WHAT’S NEW IN THE SIXTH EDITION:
There is a new
Case Study
on “The Incentive Effects of Gasoline Prices.” Principle 10 on the Short-Run
Trade-off Between Inflation and Unemployment has been updated to reflect changes in the economy in
2008–2009 and some of the response from the Obama administration.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
➢ that economics is about the allocation of scarce resources.
➢ that individuals face trade-offs.
CONTEXT AND PURPOSE:
Chapter 1 is the first chapter in a three-chapter section that serves as the introduction to the text.
Chapter 1 introduces ten fundamental principles on which the study of economics is based. In a broad
sense, the rest of the text is an elaboration on these ten principles. Chapter 2 will develop how
1
TEN PRINCIPLES OF ECONOMICS
2 ❖ Chapter 1/Ten Principles of Economics
KEY POINTS:
• The fundamental lessons about individual decisionmaking are that people face trade-offs among
alternative goals, that the cost of any action is measured in terms of forgone opportunities, that
rational people make decisions by comparing marginal costs and marginal benefits, and that people
change their behavior in response to the incentives they face.
CHAPTER OUTLINE:
I. Introduction
A. The word “economy” comes from the Greek word
oikonomos
meaning “one who manages a
household.”
B. This makes some sense because in the economy we are faced with many decisions (just as a
household is).
Begin by pointing out that economics is a subject that students must confront in their
daily lives. Point out that they already spend a great deal of their time thinking about
economic issues: changes in prices, buying decisions, use of their time, concerns
about employment, etc.
Chapter 1/Ten Principles of Economics ❖ 3
II. How People Make Decisions
A. Principle #1: People Face Trade-offs
1. “There ain’t no such thing as a free lunch.” Making decisions requires trading one goal for
another.
2. Examples include how students spend their time, how a family decides to spend its income,
3. An important trade-off that society faces is the trade-off between efficiency and equality.
a. Definition of efficiency: the property of society getting the maximum benefits
from its scarce resources.
4. Recognizing that trade-offs exist does not indicate what decisions should or will be made.
B. Principle #2: The Cost of Something Is What You Give Up to Get It
2. What are the costs of going to college?
3. Definition of opportunity cost: whatever must be given up in order to obtain some
item.
Table 1
As you discuss the ten principles, make sure that students realize that it is okay if
4 ❖ Chapter 1/Ten Principles of Economics
C. Principle #3: Rational People Think at the Margin
1. Economists generally assume that people are rational.
a. Definition of rational: systematically and purposefully doing the best you can to
achieve your objectives.
2. Many decisions in life involve incremental decisions: Should I remain in school this semester?
Should I take another course this semester? Should I study another hour for tomorrow’s
exam?
a. Definition of marginal change: a small incremental adjustment to a plan of
action.
3. A rational decision maker takes an action if and only if the marginal benefit is at least as
large as the marginal cost.
D. Principle #4: People Respond to Incentives
1. Definition of incentive: something that induces a person to act.
2. Because rational people make decisions by weighing costs and benefits, their decisions may
change in response to incentives.
One of the hardest ideas for students to grasp is that “free” things are not truly free.
Thus, you will need to provide students with numerous examples of such “free”
Chapter 1/Ten Principles of Economics ❖ 5
3. Many public policies change the costs and benefits that people face. Sometimes policymakers
4. Example: Seat belt laws increase the use of seat belts but lower the incentives of individuals
5.
Case Study: The Incentive Effects of Gasoline Prices
6.
In the News: Incentive Pay: Where the Buses Run on Time
a. Most bus drivers in Chile are paid per passenger rather than per hour, giving them an
incentive to more quickly run their routes to pick up as many passengers as possible.
III. How People Interact
A. Principle #5: Trade Can Make Everyone Better Off
1. Trade is not like a sports contest, where one side gains and the other side loses.
6 ❖ Chapter 1/Ten Principles of Economics
Activity 1—Getting Dressed in the Global Economy
Type: In-class assignment
Topics: Specialization, interdependence, self-interest, consumer choice,
international trade
Materials needed: None
Time: 20 minutes
Class limitations: Works in any class size
Purpose
The advantages of specialization and division of labor are very clear in this example. The
Instructions
Ask the class to answer the following questions. Give them time to write an answer to each
question, then discuss their answers before moving on to the next question. The first question
1. Where did your clothes come from?
2. Who worked to produce your clothes?
3. What things do you consider when buying a garment?
4. Where were your clothes produced (what countries)?
Common Answers and Points for Discussion
1. Where did your clothes come from?
There are many possible ways to answer, but many students will say “the mall” or another
2. Who worked to produce your clothes?
There is no end to the possible answers; garment and textile workers are obvious but most
3. What things do you consider when buying a garment?
Most answers focus on preferences (fit, style, quality, color). Price is cited less frequently. Ask
Chapter 1/Ten Principles of Economics ❖ 7
B. Principle #6: Markets Are Usually a Good Way to Organize Economic Activity
1. Many countries that once had centrally planned economies have abandoned this system and
are trying to develop market economies.
4. When a government interferes in a market and prevents price from adjusting, household and
firm decisions become distorted.
5. Centrally planned economies failed because they did not allow the market to work.
6.
FYI: Adam Smith and the Invisible Hand
C. Principle #7: Governments Can Sometimes Improve Market Outcomes
1. The invisible hand will only work if the government enforces property rights.
3. Government policy can improve efficiency when there is market failure.
Explain to students that when households and firms do what is best for themselves,
they often end up doing what is best for society, as if guided by market forces—or an
4. Where were your clothes produced (what countries)?
A large number of countries will be represented, even in small classes. Asia is always well
This pattern shows the limits of simple explanations such as “cheap labor.” Briefly discuss the
importance of comparative advantage and specialization.
8 ❖ Chapter 1/Ten Principles of Economics
a. Definition of market failure: a situation in which a market left on its own fails to
allocate resources efficiently.
4. Examples of Market Failure
a. Definition of externality: the impact of one person’s actions on the well–being of
a bystander.
5. Note that the principle states that the government
can
improve market outcomes. This is not
saying that the government always
does
improve market outcomes.
IV. How the Economy as a Whole Works
A. Principle #8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and
Services
1. Differences in living standards from one country to another are quite large.
2. Changes in living standards over time are also great.
a. Training in economics helps us to understand fallacies and to anticipate unintended
consequences.
b. This is an excerpt from a commencement address by Robert D. McTeer, Jr., the former
President of the Federal Reserve Bank of Dallas and describes why students should study
economics.
B. Principle #9: Prices Rise When the Government Prints Too Much Money
Chapter 1/Ten Principles of Economics ❖ 9
3. Examples: Germany after World War I (in the early 1920s) and the United States in the
1970s.
C. Principle #10: Society Faces a Short-Run Trade-off between Inflation and Unemployment
1. Most economists believe that the short-run effect of a monetary injection is lower
unemployment and higher prices.
2. The short-run trade-off between inflation and unemployment plays a key role in the analysis
of the business cycle.
3. Definition of business cycle: fluctuations in economic activity, such as employment
and production.
6.
FYI: How to Read this Book
a. Economics is very useful to understand, but it can be a difficult subject to grasp.
b. There are nine tips to make reading and understanding the material in the book easier.
i. Read before class.
ii. Summarize, don’t highlight.
10 ❖ Chapter 1/Ten Principles of Economics
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1. There are many possible answers.
2. A country is better off by trading because trade allows more to be produced through specialization.
Markets allow the “invisible hand” to guide self-interested individuals into promoting economic well–
3. The three principles that describe how the economy as a whole works are: (1) a country’s standard
of living depends on its ability to produce goods and services; (2) prices rise when the government
prints too much money; and (3) society faces a short-run trade-off between inflation and
Activity 2—So Many Things to Do, So Little Time
Type: In-class assignment
Topics: Trade-offs, opportunity cost, thinking at the margin, incentives
Materials needed: None
Time: 10 minutes
Class limitations: Works in any class size
Give students a list of activities with corresponding time requirements: sleep, 8 hours; sleep,
6 hours; eat breakfast, 30 minutes; ride a bike, 1 hour; go hiking, 2 hours; study, 3 hours;
Chapter 1/Ten Principles of Economics ❖ 11
Questions for Review
1. Examples of trade-offs include time trade-offs (such as studying one subject over another or studying
2. The opportunity cost of seeing a movie includes the monetary cost of admission plus the time cost of
3. The marginal benefit of a glass of water depends on your circumstances. If you have just run a
4. Policymakers need to think about incentives so they can understand how people will respond to the
policies they put in place. The text’s example of seat belt laws shows that policy actions can have
5. Trade among countries is not a game with some losers and some winners because trade can make
6. The “invisible hand” of the marketplace represents the idea that even though individuals and firms
7. The two main causes of market failure are externalities and market power. An externality is the
impact of one person’s actions on the well-being of a bystander, such as from pollution or the
8. Productivity is important because a country’s standard of living depends on its ability to produce
9. Inflation is an increase in the overall level of prices in the economy. Inflation is caused by increases
in the quantity of a nation’s money.
10. Inflation and unemployment are negatively related in the short run. Thus, reducing inflation entails
costs to society in the form of higher unemployment in the short run.
Problems and Applications
1. a. A family deciding whether to buy a new car faces a trade-off between the cost of the car and
12 ❖ Chapter 1/Ten Principles of Economics
b. For a member of Congress deciding whether to increase spending on national parks, the
trade-off is between parks and other spending items or tax cuts. If more money goes into
the park system, that may mean less spending on national defense or on the police force. Or
instead of spending more money on the park system, taxes could be reduced.
2. When the benefits of something are psychological, such as going on a vacation, it is not easy to
compare benefits to costs to determine if it is worth doing. But there are two ways to think about the
benefits. One is to compare the vacation with what you would do in its place. If you did not go on
vacation, would you buy something like a new set of golf clubs? Then you can decide if you would
3. If you are thinking of going skiing instead of working at your part-time job, the cost of skiing includes
4. If you spend $100 now instead of saving it for a year and earning 5 percent interest, you are giving
up the opportunity to spend $105 one year from now.
5. The fact that you have already sunk $5 million is not relevant to your decision anymore, because that
money is gone. What matters now is the chance to earn profits at the margin. If you spend another
6. a. The provision of Social Security benefits lowers an individual’s incentive to save for retirement.
The benefits provide some level of income to the individual when she retires. This means that the
individual is not entirely dependent on savings to support consumption through the years in
retirement.
Chapter 1/Ten Principles of Economics ❖ 13
7. a. When welfare recipients have their benefits cut off after two years, they have a greater incentive
to find jobs than if their benefits were to last forever.
8. By specializing in each task, you and your roommate can finish the chores more quickly. If you
divided each task equally, it would take you more time to cook than it would take your roommate,
and it would take him more time to clean than it would take you. By specializing, you reduce the total
time spent on chores.
9. a. Efficiency: The market failure comes from the market power of the cable TV firm.
b. Equity
10. a. If everyone were guaranteed the best healthcare possible, much more of our nation’s output
would be devoted to medical care than is now the case. Would that be efficient? If you believe
that doctors have market power and restrict health care to keep their incomes high, you might
think efficiency would increase by providing more healthcare. But more likely, if the government
mandated increased spending on healthcare, the economy would be less efficient because it
would give people more healthcare than they would choose to pay for. From the point of view of
equality, if poor people are less likely to have adequate healthcare, providing more health care
would represent an improvement. Each person would have a more even slice of the economic
pie, though the pie would consist of more healthcare and less of other goods.
11. Because average income in the United States has roughly doubled every 35 years, we are likely to
have a better standard of living than our parents, and a much better standard of living than our
14 ❖ Chapter 1/Ten Principles of Economics
grandparents. This is mainly the result of increased productivity, so that an hour of work produces
more goods and services than it used to. Thus, incomes have continuously risen over time, as has
the standard of living.
12. If Americans save more and it leads to more spending on factories, there will be an increase in
production and productivity, because the same number of workers will have more equipment to work
13. a. Both of these goals are intended to improve equality. However, reducing the cost of healthcare
will lead to greater consumption of healthcare and less consumption of other goods. This reduces
efficiency.
14. When governments print money, they impose a “tax” on anyone who is holding money, because the
value of money is decreased.
15. To make an intelligent decision about whether to reduce inflation, a policymaker would need to know
what causes inflation and unemployment, as well as what determines the trade-off between them.
This means that the policymaker needs to understand how households and firms will adjust to a
decrease in the money supply. How much will spending decline? How much will firms lower output?
16. Raising taxes will lead to reduced spending in the economy. This will cause a short-run increase in
unemployment and a drop in prices. However, printing more money will cause a long-run rise in
inflation because the value of money will be lowered.