Economics

Basic Concepts
Chapter 1

Musharrat Shabnam Shuchi

Assistant Professor
Department of Economics
 What is Economics?
• Economics is the study of how society manages its
scarce resources.
• Economists study how people make decisions: how
much they work, what they buy, how much they save,
and how they invest their savings.
• Economists also study how people interact with one
another.
• Finally, economists analyze the forces and trends that
affect the economy as a whole, including the growth
in average income, the fraction of the population that
cannot find work, and the rate at which prices are
rising.
10 Principles of Economics

How People Make Decisions

1: People Face Trade-offs
2: The Cost of Something Is What You Give Up to Get It
3: Rational People Think at the Margin
4: People Respond to Incentives

How People Interact

5: Trade Can Make Everyone Better Off
6: Markets Are Usually a Good Way to Organize Economic
Activity
7: Governments Can Sometimes Improve Market Outcomes

How the Economy as a Whole Works

8: A Country’s Standard of Living Depends on Its Ability to
Produce Goods and Services
9: Prices Rise When the Government Prints Too Much Money
10: Society Faces a Short-Run Trade-off between Inflation and
Unemployment
 Ten Principles of Economics
• Scarcity means that society has limited
resources and therefore cannot produce
all the goods and services people wish to
have.
• The study of economics has many facets,
but it is unified by several central ideas
which are listed under the Ten Principles
of Economics.
 Principle 1: People Face Trade-offs

• “There ain’t no such thing as a free lunch.”

• One classic trade-off is between “guns and
butter.” The more a society spends on
national defense (guns) to protect its
shores from foreign aggressors, the less it
can spend on consumer goods (butter) to
raise the standard of living at home.
• To get something that we like, we usually
have to give up something else that we
also like. Making decisions requires
trading off one goal against another.
Principle 1: People Face Trade-offs
• The society faces a trade-off between
efficiency and equality.
• Efficiency means that society is getting
the maximum benefits from its scarce
resources.
• Equality means that those benefits are
distributed uniformly among society’s
members.
 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.
• The opportunity cost of an item is what you
give up to get that item. It is the cost of letting
go the next best alternative.
• When making any decision, decision makers
should be aware of the opportunity costs that
accompany each possible action.
• When you spend a year listening to lectures,
reading textbooks, and writing papers, you
cannot spend that time working at a job.
 Principle 3: Rational People Think
at the Margin
• Rational people are the people who
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.
• Keep in mind that margin means “edge,”
so marginal changes are adjustments
around the edges of what you are doing.
Rational people often make decisions by
comparing marginal benefits and marginal
 Principle 3: Rational People Think
at the Margin
• When exams roll around, your decision is
not between blowing them off and studying
24 hours a day but whether to spend an
extra hour reviewing your notes instead of
watching TV.
• Why is water so cheap, while diamonds
are so expensive?
• 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 (such as the
prospect of a punishment or reward) that
induces a person to act. Because rational
people make decisions by comparing costs
and benefits, they respond to incentives.
• Incentives are key to analyzing how markets
work. For example, when the price of an
apple rises, people decide to eat fewer
apples. At the same time, apple orchards
decide to hire more workers and harvest
more apples. In other words, a higher price in
a market provides an incentive for buyers to
consume less and an incentive for sellers to
produce more.
 Principle 5: Trade Can Make
Everyone Better Off
• 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
• 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.
• The success of market economies is puzzling. 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 of
numerous goods and services, and all of them are
interested primarily in their own well-being. Yet
despite decentralized decision making and self-
interested decision makers, market economies
have proven remarkably successful in organizing
economic activity to promote overall economic
well-being.
 Principle 6: Markets Are Usually a Good
Way to Organize Economic Activity
• In his 1776 book An Inquiry into the
Nature and Causes of the Wealth of
Nations, economist Adam Smith made the
most famous observation in all of
economics: Households and firms
interacting in markets act as if they are
guided by an
“invisible hand” that leads them to
desirable market outcomes.
 Principle 6: Markets Are Usually a Good
Way to Organize 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. 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
 Principle 6: Markets Are Usually a Good
Way to Organize Economic Activity
• Smith’s insight has an important corollary:
When a 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 an
economy.
 Principle 7: Governments Can
Sometimes Improve Market Outcomes
• If the invisible hand of the market is so
great, why do we need government?
• One reason we need government is that
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. Most important, market
economies need institutions to enforce
property rights so individuals can own and
control scarce resources.
 Principle 7: Governments Can Sometimes
Improve Market Outcomes
• Property rights-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. Ex-
Pollution.
 Principle 8: A Country’s Standard of Living
Depends on Its Ability to Produce Goods
and Services
• Productivity is the quantity of goods and
services produced from each unit of labor
input.
• Almost all variation in living standards is
attributable to differences in countries’
productivity. In nations where workers can
produce a large quantity of goods and
services per hour, most people enjoy a high
standard of living; in nations where workers
are less productive, most people endure a
more meager existence..
 Principle 9: Prices Rise When the
Government Prints Too Much Money
• Inflation- an increase in the overall level
of prices in the economy.
• What causes inflation? In almost all cases
of large or persistent inflation, the culprit is
growth in the quantity of money. When a
government creates large quantities of the
nation’s money, the value of the money
falls.
Principle 10: Society Faces a Short-Run Trade-off
between Inflation and Unemployment

• Although a higher level of prices is, in the

long run, the primary effect of increasing
the quantity of money, the short-run story
is more complex and controversial.

• This line of reasoning leads to one final

economy-wide trade-off: a short-run trade-
off between inflation and unemployment.
Principle 10: Society Faces a Short-Run Trade-off
between Inflation and Unemployment

• Business cycle—the irregular and largely

unpredictable fluctuations in economic
activity, as measured by the production of
goods and services or the number of
people employed.