Topic 1

Introduction
Ten Principles of Economics

Principles of Economics 3
7th Edition
Scarcity

•Scarcity refers to the limited

nature of society’s resources.
•For example, Hasan wished he
had more time to study but his
time was a scarce resource.

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Scarcity

• We encounter scarcity
in every decision we
make.

• For example, a
household must decide
who does the chores
and how to allocate its
scarce resources.

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 Scarcity

• Likewise, society must decide what jobs will

be done and who will do them. It must also
allocate the goods and services that are
produced.

• Management of society’s resources is

important because we cannot produce all
the goods and services people wish to have.

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Economics

• Economics is the study of how society manages its

scarce resources.

• For example, economics helped Jing to understand

the production, consumption and transfer of
wealth.

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 Economics
• In most societies, resources
are allocated through the
combined choices of millions
of households and firms.

• Economists study how people

make decisions: how much
they work, what they buy,
how much they save and how
they invest their savings.

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Economics

• Economists also study how people interact

with one another.

• For instance, economists examine how the

buyers and sellers of a good interact to
determine the price at which the good is sold
and the quantity that is sold.

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How people make decisions

• The behaviour of an economy reflects the behaviour of

the individuals who make up the economy.

• Thus we begin our study of economics with the

principles of individual decision making.

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PRINCIPLE 1

• People face trade-offs.

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Trade-offs

• Scarcity creates trade-offs.

• How do you divide your time between studying
different subjects. Or between work, hanging out
with friends and sleeping in?
• Each hour you spend doing one activity is one
hour less that you have to do something else.

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Trade-offs

• How does your family divide its income between

housing, food, clothing and entertainment?

• How does the government divide its revenue between

education, health care, infrastructure and emergency
services?

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Efficiency

• Efficiency is the property of society

getting the most it can from its scarce
resources.

• For example, taxpayers want to see their

tax dollars spent efficiently.

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Equity

• Equity is the property of distributing economic

prosperity fairly among the members of society.

• For example, taxation can be used to

redistribute wealth from rich households to
poor households, thereby increasing equity.

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Efficiency versus equity

• Most societies value both efficiency and equity.

Unfortunately, there is often a trade-off
between these two goals.

• For example, funding public education and

health care requires the government to raise
taxes. But taxes reduce the reward for working
hard and being successful, leading to a loss of
efficiency.

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PRINCIPLE 2

• The cost of something is what you give

up to get it.

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What did you give up to
attend university?

• You (or your parents) have to pay university

fees, buy textbooks, and purchase food and
housing.

• These costs are part of the equation but they

are not the whole story.

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What did you give up to
attend university?

• On the one hand, you would still have to

purchase food and housing if you had not
chosen to attend university. Would these cost
have been different?

• On the other hand, the biggest cost of a

university education is usually the cost of your
time. What would you be doing with your time if
you were not studying?

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Opportunity cost

• Opportunity cost is the best alternative that

must be given up to obtain some item.

• For example, my opportunity cost of sitting

through this lecture is reading a book and
enjoying an espresso at a local café.

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PRINCIPLE 3

• Rational people think at the margin.

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 Marginal change

• Marginal change is a small incremental

adjustment to a plan of action.

• Marginal benefit is the benefit created by a

marginal change.

• Marginal cost is the cost created by a marginal

change.

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Marginal change

• An example of an all-or-nothing decision is

‘Should I sleep or stay up all night?’

• An example of a marginal decision is ‘Should I

get out of bed now, or press the snooze button
and sleep in for another 10 minutes?’

• Rational people often make decisions by

comparing the marginal benefit of an action with
the marginal cost.

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Why do diamonds cost more than water?

• Humans need water to survive, while diamonds

are unnecessary, but people are willing to pay
much more for diamonds than a cup of water.

• A person’s willingness to pay for a good

depends on the marginal benefit that an extra
unit will yield. In turn, the marginal benefit
depends on how many units a person already
has.

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Why do diamonds cost more than water?

• The marginal benefit of an extra cup of water is

small because water is plentiful. However,
many people consider the marginal benefit of
an extra diamond to be large because
diamonds are so rare.

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PRINCIPLE 4

• People respond to incentives.

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People respond to incentives

• Understanding how people respond to

incentives is central to understanding how
markets work.

• When the price of apples rises, people decide

to eat fewer apples.

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People respond to incentives

• At the same time, apple orchards decide to hire

more workers and harvest more apples.

• Incentives are also important in public policy.

For example, a tax on petrol leads people to
purchase smaller, more fuel efficient cars.

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Do seat belt laws cause accidents?

• Wearing a seatbelt increases the probability

that you will survive an accident. For this
reason it is compulsory to wear seat belts in
many countries.

• Perversely, seat belt laws may reduce your

incentive to drive safely.

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Do seat belt laws cause accidents?

• Driving slowly and carefully is costly in terms of

both time and energy. Seat belts reduce the
marginal benefit of safe driving because they
reduce the risk of serious injury and death.

• Some studies have shown that while

compulsory seat belt laws have led to fewer
deaths per accident, they have also led to an
increase in the number of accidents.

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Principle 5

• Trade can make everyone better off.

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Trade can make everyone better off

• Imagine a world in which your family didn’t

trade with anyone else.

• You would have to grow your own food, make

your own clothes, build your own house and
make your own tools.

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Trade can make everyone better off

• Instead, we each specialise in the activities we

do best. Trade allows us to enjoy a greater
variety of products at lower cost.

• The same is true for trade between nations.

Trade allows countries to specialise in what
they do best and to enjoy a greater variety of
goods and services.

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principle 6

• Markets are usually a good way to organise

economic activity.

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Market economy

• A market economy is an economy that

allocates resources through the decentralised
decisions of many firms and households as they
interact in markets for goods and services.

• It sits in contrast with a planned economy.

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Market economy

• Decisions are made by millions of self-

interested households and firms.

• Firms decide whom to hire and what to make

• Households decide which firms to work for and

what to buy with their incomes.

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Market economy

• Firms and households interact in the

marketplace, where prices and self-interest
guide their decisions.

• In a market economy, no one is looking out for

the economic wellbeing of society as a whole.

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The Invisible hand

• The invisible hand is the idea that buyers and

sellers freely interacting in a market economy will
create an outcome that allocates goods and
services to those people who value them most,
and will make the best use of scarce resources.

• The concept was proposed by Adam Smith in An

Inquiry into the Nature and Causes of the Wealth
of Nations (1776).

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The invisible hand

• Within a market economy, prices are the

instrument with which the invisible hand directs
economic activity.

• 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.

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The invisible hand

• Smith’s great insight was that prices adjust to

guide buyers and sellers to reach outcomes that
can maximise society’s wellbeing as a whole.

• When the government prevents prices from

adjusting naturally to supply and demand, it
impedes the invisible hand’s ability to coordinate
the millions of households and firms that make up
the economy.

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principle 7

• Governments can sometimes improve market

outcomes.

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Governments can sometimes improve market
outcomes

• The invisible hand can only function if

government enforces the rules and maintains
the institutions that are key to a market
economy.

• We rely on government-provided police and

courts to enforce our property rights over the
things we produce.

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Governments can sometimes improve market
outcomes

• Government also has a role to play when it

comes to the goal of equity.

• The invisible hand does not ensure that

everyone has sufficient food, decent clothing
and adequate health care.

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Market Failure

• Market failure is a situation in which a market

left on its own fails to allocate resources
efficiently.

• The inability of unregulated markets to limit

pollution is a form of market failure.

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Externality

• Externality is the uncompensated impact of

one person’s actions on the wellbeing of a
bystander.

• A positive externality makes the bystander

better off.

• A negative externality makes the bystander

worse off.

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Market Power

• Market power is the ability of a single economic

actor (or small group of actors) to have a
substantial influence on market prices.

• For example, a monopoly can earn substantial

profits by exercising its market power.

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Principle 8

• A country’s standard of living depends on its

ability to produce goods and services.

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Income and living standards

• Citizens of high-income countries have more

TV sets, more cars, better nutrition, better
health care and longer life expectancy than
citizens of low-income countries.

• Changes in living standards over time are also

large. In Australia, incomes have historically
grown about 2 per cent per year.

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Income and living standards

• What explains these large differences in living

standards among countries and over time?

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Productivity

• Productivity is the quantity of goods and

services produced from each hour of a
worker’s time.

• For example, almost all variation in living

standards is attributable to differences in
countries’ productivity.

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Productivity and living standards

• If productivity is the primary determinant of

living standards, other explanations (such as
labour unions or award wage laws) must be of
secondary importance.

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Productivity and living standards

• When thinking about how any policy will affect

living standards, the key question is how it will
affect our ability to produce goods and services.

• Policies that ensure workers are well educated,

have the tools needed to produce goods and
services and have access to the best available
technology will raise productivity and boost
living standards.

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Principle 9

• Prices rise when the government prints too

much money.

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Inflation

• Inflation is an increase in the overall level of

prices in the economy.

• In most cases of large or persistent inflation,

the culprit turns out to be the growth in the
quantity of money. When a government creates
large quantities of the nation’s money, the
value of the money falls.

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Principle 10

• Society faces a short-term trade-off between

inflation and unemployment.

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Phillips curve

• The Phillips curve is the short-term trade-off

between inflation and unemployment.

• For example, reducing inflation is often thought

to cause a temporary rise in unemployment.

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Sticky prices

• Suppose that the government reduces the

quantity of money in the economy.

• In the long term, the only result of this policy

change will be a fall in the overall level of
prices.

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Sticky prices

• However, it may take several years before all

firms issue new catalogues, all unions make
wage concessions and all restaurants print
new menus.

• Prices are said to be sticky in the short term.

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Sticky prices, inflation and
unemployment
• When the government reduces the quantity of
money, it reduces the amount that people
spend.

• Lower spending, together with prices that are

stuck too high, reduces the quantity of goods
and services that firms sell.

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Sticky prices, inflation and unemployment

• Lower sales, in turn, cause firms to lay off

workers.

• Thus, the reduction in the quantity of money

raises unemployment temporarily until prices
have fully adjusted to the change.

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 Thank
You

Principles of Economics
7th Edition
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