Ten Principles of Economics Prof. Dr. E. S. Mundhe Karmaveer Bhaurao Patil College, Vashi, Navi Mumbai Abstract: Economics is basically the study of using the scarce resources wisely. The behavior of economy reflects the behavior of individuals and so of the society who make the economy. Households and society have much in common. They have to make many decisions. Both the household and society have to allocate their scarce resources among various purposes. Scarcity, various choices have to be made between alternatives. A society too cannot produce all the goods and services, people wish to have. Economics is the study of how society uses scarce resources to produce and distribute valuable commodities among the people. The essence of economics is to acknowledge the reality of scarcity of resources and then to organize the society to achieve the most efficient use of resources. Economics is a very important discipline. Unless one understands the basic principles of economics, it would not be possible to design relevant economic policies. If the economic policies are wrong, people can be in serious trouble. It is then quite important that we understand the basic principles of economics very well, in order to be able to design proper economic policy. Keywords: principles of economics, scarcity, trade-offs, opportunity cost, decision making. Introduction: N.Gregory Mankiw divides ten principles of economics into three groups. 1. Principles concerning how people make decisions 2. Principles concerning how people interact with each other 3. Principles concerning the forces and trends that affect how the economy as a whole works. The first four principles deal with individual decision making. The first principle explains how people face trade-offs in their lives. Because people face trade-offs, making decisions requires comparing the costs and benefits of alternative courses of action. This is explained in the second principle of economics. However, whatever decisions are made in life, are not really easy to make. According to the third principle, a rational individual thinks at the margin. People make decisions by comparing costs and benefits, and therefore, their behavior may change when the costs or benefits change. Thus, people respond in incentives and this is explained in the fourth principle of economics. The first four principles inform how individuals make decisions while the next three principles inform that many of the decisions affect not only themselves but other people as well. Principles five, six and seven explain how people interact with one another. The rest of the three principles are concerned with the working of the economy as a whole. Principle One: People Face Trade-Offs: The first principle of economics states that people face trade-offs. A technique of reducing or forgoing one or more desirable outcomes in exchange for increasing or obtaining other desirable outcomes in order to maximize the total return or effectiveness under given circumstances is termed as trade-offs. When someone sacrifices one thing for the other that is called a trade-off. There are limited goods and services available to 1 st September 2016 Webside: www.ijmms.in Email: ijmms14@gmail.com Page 1
people for consumption. But, the needs of people are endless. Thus, there is scarcity of goods and services that fail to satisfy people s needs. Therefore, people have to make decision on how to use these limited resources and distribute them among different people. This is an important fact of life for an economist. If you decide to go and watch a movie with your friends, you are losing out on the time that you would have spent otherwise. If you decide to buy a new cell phone, then you have to sacrifice on buying a new pair of shoes. If you plant one variety of rice in your field, you must forego the chance of planting another. The fact that we have to give up one thing in order to have another is referred to as trade-offs in economics. We face trade-offs because our resources are limited. Consider a student, who decides to study economics for one hour; he has to give up one hour studying another subject. People face different kinds of trade-offs while taking decisions. The same is true with families and societies. When the family decides to spend one rupee on something, they will have one rupee less to spend on something else. Societies consist of individuals and families. Thus, societies too face different kinds of trade-offs. For instance, if a country spends more on defense, it will have less to spend on infrastructure. Another important trade-offs is between a clean environment and a high level of income. Principle Two: Opportunity Cost Affect Decision Making: The cost of an alternative that must be foregone to select another alternative. It is the benefit that one would receive on selecting another alternative option. Opportunity costs affect decisions. We have seen that there are trade-offs do doing something. Doing one thing precludes doing something else. Therefore, when we do one activity, we forego the chance of doing the second activity. In other words, when we do something, we pay a cost, which is the cost of not being able to do the next best thing. This cost has a name in Economics. It is referred to as Opportunity cost. We pay this cost for the same reason that trade-offs exist: limited resources at the disposal of the individual. The opportunity cost of playing football today evening is perhaps the foregoing of the chance to play cricket. When we eat an ice-cream, we forego the chance of using that money for something else. The enjoyment lost because we could not spend our money on our next preferred alternative is the opportunity cost of eating the ice-cream. Obviously, we would spend the money on eating the ice-cream only if the opportunity cost of eating the ice-cream were not much higher than the enjoyment one would have from eating the ice-cream. Consider making decision on whether to go to college or not. If going college is the decision made, the benefit he gets from this decision is the intellectual enrichment and a lifetime of better job opportunities. Now these benefits must be compared with the cost the student incurs. This can be describe in terms of the money spend on tuitions, books, room and board. Still, this total cost does not truly represent what the student gives up to spend a year in college. Opportunity cost is the cash flows prevented by taking one course of action instead of another. For instance, the opportunity cost of the services and capital of the entrepreneur is the returns 1 st September 2016 Webside: www.ijmms.in Email: ijmms14@gmail.com Page 2
which the entrepreneur could have earned in an alternative use of his services and capital. The opportunity cost of a decision is the value of the best available alternative foregone. If alternative uses are many, then the opportunity cost is equal to the earnigs in the next best alternative. The opportunity cost applies to all situations where a thing can have alternative uses. In the absence of any alternative use, the opportunity cost is zero. Principle Three: Rational People Think at the Margin: The third principle of economics states that rational people think at the margin. Marginal benefit is the additional satisfaction or utility that a person receives from consuming an additional unit of a goods or service. A person s marginal benefit is the maximum amount he is willing to pay to consume that additional unit of a goods or service. Economists normally assume the people are rational. Rational people do their best to achieve the best from the given opportunities. We will see firms deciding about how many workers to be hired and how much product to be produced and sold to maximize profits. Similarly, consumers deciding about which bundle of goods and services to be bought to maximize satisfaction subject to their income and prices of goods and services. The word marginal means additional. When you buy a burger, it meets your hunger. But, another additional burger may not. So, if you think at the margin, you are thinking about what the next or additional action means for you. An individual can make better decisions by thinking at the margin. When a student faces examination period, he has not to make decision whether to skip the exams of keep studying all the day, but to decide whether to spend an extra hour to review the notes instead of going to play for an hour. In many situations, people make the best decisions by thinking at the margin. Suppose the additional revenue that I am going to get from producing one more cricket ball is greater than the cost of producing the extra ball. Let us say an additional cricket ball sells for Rs. 50 while it costs only Rs. 20 to produce the additional ball. Clearly, a rational producer will decide to produce the ball because a profit of Rs.30 is to be made by doing so. On the other hand, if the price of cricket balls falls to rs.15 while the cost of producing it remains rs.20, it will not make sense to produce the ball since the cost of making an additional ball exceeds the revenue to be earned from it. The cost of producing the extra ball is called marginal cost while the revenue obtained from selling an extra ball is called marginal revenue. If marginal revenue exceeds marginal cost, it obviously makes sense to produce the extra ball. If the marginal revenue is less than marginal cost, it will not pay to produce the extra ball. This principle works in all walks of life. Principle Four: People Respond to Incentives: The fourth principle of economics states that people respond to incentives. An incentive is something that motivates an individual to perform an action. Incentives can be in the form of money, gifts, discounts, etc. rational people, who make decision by comparing cost and benefits, respond to incentives. Incentives play a very 1 st September 2016 Webside: www.ijmms.in Email: ijmms14@gmail.com Page 3
important role in decision making. People make rational decisions be comparing the marginal cost and marginal benefits. Therefore, if the marginal cost and marginal benefits change, their behaviors change. This indicates that people respond to incentives. When price of apple increases, people decide to eat more bananas and fewer apples to save the cost of buying apples. Incentives are very important determinants of how people will behave in given situations. Farmers toil hard in the fields because they hope that their crop can be sold profitably. If a farmer did not see that hope, he would not work very hard. Nearly everybody responds to incentives, even those who are in the most unfortunate situation. Prisoners of concentration camps sometimes chose to serve in the households of their Nazi masters because they hoped that this would give them a better chance of survival. Principle Five: Trade Can Make Everyone Better Off: The words exchange and trade refer to the same activity. Adam Smith pointed to the basic propensity of humans to truck and barter. Exchanging something that you have a lot of with something that you utterly lack makes you better off. People who have one thing and want a different thing can exchange or trade it voluntarily with each other. Trade can make everyone better off. When people trade with each other, they get an opportunity to buy a variety of goods and services. Trade between two countries can make each country better off. Similarly, families and people gain from their ability to trade with others. Trade allows each person to specialize in the activities he or she does best whether it is farming, carpentry, home building and so on. By trading or exchanging with others, people can buy a greater variety of goods and services at lower cost. Similarly, countries can benefit from the ability to trade or exchange with one another. Trade allows countries to specialize in what they do best and enjoy a large variety of goods and services. Motorola (US) and Samsung (S. korea) produce the same kind of products of Smart phones, sony (Japan) and HCL (India) produce the same kind of products of laptops, Maruti (India) and Honda (Japan) produce the same kind of SUV products of automobiles. However, trading between different countries is not like a competition. Rather, trading between two countries make each country a better off. Trade allows countries to specialize in what they do best and to enjoy a greater variety of goods and services. Thus, every participant gets benefited in the trading or simply called exchange. Principle Six: Market are Usually a Good Way to Organize Economic Activity: The sixth principle of economics states that markets are usually a good way to organize economic activity. The organization of economic activities in an economy will depend on the economic system prevailing in a economy. An economic system is composed of people, institution and their relationships to resources. It deals with the production, distribution and consumption of goods and services in a particular society. There are three types of economic systems, namely; Command economy, Market economy and Mixed economy. In a market economy, economic activities are directed through price mechanism. Price mechanism is the system in a market economy whereby changes in price in response to changes in demand and supply bring about 1 st September 2016 Webside: www.ijmms.in Email: ijmms14@gmail.com Page 4
equality between demands and supply. Market has a power of resource allocation. Markets facilitate exchange. A market is a mechanism through which buyers and sellers can voluntarily carry out transactions. A variety of goods and services are exchanged on markets. Market is a mechanism through which buyers and sellers interact to set prices and exchange goods and services. According to Adam Smith, households and firms interacting in markets act as if they are guided by an invisible hand that leads them to desirable market outcomes. Principle Seven: Government can Sometimes Improve Market Outcomes: The seventh principle of economics states that government can sometimes improve market outcomes. The markets do not achieve maximum efficiency in the allocation of scarce resources and governments feel it necessary to intervene to rectify this and other problems of the market. The conditions required for markets to perform their allocative and creative functions in an optimal manner are not likely to be satisfied in any economy. The important problems of a market economy are; domination by few, removes incentive to be efficient, unequal distribution, externality, imperfect information, fail to provide public goods, macroeconomic instability etc. Since there are many problems and failures of market economy we need government to correct market failures or at least to lessen them. The government has an important role to play in the economic development of a country, rather as an agency to correct market failures. The government can play an important role to correct market failures and improve economic efficiency. According to R.A.Musgrave and P.B.Musgrave, government policy is needed to guide, correct, and supplement the market mechanism in certain respects. The government has to play the roles of to correct market imperfections, to correct problems of imperfect information, to improve legal structure, to provide public goods and merit goods, to correct the problems arising from externalities, to correct unequal distribution of income and wealth, to improve an institutional environment, to secure important social objectives, to provide social security and to guide the use of natural resources. Principle Eight: a Country s Standard of Living Depends on Its Ability to Produce Goods and Services: The eighth principle of economics states that standard of living of a country depends on its ability to produce goods and services. The standard of living in a country at a given point of time refers to the quantity of goods and services that are available per person in that country at that time. So, in effect, the standard of living in a country is the amount of food, medicines, education, clothes, housing, entertainment, infrastructure and other goods, health care and services that are available to an average citizen of that country. Thus, the standard of living in a country at a point of time (normally a year) depends upon two things a) How much is produced in the country at that point of time b) The number of people in the country at that point of time. Two things should be noted about the standard of living. Firstly, it is dynamic, rather than static. That is, the standard of living in a country can improve or deteriorate. Countries like China and India have had significant improvements in their standards of living over the years. This has happened because these countries have been producing goods and services at a faster 1 st September 2016 Webside: www.ijmms.in Email: ijmms14@gmail.com Page 5
rate than the rate at which their population is increasing. It is very clear that the standard of living of people around the world is not same. Standard of living depends on the earning of the individuals. If a country increases its productivity, the standard of living of the citizens increases accordingly and to increase the productivity, various policies are required to be made by the government. Principle Nine: Prices Rise When the Government Prints too Much Money: The principle ninth of economics states that price rises when the government prints too much money. A sustained rise in money supply in a country is likely to result in rise in prices. The relation between quantity of money and inflation can be explained by the quantity theory of money. According Milton Friedman, inflation is always and everywhere a monetary phenomenon. When the price level rises, people have to pay more for the same amount of goods and services they buy. On the other hand, price level is also a measure of the value of money. A rise in price level means a lower value of money because each rupee in your wallet now buys a smaller quantity of goods and services. Principle Ten: Society Faces a Short-Run Trade off Between Inflation and Unemployment: The tenth principle of economics states that society faces a short-run trade-off between inflation and unemployment. Increase in wages in one of the important factors responsible for inflation. A.W.Phillips, the British economist conducted a careful study of the data of more than a century pertaining to money wages, inflation and unemployment in the United Kingdom. His studies led to the conclusion that wages tend to raise when unemployment was low and vise-versa. The rise in wages increases costs which in turn lead to rise in prices. From, Philips analyzed the short term relationship between unemployment and inflation. Inflation-unemployment trade-off refers to a situation where increased employment is accompanied by increased inflation, while lower inflation is accompanied by lower employment growth. You cannot have a low level of inflation and a high level of employment simultaneously. Policy makers have to make a choice of having one (either low inflation or high employment) at the cost of another desirable situation (high unemployment or high inflation rate). References: 1. N.Gregory Mankiw, Principles of Microeconomics, 7 th edition, Cengage Learning, 2015 2. Dr. Keshav N. Ghorude and others, Economics-I (Microeconomics), Tech-Max Publications, Pune, 2016 3. A.D.Mascarenhas and Dr.P.A.Johnson, Microeconomics, Manan Prakashan, 2016 4. Dept. of economics, Mumbai University, Study Material. 2016 5. https://en.wikiversity.org/wiki/10_principles_of_economics 6. http://www.swlearning.com/economics/mankiw/principles2e/principles.html 7. http://www.improbable.com/airchives/paperair/volume9/v9i2/mankiw.html 8. https://windward.hawaii.edu/facstaff/briggsp/introduction%20and%20syllabus/chap_01.pdf 1 st September 2016 Webside: www.ijmms.in Email: ijmms14@gmail.com Page 6