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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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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 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 choose S1 PS1 < PS2 choose S2

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HOW PEOPLE MAKE DECISIONS

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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HOW PEOPLE MAKE DECISIONS

Principle #1: People Face Tradeoffs

Society faces an important tradeoff:

efficiency vs. equity

efficiency: getting the most out of scarce

resources

equity: distributing prosperity(chadhati) fairly

(thik- thik) 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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HOW PEOPLE MAKE DECISIONS

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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HOW PEOPLE MAKE DECISIONS

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(jatu karvu) 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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HOW PEOPLE MAKE DECISIONS

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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HOW PEOPLE MAKE DECISIONS

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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HOW PEOPLE MAKE DECISIONS

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 gas prices, sales of hybrid cars (e.g., Toyota Prius) rise. In response to higher cigarette taxes, teen smoking falls.
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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.

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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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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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CHAPTER 1

India's exports rise 34.42% in April 2011

Exports jumped 34.42% in April 2011 to $ 23.8 billion

continuing the fast paced growth of the previous fiscal.

Imports, too, continued to rise although at a lower

pace of 14/13% to $32.8 billion. The trade deficit for April 2011 was estimated at $ 8.98 billion which was lower than the deficit of $ 11.02 billion during April 2010.

Oil imports during April, 2011 were valued at $ 10.18

billion which was 7.7% higher than oil imports of $ 9.45 billion in the corresponding period last year.
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Indian Exports Forecast to Escalate, Constraining Brazilian Expansion

Exports
Strong export growth by India is expected to continue. This expansion, paired with a significant upward revision in the 2010 forecast, generates a substantially higher 2011 forecast. Comparatively low prices, a beneficial exchange rate, ample supplies and robust Southeast Asian and Middle East demand are spurring shipments. In addition to benefiting from increased market access and growing demand in key markets, India is better able to compete with Brazil due to its price competitiveness. As a result, India is expected to capture some market share from Brazil, the worlds leading exporter. Therefore, growth in Brazilian exports is revised significantly downward.
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 The United States is forecast higher on a

competitive dollar, strong Asian demand, and tight Oceania supplies. Improved Asian market access spurs an increase for Mexico. The EU is revised upward on ample supplies enabling shipments to Russia and the short term sales to Turkey.

Lower than expected production

reduces Argentina, which are forecast less than half of the volume achieved just two years ago. Despite ample supplies, high prices cause Uruguay to struggle to expand shipments, generating a downward revision.
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Imports
A downward revision in the United States is driven by
increased production, constrained consumption as economic recovery is slower than expected and a weaker dollar a relatively high-priced Oceania product hinders imports. Similarly, sluggish economic recovery and elevated prices hinder Mexican and EU imports. The EU is also negatively impacted by further reductions in Argentine exportable supplies.

Korea is revised upward on lower production, reduced

pork supplies and rising consumer confidence in US beef.
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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

Principle #6: Markets Are Usually A Good Way to Organize Economic Activity

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

Principle #6: Markets Are Usually A Good Way to Organize Economic Activity

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

Principle #7: Governments Can Sometimes Improve Market Outcomes

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

Principle #7: Governments Can Sometimes Improve Market Outcomes

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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HOW THE ECONOMY AS A WHOLE WORKS

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. The U.S. standard of living today is about eight times larger than 100 years ago.

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HOW THE ECONOMY AS A WHOLE WORKS

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

10-11 - 54000 Rs p.a

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PPP growth ( in $)
Country 2011 2012
Australia 40,816 China 8,288 Denmark 37,585
42,291 9,157 38,778

2013
43,801 10,103 40,002

2014
45,327 11,172 41,323

India 3,608 Mauritius 14,746

3,892
15,483

4,213
16,257

4,571
17,119

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HOW THE ECONOMY AS A WHOLE WORKS

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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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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HOW THE ECONOMY AS A WHOLE WORKS

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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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:

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