Ten Principles of Economics (N. Gregory Mankiw)

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 (N. Gregory Mankiw)
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 i.e. Microeconomics.

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. An athlete who can earn millions if they drop out of college and play as a professional athlete is well-aware that his opportunity cost at college is very high. It is not surprising that he decided 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. Economics based on rational decisions and in economics, rational actor do the best what he can to achieve his objectives, within the given 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.

As economics tells us, rational actors make their decisions via comparing marginal benefits and marginal costs of their choices. This is known as Marginal Decision-Making. It helps them to explain economic phenomena. Actually, ceteris paribus, a person’s willingness to pay for a good is based on the marginal benefit. Marginal benefit means the benefit that an extra unit of the good would have. However, marginal benefit depends on how many units a person consumes previously or already has. A rational decision-maker takes a decision to pay for the good if and only if the marginal benefits of the good exceed the marginal cost of the good.

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. As rational actors make decisions by comparing marginal costs and marginal benefits, they actually respond to incentives.

Incentives play a pivot role in decision making. These also play as a signal. A higher price of a good provides a signal to buyers to consume less and to 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 nation can better off isolating itself from all other nations. As in this case, that nation should grow own food, own clothes and build own houses which may compromise efficiency and result in waste of scarce resources as specialization in every field is not possible in a given time.

 Trade Can Make Everyone Better Off (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)

There is a positive relationship between productivity and living standards. Productivity means the quantity of goods and services produced from each unit of labor input. This relationship also has profound implications for public policy. To increase living standards, government needs to enhance productivity with higher literacy rate, skills, and best available technology.

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

When a government prints large quantities of 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.

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 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
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