Introduction:

There is no mystery to what an economy is. Whether we are talking about the economy of Los
Angeles, the United States, or the whole world. Economics is the study of how society manages
its scarce resources. For example, how people decide what to buy, save, and spend, how much
to produce and how many workers to hire.
We will summarize below the 10 principles of economics and what does it means to think like an
economist

The Summary:
An economy is just a group of people dealing with one another as they go about their lives.
Because the behavior of an economy reflects the behavior of the individuals who
make up the economy; we begin our study of economics with four principles of
individual decision-making.

Principle 1: People Face Trade-offs:

To get one thing that we like, we usually have to give up another thing that we like. Making
decisions requires trading off one goal against another.
We have many examples for trade-off in Economics, “guns and butter.” The more a society
spends on national defense to protect its shores from foreign aggressors, the less it can spend on
consumer goods to raise the standard of living at home.
Another trade-off society faces is between efficiency and equality; efficiency refers to the size of
the economic pie, and equality refers to how the pie is divided into individual slices.

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

Because people face trade-offs, making decisions requires comparing the costs and benefits of
alternative courses of action.
EX: Consider the decision to go to college. The main benefits are intellectual enrichment
and a lifetime of better job opportunities. The costs include place to sleep, food to eat and time
spent listening to lectures, reading textbooks, and writing papers. You can spend that time
working at a job or playing professional sports.
The opportunity cost of an item is what you give up to get that item

Principle 3: Rational People Think at the Margin

Rational people purposefully do the best they can to achieve their objectives, given the available
opportunities. Rational people know that decisions in life are rarely black and white but usually
involve shades of gray.
EX: Consider an airline deciding how much to charge passengers who fly standby.The average
cost of each seat is $500. Imagine that a plane is about to take off with ten empty seats and a
standby passenger waiting at the gate will pay $300 for a seat. The marginal cost is merely the
cost of the bag of peanuts and can
of soda that the extra passenger will consume. The company should sell that ticket as long as
passenger pays more than the marginal cost.
Economists use the term marginal change to describe a small incremental adjustment to an
existing plan of action.
Principle 4: People respond to incentives

An incentive is something that induces a person to act. Because rational people make decisions
by comparing costs and benefits, they respond to incentives. For example, a higher price in a
market provides an incentive for buyers to consume less and an incentive for sellers to produce
more
Public policymakers should never forget about incentives: Many policies change the costs or
benefits that people face and, therefore, alter their behavior. A tax on gasoline, for instance,
encourages people to drive smaller, more fuel-efficient cars

How People Interact

The first four principles discussed how individuals make decisions. As we go about our lives,
many of our decisions affect not only ourselves but other people as well. The next three principles
concern how people interact with one another

Principle 5: Trade can make everyone better off

Trade between countries is not like a sports contest in which one side wins and the other side
loses. In fact, 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

In a market economy, millions of firms and households make the decisions. Firms decide whom
to hire and what to make. Households decide which firms to work for and what to buy with their
incomes.
Market Economy is an economy that allocates resources through the decentralized decisions of
many firms and households as they interact in markets for goods and services. In a market
economy, no one is looking out for the economic well-being of society as a whole. Free markets
contain many buyers and sellers are interested primarily in their own well-being. Yet, market
economies have proven remarkably successful in organizing economic activity to promote overall
economic well-being.
As you study economics, you will learn that prices are the instrument with which the invisible
hand directs economic activity.
When the government prevents prices from adjusting naturally to supply and demand, it impedes
the invisible hand’s ability to coordinate the decisions of the households and firms that make up
the economy. This explains the great harm caused by policies that directly control prices

Principle 7: Governments can sometimes improve Market

Outcomes

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. Market economies need institutions to enforce
property rights so individuals can own and control scarce resources.
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.

Another reason we need government is to intervene in the economy and change the allocation of
resources: to promote efficiency or to promote equality. That is, most policies aim either to
enlarge the economic pie or to change how the pie is divided.
Consider first the goal of efficiency. Although the invisible hand usually leads markets to allocate
resources to maximize the size of the economic pie, this is not always the case.
One possible cause of market failure is an externality such as pollution Another possible cause of
market failure is market power, which refers to the ability of a single person (or small group)
to unduly influence market prices
Now consider the goal of equality. The invisible hand can nonetheless leave sizable disparities in
economic wellbeing. A market economy rewards people according to their ability to produce
things that other people are willing to pay for .This will call for government intervention. In
practice, many public policies, such as the income tax and the welfare system, aim to achieve a
more equal distribution of economic well-being.

How the economy as a whole works

The last three principles concern the workings of the economy as a whole.

Principle 8: A Country’s standard of living depends on its

ability to produce Goods and Services

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.
The relationship between productivity and living standards has profound implications for public
policy. To boost living standards, policymakers need to raise productivity by ensuring that workers
are well educated, have the tools needed to produce goods and services, and have access to the
best available technology and services.

Principle 9: Prices rise when the government prints Too Much

Money

The growth in the quantity of money is a cause of inflation. When a government creates large
quantities of the nation’s money, the value of the money falls.
The high inflation was associated with rapid growth in the quantity of money, and the low inflation
of was associated with slow growth in the quantity of money.

Principle 10: Society faces a short-run trade-off between

inflation and unemployment

Although a higher level of prices is the primary effect of increasing the quantity of money in the
long run .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.
Policymakers can exploit the short-run trade-off between inflation and unemployment using
various policy instruments. By changing the amount that the government spends, the amount it
taxes, and the amount of money it prints, policymakers can influence the overall demand for
goods and services. Changes in demand in turn influence the combination of inflation and
unemployment that the economy experiences in the short run. Because these instruments of
economic policy are potentially so powerful, how policymakers should use these instruments to
control the economy.

How to think like an Economist?

Economists play two roles: Scientists: try to explain the world Policy advisors: try to
improve it
In the first role as a scientist, economists employ the scientific method,

The Scientific Method: observation, theory, and more

Observation

Economists use theory and observation like other scientists. An economist might live in a country
experiencing rapidly increasing prices and be moved by this observation to develop a theory of
inflation. The theory might assert that high inflation arises when the government prints too much
money. To test this theory, the economist could collect and analyze data on prices and money
from many different countries
Due to the difficulty that economists face to conduct experiments, economists pay close attention
to the natural experiments offered by history.

The Role of Assumptions

Economists make assumptions to simplify the complex world and make it easier to understand.
Economists use different assumptions to answer different questions.
The art in scientific thinking is deciding which assumptions to make.

Economic Models
Economists use models to study economic issues. They are most often composed of
diagrams and equations.

The First Model: The Circular-Flow Diagram:

A visual model of the economy shows how dollars flow through markets among
households and firms. Firms produce goods and services using inputs, such as labor,
land, and capital (buildings and machines). These inputs are called the factors of
production. Households own the factors of production and consume all the goods and
services that the firms produce.
In the markets for goods and services, households are buyers, and firms are sellers. In
particular, households buy the output of goods and services that firms produce. In the
markets for the factors of production, households are sellers, and firms are buyers
According to the circular flow diagram :
 The circular flow model demonstrates how money moves from producers to
households and back again in an endless loop.
 Money moves from producers to workers as wages and then back from workers
to producers as workers spend money on products and services.
 When all of these factors are totaled, the result is a nation's gross domestic
product (GDP) or the national income.

The Second Model: The Production Possibilities Frontier

A graph that shows the various combinations of output. The production possibility frontier is a
curve illustrating the varying amounts of two products that can be produced when both depend on
the same finite resources. According to production possibilities frontier :
 The production of one commodity may increase only if the production of the other
commodity decreases.
 Producing less than the quantities indicated by the Production possibilities frontier , this is
a sign that resources are not being used to their full potential. In this case, it is possible to
increase the production of some goods without cutting production in other areas.
 There are limits to production, each economy must decide what combination of goods
and services should be produced in order to attain maximum resource efficiency.

Microeconomics and Macroeconomics

The field of economics is traditionally divided into two broad subfields. Macroeconomics
Microeconomics
Microeconomics is the study of how households and firms make decisions and how they interact
in markets.
Macroeconomics is the study of economy-wide phenomena, including inflation, unemployment,
and economic growth.
These two branches of economics are closely intertwined, yet distinct – they address different
questions.
The Economist as Policy Advisor:

When economists are trying to explain the world, they are scientists. When they are trying to help
improve it, they are policy advisers.

Positive versus Normative Analysis

As scientists, economists make positive statements, which attempt to describe the world as it is.
As policy advisors, economists make normative statements, which attempt to prescribe how the
world should be. Positive statements can be confirmed or refuted, normative statements cannot.
When economists make normative statements, they are acting more as policy advisers than
scientists.
Economists as a group are often criticized for giving conflicting advice to policymakers.

Economists often appear to give conflicting advice to policymakers for two basic reasons:

1-Economists may disagree about the validity of alternative positive theories about how the world
works.
EX: Economists disagree about whether the government should tax a household’s income or its
consumption (spending)
We can have two groups of economists hold different normative views about the tax system
because they have different positive views about the responsiveness of saving to tax incentives.

2-Economists may have different values and therefore different normative views about what
policy should try to accomplish

Economists who advise policymakers offer conflicting advice either because of differences in
scientific judgments or because of differences in values. At other times, economists are united in
the advice they offer, but policymakers may choose to ignore it.