Principles of Economics
Basic Concepts and Definitions
- Scarcity is known as the limited nature of society's resources.
- Economics is the field of how society controls its scarce resources such as:
- what to buy, how to save, and spend
- how companies and firms decide how much to produce, how many workers to recruit
- how society plans to use their resources on consumer goods, education, healthcare, military, etc.
Ten Principles of Ecnonomics
Principle # 1: People face trade-offs
- How society geta the most from their resources (efficiency)
- Whether or not prosperity is distributed uniformely among society's members (equality)
- Redistribute wealth from rich to poor without jeopardizing incentives to be productive (Tradeoff)
- Example: For example, tax paid by rich people and then distributed to poor may improve life equality of some but
lower the incentive for hard work and therefore reduce the level of production.
Principle # 2: The cost of something is what you give up to get it
- Decisions are made based on comparing the costs and benefits of alternative choices.
- The opportunity cost of any item is is defined as "whatever must be given up to obtain it".
Example: Traveling to Disneyland is not just the price of the trip and the ticket, but the value of the time spent at the theme park.
Principle # 3: Rational People Think at the Margin
- Rational people are known for doing what it takes to their goals.
- Example: When an employee considers whether to pay for additional professional development, s/he evaluates to fees and the extra income s/he could earn after completing the training.
Principle # 4: People Respond to Incentives
- Incentive is like a reward that motivates a person to act.
- Rational people react to incentives.
- Example: When electricity bills rise, home owners (consumers) use renewable energy like solar panels to generate electricity
Exercise on Applying the Principles of Economics: Costs and Benefits
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Solution to the Exercise on Applying the Principles of Economics: Costs and Benefits
Principle # 5: Trade Can Make Everyone Better Off
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- It is not expected from a country or a society to become full self-sufficient, but rather produces particular goods/services and exchange them for other goods.
- How could countries take benefit from trade?
- Increase income by selling their goods to foreign countries
- Alternatively, it's cheaper to buy goods from abroad than produced them locally
- Countries benefit from trading with one another
Principle # 6: Markets Are Usually A Good Way to Organize Economic Activity
- Market is defined as a group of buyers and sellers
- Economic actitvity is based on the goods that are produced, how to produce them, and who is getting them.
- Market prices reflect both the value of a product to consumers and the cost of the resources used to produce it
- Definition of 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.
- Centrally planned economies have failed because they did not allow the market to work properly
- Adam Smith and the Invisible Hand:
Adam Smith's 1776 work suggested that although individuals are motivated by self-interest,
an invisible hand guides this self-interest into promoting society's economic well-being.
- So, the interaction of buyers and sellers governs prices.
Principle # 7: Governments Can Sometimes Improve Market Outcomes
- There are two broad reasons for the government to interfere with the economy:
the promotion of efficiency and equality.
- Market failure is defined as a situation in which a market left on its own fails to allocate resources efficiently.
- Externalities is the impact of one person's actions on the well-being of a bystander, for example pollution.
- Market power is defined as the ability of a single economic actor (or small group of actors) to have
a substantial influence on market prices.
- Hence, government policy can be most useful when there is market failure and promote efficiency.
Exercise on Applying the Principles of Economics: Government Role
Check your answers here:
Solution to the Exercise on Applying the Principles of Economics: Government Role
Principle # 8: A country's standard of living depends on its ability to produce goods & services
- Differences in the standard of living from one country to another are quite large.
- Differences in living standards over time are also quite important, which are explained in differences in productivity.
- A key determinant of living standards is productivity, which represents
the quantity of goods and services produced per unit of labor.
- High productivity implies a high standard of living.
- Productivity depends on the tools, skills, well-educated workers, and access to the best available technology.
- Hence, economic policies must be drafted in a way to induce a positive impact and enhance the capability to produce goods and services.
Principle # 9: Prices rise when the government prints too much money
- Inflation is defined as a sustained increase in the overall level of prices in the economy.
- Usually, the fall of money value is triggered when the government creates a large amount of money, and the faster this done,
the greater the inflation rate is.
- 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.
- Examples: Germany after World War I in the 1920s), and the United States in the 1970s.
Principle # 10: Prices rise when the government prints too much money
- Most economists believe that the short-run economic policies (1 to 2 years) effect of a monetary injection
into the economy leads to lower unemployment and higher prices.
- An increase in the amount of money in the economy stimulates spending and
increases the demand of goods and services in the economy, which in turn
increases production and ultimately hiring more workers, i.e., lower unemployment.
Some economists are not sure if this relationship still exists.
Date of last modification: 2019