Microeconomics - Ten Principles of Economics

Table of Contents

How People Make Decisions

scarcity: the limited nature of society’s resources economics: the study of how society manages its scarce resources

Principle 1: People Face Trade-offs

To get one thing we like, we usually have to give up another thing that we like. Making decisions requires trading-off one goal against another.

  • student cannot learn two or more things at the same time
  • how to spend family income
  • guns (defense) and butter (living conditions)

Efficiency and  Equality

  • Efficiency means the property of society getting the most it can from its scarce resources.
  • Equality means the property of distributing economic prosperity uniformly among the members of society.
  • In other words, efficiency refers to the size of the economic pie, and equality refers to how the pie is divided into individual slices.
  • When government tries to cut the economic pie into more equal slices, the pie get smaller.

Nonetheless, people are likely to make good decisions only if they understand the options they have available. Our study of economics, therefore, starts by acknowledging life’s trade-offs.

Principle 2: The Cost of Something Is What You Give Up to Get It

Opportunity cost: whatever must be given up to obtain some item. When making any decision, decision makers should be aware of the opportunity costs that accompany each possible action.

Principle 3: Rational People Think at the Margin

Rational people systematically and purposefully do the best they can to achieve their objectives, given the available opportunities.  Marginal change: a small incremental adjustment to a plan of action. e.g. when exam around, study one more hour instead of playing games.

Rational people often make decisions by comparing marginal benefits and marginal costs.

  • airline ticket
  • why is water so cheap, while diamonds are so expensive?
    • water is plentiful -> margin benefit is small
    • diamonds are so rare -> margin benefit is large A rational decision maker takes an action if and only if the marginal benefit of the action exceeds 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. People respond to incentives, the rest is commentary.

Auto safety

  • 1950s, no seat belt, accident is costly -> seat belt law -> accident is not that costly -> people drive faster (cost less time) -> few deaths per accident but more accidents -> little change in driver deaths and an increase in the number of pedestrian deaths.

When analyzing any policy, we must consider not only the direct effects but also the less obvious indirect effects that work through incentives. If the policy changes incentives, it will cause people to alter their behavior.

Incentive Pay Chicago buses do not take the shortcut when around congestion, because they have no incentive to do so. If they are paid by passengers like taxi rather than by bus company, they will choose the shortcuts to get more passengers like other cars do. It will increase the bus driver’s productivity but also increase the risk of having accidents.

How People Interact

Principle 5: Trade Can Make Everyone Better Off

Trade between two countries is not like a sports contest in which one side wins and the other side loses. In fact, the opposite is true: Trade between two countries can make each country better off.

Trade allows 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 Economic Activity

Communist countries worked on the premise that government officials were in the best position to allocate the economy’s scarce resources. The theory behind central planning was that only the government could organize economic activity in a way that promoted economic well-being for the country as a whole. Central planners failed because they tried to run the economy with one hand tied behind their backs — the invisible hand of the marketplace.

In a market economy, the decisions of a central planner are replaced by the decisions of millions of firms and households.

Households and firms interacting in markets act as if they are guided by an “invisible hand” that leads them to desirable market outcomes. — Adam Smith

In any market, buyers look at the price when determining how much to demand, and sellers look at the price when deciding how much to supply. As a result of the decisions that buyers and sellers make, market prices reflect both the value of a good to society and the cost to society of making the good. Smith’s great insight was that prices adjust to guide these individual buyers and sellers to reach outcomes that, in many cases, maximize the well-being of society as a whole.

Principle 7: Governments Can Sometimes Improve Market Outcomes

property right: the ability of an individual to own and exercise control over scarce resources. market failure: a situation in which a market left on its own fails to allocate resources efficiently. externality: the impact of one person’s actions on the well-being of a bystander. market power: the ability of a single economic actor (or a small group of actors) to have a substantial influence on market prices.

The invisible hand is powerful, but it is not omnipotent. The economy needs the government to

  • enforce the rules and maintain the institutions that are key to a market economy
  • enforce property right
    • We all rely on government-provided police and courts to enforce our rights over the things we produce — and the invisible hand counts on our ability to enforce our rights.
  • promote efficiency
    • market failure because externality (e.g. pollution) and market power (e.g. monopoly)
  • promote equality

How the Economy as a Whole Works

Principle 8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services

Why the differences in living standards among countries and over time are so large? Almost all variation in living standards is attributable to differences in countries’ productivity — that is, the amount of goods and services produced from each unit of labor input. When thinking about how any policy will affect our living standards, the key question is how it will affect our ability to produce goods and services.

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

inflation: an increase in the overall level of prices in the economy

What cause inflation? In almost all cases of large or persistent inflation, the culprit is growth in the quantity of money.

The broken window fallacy Some teenagers, being the little beasts that they are, toss a brick through a bakery window. A crown gathers and laments, “What a shame”. But before you know it, someone suggests a silver lining to the situation: Now the baker will have to spend money to have the window repaired. This will add to the income of the repairman, who will spend his additional income, which will add to another seller’s income, and so on. The chain of spending will multiply and generate higher income and employment. If the broken window is large enough, it might produce an economic boom! But if the baker hadn’t spent his money on window repair, he would have spent it on the new suit he was saving to buy. Then the tailor would have the new income to spend, and so on. The broken window didn’t create new spending; it just diverted spending from somewhere else.

Principle 10: Society Faces a Short-Run Trade-off between Inflation and Unemployment

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 many over time cause firms to raise their prices, but in the meantime, it also encourage them to hire more workers and produce a larger quantity of goods and services.
  • More hiring means lower unemployment.

business cycle: fluctuations in economic activity, such as employment and production.

Case: 2008 deep economic downturn -> Barack Obama: stimulus package of reduced taxes and increased government spending -> Federal Reserve: increased the supply of money -> reduce unemployment -> might over time lead to an excessive level of inflation.


  1. The fundamental lessons about individual decision making are that people face trade-offs among alternative goals, that the cost of any action is measured in terms of forgone opportunities, that rational people make decisions by comparing marginal costs and marginal benefits, and that people change their behavior in response to the incentives they face.
  2. The fundamental lessons about interactions among people are that trade and interdependence can be mutually beneficial, that markets are usually a good way of coordinating economic activity among people, and that the government can potentially improve market outcomes by remedying a market failure or by promoting greater economic equality.
  3. The fundamental lessons about the economy as a whole are that productivity is the ultimate source of living standards, that growth in the quantity of money is the ultimate source of inflation, and that society faces a short-run trade-off between inflation and unemployment.

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