs and benefits of marginal

TEN PRINCIPLES OF ECONOMICS

HOW PEOPLE MAKE DECISIONS

Principle #3: Rational People Think at the

A student considers whether to go to college

Cost of Flight or train

Why water is so cheap and diamond are so expensive?

TEN PRINCIPLES OF ECONOMICS

TEN PRINCIPLES OF ECONOMICS

HOW PEOPLE MAKE DECISIONS

Principle #4: People Respond to Incentives

Incentive: something that induces a person to

Rational people respond to incentives because

TEN PRINCIPLES OF ECONOMICS

Many public policies change the costs and