The Ten Principles of Economics by Mankiw, helping you to think rationally

The comprehensive self-examination of the period.

Principle One: People Face Trade-offs

There is no such thing as a free lunch. To get one thing, we usually have to give up another—opportunity cost.

Examples: allocation of student's time, guns versus butter, pollution control, efficiency versus equality, professional athletes choosing to forgo education.

The first lesson about decision-making can be summed up in a proverb: "There is no such thing as a free lunch." To obtain something we like, we usually have to give up something else we like. Making decisions requires us to make trade-offs between one goal and another.

Consider a student who must decide how to allocate her most precious resource—time. She can spend all her time studying economics; she can spend all her time studying psychology; or she can divide her time between the two subjects. For every hour she spends studying one subject, she must give up an hour she could have spent studying the other subject. And for every hour she spends studying a subject, she must give up time that could have been used for sleeping, biking, watching TV, or working to earn some pocket money.

Parents can also decide how to use their household income. They can buy food, clothing, or take the whole family on vacation. Or they can save a portion of their income for retirement or their children's college education. When they choose to spend an extra dollar on one of the above items, they have to spend one dollar less on some other item.

When people form a society, they face various trade-offs. A typical trade-off is the trade-off between "guns and butter." When we spend more money on national defense to protect our shores from foreign invasion (guns), we have less money available for personal consumption of goods that can improve our standard of living (butter). In modern society, the trade-off between a clean environment and a high income level is equally important. Laws requiring businesses to reduce pollution increase the cost of producing goods and services. Due to the high costs, these businesses earn less profit, pay lower wages, charge higher prices, or some combination of these three outcomes. Therefore, although pollution control benefits us with a cleaner environment and the resulting improvement in health levels, the cost is a reduction in income for business owners, workers, and consumers.

Another trade-off that society faces is between efficiency and equality. Efficiency refers to society getting the most from its scarce resources. Equality refers to the fair distribution of the fruits of these resources to society members. In other words, efficiency refers to the size of the economic pie, while equality refers to how to divide that pie. When designing government policies, these two goals are often in conflict.

For example, let's consider policies aimed at achieving a more equal distribution of economic welfare. Some of these policies, such as welfare systems or unemployment benefits, are designed to help the most needy members of society. Other policies, such as personal income taxes, require economically successful individuals to support the government more than others. While these policies have benefits in achieving greater equality, they come at the cost of reducing efficiency. When the government redistributes income from the rich to the poor, it reduces the reward for hard work; as a result, people work less, and the production of goods and services decreases In other words, when the government wants to divide the economic pie into more equal smaller pieces, the pie becomes smaller.

Recognizing that people face trade-offs does not tell us what decisions people will or should make. A student should not give up studying psychology just because they need to increase their time studying economics. Society should not stop protecting the environment just because environmental regulations lower our material standard of living. Nor should helping the poor be neglected just because it distorts work incentives for them. However, understanding trade-offs in life is important because people can only make good decisions when they understand the choices available to them.

Principle 2: The cost of something is what you give up to get it

(Opportunity Cost)

Accounting cost = Labor and Capital

Economic cost = Opportunity cost of Labor and Capital.

Because people face trade-offs, making decisions involves comparing the costs and benefits of alternative courses of action. However, in many cases, the cost of an action is not as obvious as it may seem at first glance.

For example, consider the decision of whether to go to college. The benefit is gaining knowledge and having better job opportunities throughout life. But what is the cost? To answer this question, you would think about adding up the money you spend on tuition, books, housing, and food. But this sum does not truly represent what you gave up to go to college last year.

The first issue with this answer is that it includes some things that are not the true cost of going to college. Even if you leave school, you still need a place to sleep and food to eat. Only the part of accommodation and food at college that is more expensive than elsewhere is the cost of going to school. In fact, the cost of accommodation and food at college may be lower than what you would pay for rent and food living on your own. In this case, the savings on accommodation and food are the benefit of going to college.

The second issue with this cost calculation is that it ignores the biggest cost of going to college - your time. When you spend a year attending classes, studying, and writing papers, you cannot spend that time working. For most students, the wages they forego to attend school is the single largest cost of their education.

The opportunity cost of something is what you give up to get that something. When making any decision, such as whether to go to college, decision-makers should recognize the opportunity cost that comes with each possible action. In fact, decision-makers are usually aware of this. Athletes of college age who could earn millions by dropping out and pursuing professional sports deeply understand that the opportunity cost of going to college is very high. They often decide that it is not worth paying this cost to gain the benefits of going to college. This is not surprising.

Principle 3: Rational people think at the margin

Common application: Comparing marginal costs and marginal benefits to improve economic efficiency. Example: How much should an airline charge customers for a ticket refund.

Many decisions in life involve making small incremental adjustments to existing action plans. Economists refer to these adjustments as marginal changes. In many cases, people can make optimal decisions by considering marginal quantities. For example, suppose a friend asks you how many years he should study in school. If you compare the lifestyle of a person with a doctoral degree to someone who has not completed primary school, he will complain that this comparison is not helpful for his decision-making. Your friend most likely has received some level of education and is deciding whether to study for another year or two. To make this decision, he needs to know the additional benefits and costs of studying for an extra year. By comparing the marginal benefits and marginal costs, he can evaluate whether studying for another year is worthwhile.

Another example of how considering marginal quantities can help make decisions is when an airline decides how much to charge passengers for standby tickets. Suppose a 200-seat plane is flying domestically once, and the airline's cost is $100,000. In this case, the average cost per seat is $100,000 / 200, which is $500. Some may conclude that the airline's ticket price should never be lower than $500.

However, the airline can increase profits by considering marginal quantities. Suppose there are 10 empty seats on a plane about to take off. A passenger waiting at the gate is willing to pay $300 for a ticket. Should the airline sell him the ticket? Of course. If there are empty seats on the plane, the cost of adding one more passenger is minimal. Although the average cost per passenger is $500, the marginal cost is only the cost of a pack of peanuts and a can of soda that the additional passenger will consume. As long as the money paid by the standby passenger is greater than the marginal cost, selling him the ticket is profitable.

As these examples illustrate, individuals and businesses make better decisions by considering marginal quantities. Only when the marginal benefits of an action exceed the marginal costs will a rational decision-maker take that action.

Principle 4: People respond to incentives

When the external environment changes, people will adjust their strategies accordingly.

Example: The policy of car seat belts and car safety directly increases the survival rate of passengers in car accidents, but indirectly reduces the benefits of cautious and slow driving, leading to an increase in the frequency of accidents and a significant increase in pedestrian deaths.

Because people make decisions by comparing costs and benefits, when costs or benefits change, people's behavior also changes. This means that people respond to incentives. For example, when the price of apples rises, people decide to eat more pears and fewer apples because the cost of buying apples has increased. At the same time, apple orchard owners decide to hire more workers and pick more apples because the profit from selling apples has also increased.

For those designing public policies, the central role of incentives in decision-making is important. Public policies often change the costs or benefits of private actions. When decision-makers fail to consider how behavior changes due to policy reasons, their policies can have unintended consequences.

To illustrate this unwanted effect, consider public policies related to seat belts and car safety. In the 1950s, cars with seat belts were rare. Now all cars have seat belts, and the reason for this change is public policy. In the late 1960s, Ralph Nader's book "Unsafe at Any Speed" drew public attention to car safety The response of Congress is to legislate requiring car companies to produce various safety devices, including seat belts, which have become standard equipment in all new cars.

How does the seat belt law affect car safety? The direct impact is obvious. With seat belts in all cars, more people buckle up, increasing the chances of survival in major accidents. In this sense, seat belts have saved lives. The direct impact of seat belts on safety is the motivation behind Congress's requirement for seat belts.

However, to fully understand the impact of this law, it is necessary to recognize that people change their behavior due to the incentives they face. In this case, the relevant behavior is the speed and caution of drivers while driving. Driving slowly and cautiously comes at a cost because it consumes the driver's time and energy. When deciding the level of caution to drive with, rational individuals compare the marginal benefits and costs of driving cautiously. When the benefits of increasing safety are high, they will drive more slowly and cautiously. This can explain why people drive more slowly and cautiously on icy roads compared to clean roads.

Now, let's consider how the seat belt law changes the cost-benefit calculation for a rational driver. Seat belts reduce the cost of accidents for drivers by reducing the probability of injuries and fatalities. Therefore, the seat belt law reduces the benefits of driving slowly and cautiously. People's response to seat belts is similar to their response to improved road conditions - they drive faster and more recklessly. As a result, the ultimate outcome of the seat belt law is an increase in the number of accidents.

How does this law affect the number of deaths from driving? Drivers who wear seat belts are more likely to survive in any given accident, but they are also more likely to find themselves in more accidents. The net effect is uncertain. Furthermore, the decrease in safe driving levels has an obvious adverse effect on pedestrians (as well as drivers who do not wear seat belts). They are at risk due to this law, as they may find themselves in accidents without the protection of seat belts. Therefore, seat belt laws tend to increase the number of pedestrian deaths.

At first glance, this discussion about incentives and seat belts may seem like baseless speculation. However, economist Sam Peltzman demonstrated in an article published in 1975 that there are many unexpected effects of car safety laws. According to Peltzman's evidence, these laws reduce the number of deaths per accident while increasing the number of accidents. The net result is a small change in driver deaths, while pedestrian deaths increase.

Peltzman's analysis of car safety is just one example of how people respond to incentives in general. Many incentives studied by economists are more direct than those of car safety laws. For example, it would not be surprising that taxing apples would lead people to buy fewer apples. However, as the example of seat belts illustrates, policies sometimes have unforeseen effects. When analyzing any policy, not only should the direct effects be considered, but also the indirect effects of incentives at play. If a policy changes incentives, it will cause people to change their behavior

Principle Five: Trade Makes Everyone's Economic Situation Better

The principle of comparative advantage allows everyone to engage in industries where they have a relative advantage, and trading with each other improves the situation more than self-sufficiency.

The first four principles discuss how individuals make decisions. In the journey of our lives, many of our decisions not only affect ourselves but also impact others. The following three principles are about how people trade with each other.

Example: Policies such as reducing trade through taxes can lead to unnecessary losses.

You may have heard in the news that the Japanese are our competitors in the world economy. In some ways, this is true because American and Japanese companies produce many of the same products. Ford and Toyota compete for the same customers in the car market. Compaq and Toshiba compete for the same customers in the personal computer market.

But when thinking about competition between countries, this idea can be misleading. Trade between the United States and Japan is not like a sports game where one side wins and the other loses. In fact, the opposite is true: trade between the two countries can improve the situation for each country.

To illustrate, let's consider how trade affects your family. When a family member is looking for a job, they are competing with other family members who are also job hunting. When families shop, they are also competing with each other because each family wants to buy the best things at the lowest prices. So, in a sense, every family in the economy is competing with all other families.

Despite this competition, isolating your family from all other families would not lead to a better life. If that were the case, your family would have to grow its own food, make its own clothes, and build its own house. Clearly, your family benefits greatly from the ability to trade with other families. Whether in farming, making clothes, or building houses, trade allows everyone to specialize in what they do best. Through trade with others, people can buy a variety of goods and services at lower prices.

Countries, like families, also benefit from the ability to trade with each other. Trade allows countries to specialize in what they do best and enjoy a wide variety of goods and services. The Japanese, French, Egyptians, and Brazilians are not only our competitors but also our partners in the world economy.

Principle Six: Markets Are Usually a Good Way to Organize Economic Activities

Market Economy: An economy where many businesses and households trade goods and services in markets and allocate resources through their decentralized decisions. Guiding the economy through an invisible hand tool - prices.

When the government prevents prices from adjusting market resources spontaneously, it restricts the coordinating ability of the invisible hand. This also explains why taxes have a detrimental impact on resource allocation. Taxes distort prices and distort the decisions of businesses and households.

The collapse of communism in the Soviet Union and Eastern Europe may be the most significant change in the world in the latter half of this century. The premise of communist countries' operation was that the government's central planners could guide economic activities in the right direction. These planners decided what goods to produce, what services to provide, how much to produce, and who would produce and consume these goods and services. The theory supporting central planning was that only the government could organize economic activities in a way that promotes the overall social and economic welfare Most countries that used to have a centrally planned economy have now abandoned this system and are striving to develop a market economy. In a market economy, the decisions of central planners are replaced by the decisions of millions of businesses and households. Businesses decide whom to hire and what to produce. Households decide where to work and what to buy with their income. These businesses and households trade with each other in the market, with prices and individual interests guiding their decisions.

At first glance, the success of a market economy is a mystery. It seems chaotic for millions of self-interested households and businesses to make decisions. However, this is not the case. In fact, it has been proven that a market economy is very successful in organizing economic activities in a way that promotes overall economic welfare.

Economist Adam Smith, in his 1776 work "The Wealth of Nations," put forward the most famous observation in all of economics: households and businesses trading in the market seem to be guided by an "invisible hand," leading to desirable market outcomes. One of the purposes of this book is to explain how this invisible hand works its magic. As you study economics, you will come to know that prices are the tool the invisible hand uses to guide economic activities. Prices reflect both the social value of a good and the social cost of producing that good. Since households and businesses consider prices when deciding what to buy and sell, they inadvertently take into account the social benefits and costs of their actions. As a result, prices guide these individual decision-makers to achieve, in most cases, the maximization of overall social welfare.

An important implication of the invisible hand guiding economic activities is that when the government prevents prices from adjusting spontaneously according to supply and demand, it restricts the ability of the invisible hand to coordinate the millions of households and businesses that make up the economy. This implication explains why taxation has adverse effects on resource allocation: taxes distort prices, thereby distorting the decisions of households and businesses. This implication also explains the greater harm caused by policies like rent control that directly control prices. Furthermore, this implication also explains the failure of communism. In communist countries, prices are not determined in the market but are set by central planners. These planners lack the information reflected in prices when market forces freely respond to them. The failure of central planners is because they have tied up the invisible hand that operates in the market.

Principle Seven: Sometimes the government can improve market outcomes

Market Failure: A situation where the market itself cannot efficiently allocate resources.

Cases of market failure: Externalities, market power

While the market is usually a good way to organize economic activities, there are important exceptions to this rule. Government intervention in the economy is motivated by two reasons: to promote efficiency and to promote equality. This means that the goal of most policies is either to make the economic pie bigger or to change how the pie is divided.

The invisible hand usually effectively allocates resources in the market. However, for various reasons, there are times when the invisible hand does not work. Economists use the term "market failure" to refer to situations where the market itself cannot efficiently allocate resources. Market failure is a possible reason for externalities. Externalities refer to the impact of one person's actions on the welfare of bystanders. Pollution is a typical example. If a chemical factory does not bear all the costs of emitting smoke and dust, it will emit a large amount. In this case, the government can increase economic welfare through environmental protection.

Another possible reason for market failure is market power. Market power refers to the ability of one person (or a small group of people) to inappropriately influence market prices. For example, suppose everyone in a town needs water, but there is only one well. The owner of this well has market power over the sale of water - in this case, they are a monopolist. The owner of this well is not constrained by fierce competition, and the invisible hand that normally restrains individual self-interest through such competition is not at work. You will see that in this case, setting the price charged by the monopolist could potentially increase economic efficiency.

The invisible hand also does not ensure a fair distribution of economic outcomes. A market economy rewards individuals based on their ability to produce things that others are willing to buy. The world's best basketball players earn more money than the world's best chess players simply because people are willing to pay more to watch basketball games than chess matches. The invisible hand does not guarantee that everyone has enough food, decent clothing, and adequate healthcare. Many public policies (such as income taxes and welfare systems) aim to achieve a more equal distribution of economic welfare.

Saying that the government can sometimes improve market outcomes does not mean it always can. Public policies are not made by angels, but by highly imperfect political processes. Sometimes the policies designed only benefit those with political power. Sometimes policies are formulated by well-intentioned but poorly informed leaders. One of the purposes of studying economics is to help you judge when a government policy is suitable for promoting efficiency and fairness, and when it is not.

Principle 8: A country's standard of living depends on its ability to produce goods and services

Almost all changes in the standard of living can be attributed to changes in productivity.

We start by discussing how individuals make decisions, then examine how people trade with each other. All these decisions and exchanges together make up the "economy". The last three principles involve the operation of the overall economy.

The differences in the standard of living between countries are astonishing. In 1993, the average income of an American was $25,000. In the same year, the average income of a Mexican was $7,000, while the average income of a Nigerian was $1,500. It is not surprising that such huge differences in average income are reflected in various measures of quality of life. Citizens of high-income countries have more televisions, more cars, better nutrition, better healthcare, and longer life expectancy than citizens of low-income countries.

Over time, changes in the standard of living are also significant. In the United States, historically, income growth has been around 2% per year (adjusted for changes in the cost of living). At this rate, average income doubles every 35 years. In some countries, economic growth is even faster. For example, in Japan, average income doubled in nearly 20 years, while in South Korea, average income doubled in nearly 10 years How to explain the huge differences in living standards among countries and different periods? The answer is surprisingly simple. Almost all changes in living standards can be attributed to the differences in the productivity of each country - the difference in the amount of goods and services produced by a worker in one hour. In countries where workers can produce a large number of goods and services per unit of time, most people enjoy a high standard of living; in countries where worker productivity is low, most people have to endure a life of poverty. Similarly, a country's productivity growth rate determines the average income growth rate.

The basic relationship between productivity and living standards is simple, but its significance is profound. If productivity is the primary determinant of living standards, then the importance of other explanations should be secondary. For example, some attribute the improvement in the living standards of American workers in the last century to labor unions or minimum wage laws. But the real heroic act of American workers is that they have increased productivity. Another example is that some critics claim that the slowdown in income growth in the United States in recent years is due to the increasing competition from Japan and other countries. But the real enemy is not foreign competition, but the slowdown in American productivity growth.

The relationship between productivity and living standards also has profound implications for public policy. When considering how any policy affects living standards, the key question is how the policy affects our ability to produce goods and services. In order to improve living standards, decision-makers need to ensure that workers receive a good education, have the tools they need to produce goods and services, and have the opportunity to access the best technology.

For example, over the past decade, much of the debate in the United States has focused on the government's budget deficit - when government spending exceeds government revenue. As we will explain, the focus on the budget deficit is mainly due to its adverse impact on productivity. When the government needs to finance the budget deficit, it has to borrow money in the financial markets, similar to students borrowing money to fund their college education, or companies borrowing money to fund new factories. Therefore, when the government borrows money to finance the deficit, it reduces the amount of funds available to other borrowers. In this way, the budget deficit reduces investment in human capital (education for students) and physical capital (factories for companies). Since low investment now means low productivity in the future, it is generally believed that the budget deficit suppresses the growth of living standards.

Principle Nine: When the government issues too much currency, prices rise - inflation

In January 1921, a German newspaper cost 0.3 marks. Less than two years later, in November 1922, the same newspaper cost 70 million marks. All other prices in the economy rose to a similar extent. This event is one of the most astonishing examples of inflation in history, where inflation is the rise in the overall price level in the economy.

Although the United States has never experienced a situation close to that of Germany in the 1920s, inflation has sometimes become an economic issue. For example, during the 1970s, the overall price level more than doubled, and President Gerald Ford called inflation the "public enemy number one." In comparison, in the 1990s, inflation was around 3% per year; at this rate, prices doubled every 20 years. Because high inflation brings various costs to society, countries around the world consider maintaining low inflation as a goal of economic policy What causes inflation? In most severe or persistent cases of inflation, the culprit is always the same: the growth of the money supply. When a government creates a large amount of its own currency, the value of the currency decreases. In early 1920s Germany, when prices rose threefold on average each month, the money supply also increased threefold each month. While the situation in the United States was not as severe, U.S. economic history also draws similar conclusions: the high inflation of the 1970s was related to the rapid growth of the money supply, while the low inflation of the 1990s was related to the slow growth of the money supply.

Principle Ten: The short-term trade-off between inflation and unemployment faced by society

The Phillips Curve is generated by the slow adjustment of certain prices. Price changes are sticky, meaning that when the government reduces the money supply, prices do not change immediately, but the reduced spending leads to changes in the sales of goods and services, resulting in unemployment.

If inflation is so easy to explain, why do decision-makers sometimes have trouble protecting the economy from the pain of inflation? One reason is that people often believe that reducing inflation will temporarily increase unemployment. This alternating relationship between inflation and unemployment is called the Phillips Curve, named after the first economist to study this relationship.

The Phillips Curve remains a controversial issue among economists, but most economists now accept the idea that there is a short-term trade-off between inflation and unemployment. According to a common explanation, this trade-off arises due to the slow adjustment of certain prices. For example, suppose the government reduces the money supply in the economy. In the long term, the only consequence of this policy change is that the overall price level will decrease. However, not all prices will adjust immediately. It takes years for all businesses to issue new catalogs, all unions to make wage concessions, and all restaurants to print new menus. In other words, prices are sticky in the short term.

Because prices are sticky, various government policies have short-term effects different from their long-term effects. For instance, when the government reduces the money supply, it reduces the amount of spending by people. Lower spending combined with persistently high prices reduces the quantity of goods and services sold by businesses. The decrease in sales leads to businesses laying off workers. Therefore, before prices make complete adjustments, a decrease in the money supply temporarily increases unemployment.

The alternating relationship between inflation and unemployment is only temporary but can last for several years. Therefore, the Phillips Curve is crucial for understanding many developments in the economy. In particular, decision-makers can utilize this alternating relationship when applying various policy tools. In the short term, decision-makers can influence the combination of inflation and unemployment experienced by the economy by changing government spending, tax levels, and the money supply issued. Because these monetary and fiscal policy tools have such significant potential power, how decision-makers should use these tools to control the economy has always been a contentious issue