Ten Principles of Economics

Ten Principles of Economics

Economics is the study of how to make the best possible use of the available resources, such as capital, labor, land, etc., in the most profitable way. Resources or factors of production are always scarce, and people must make the best possible use of these resources that will maximize the utility they derive from them. Mr. N. Gregory Mankiw wrote the book “Principles of Economics” in which he gave us ten principles of economics that guide the economy and its participants.

In his book, Mr.Mankiw classifies all his ten principles of economics into three broad categories. And these three categories are – How people make decisions, how they interact with each other, and how the economy as a whole works. Let us look at these principles in detail.

How do People Make their Decisions?

The first four of the ten principles of economics fall into this category. These principles are based upon the individual decision-making process.

Principle 1: People Face Trade-Offs

Trade-offs are something that we regularly face in our day-to-day lives. In order to take one thing, we have to make choices and let go of something else. This is so because the resources that are available to us have a limit and are scarce. Hence, it is not possible for us to have all products and services as per our choice and quantity. Somewhere we all need to prioritize and leave off or let go of something that can not be accommodated. This let-off is the trade-off that one makes every time one is faced with alternatives.

On an individual level, people face the trade-off of sacrificing the consumption of one item over another. Also, they may have to spend more time on one activity than another. As a nation, the government faces a trade-off when choosing how much to spend on defense and how much to spend on consumption. Also, societies face a trade-off between a pollution-free environment and high-income levels and between efficiency and equity. Therefore, acknowledging that we have to face trade-offs at each and every stage of our life is a guiding core principle of economics.

Read more at Principle 1: People Face Trade-Offs.

Principle 2: The Cost of an Item is What We Sacrifice to Get it

People have to regularly do a cost-benefit analysis of the choices they have before choosing or preferring a particular course of action. There is an opportunity cost to everything. It is the cost of the next best choice one foregoes while choosing between two or more alternatives. The opportunity cost of spending money on buying a television is missing out on an opportunity to buy some other household item or spending that money on vacation. People must always consider the opportunity cost of any choice or item before taking the final decision.

Principle 3: Rational People Look to Maximize their Utility

Economists all over the world believe that people and businesses are rational. And therefore, they all make the best possible decisions and have the most rational choice among the various options available at their disposal. Moreover, it is also the underlying assumption that the people are very much aware of the scarcity of resources in the economy. And all this prompts them to maximize the utility or the outcome out of all these scarce resources. Consumers will go on consuming a product only and only until its marginal utility is more than its marginal cost.

Producers, sellers, and service providers often face the dilemma of selling a product at a price below their average cost. This is common in industries such as aviation, entertainment, cinema, etc. Since people are rational, they should continue to sell the product till the marginal utility of the product becomes equal to its marginal cost.

Learn more about this: Principle 3: Rational People Think at Margin

Principle 4: People Respond to Incentives

Participants in an economy are rational. Hence they respond to any extra benefit that they may get from the consumption of a product or a service. Incentives are a sort of reward for promoting the consumption of goods and services. And these may be in the form of free additional units of the product, or increased quantity of the product at the same price, or giving price discounts on the product.

Consumers react positively to incentives as it allows them to maximize their satisfaction levels. Thus, manufacturers and sellers give incentives to buyers when the momentum in the economy is low, and their sales are not up to the mark. Also, incentives are helpful as a fighting force against the competition, luring gullible customers to consume their product and drive the competition out of the market.

Also read Principle 4: People Respond to Incentives

How People Interact with Each Other?

How people deal and interact in an economy is the focus point of the next three principles of economics.

Principle 5: Trade Makes Everyone Better Off

Trade between people, businesses, and countries is essential for the betterment and well-being of one and all. An individual cannot produce each, and everything for his consumption need himself. He will be better off in producing a few things in which he specializes and leaves the rest for others to produce in which they have an edge or are better off.

Through this concept and rational decision, all the individuals and entities will ultimately do what is best for them. And in this way, they all can enjoy the benefits of specialization and economies of scale and scope. One can trade with other people and buy everything that one does not produce himself. When we see this on a broad scale, keeping in mind the entire economy, we will find that everyone is producing goods or providing a service as per his specialized skills. The same applies to big businesses and even countries. All have to depend upon each other for trading activities, and this is beneficial for society as a whole.

Read more at Principle 5: Trade Makes Everyone Better Off

Principle 6: Markets are a Good Way of Organizing Economic Activity

Free and fair markets are a must for the success of any economy. The market forces of demand and supply should act on their own to give us the price and quantity equilibrium, where demand and supplies are matched at a particular price point. It has been proven historically that any government intervention in deciding the quantity or pricing of goods and services has been always a failure in the long run. Moreover, the authoritative system of fixing a price of a product or service without studying the consumer demand pattern, consumers’ tastes and preferences, their willingness to pay, and the cost of production, etc., result in complete chaos and a crash of the market.

A free-market economy is the best form of market. The participants have the upper hand in deciding what, how, where, and how much to produce and sell at the best possible price.

Learn more about it: Principle 6: Market are usually a good way to organize economic activity

Principle 7: Government has the Resources to Improve the Outcomes of the Market

Government is the most important form of institutional body that acts as an invisible hand to control the market forces. It works day and night to ensure that the market participants follow its regulations and play the game by its rules. The government enforces property rights in the country. It encourages the people to produce and sell and participate in economic activities without any fear of being cheated or of suffering unfair losses.

Also, read Principle 7: Governments Can Sometimes Improve Market Outcomes

How the Entire Economy Works?

The last three of the ten principles tell us how an economy works.

Principle 8: The Ability to Produce Goods & Services Decides the Standard of Living of a Country

The countries of the world witness different standards of living. That, in turn, decides their access to healthcare facilities, the standard of living, gadgets, housing, consumption patterns, and life expectancy. The large variation in the standard of living of people is because of the difference in their productivity levels.

More the people produce in each hour of their work results in higher income and standard of living. Similarly, countries with low productivity levels are poor and still under-developed or developing. Good and proper education, availability of adequate tools and infrastructure, and access to modern technology are a must for a nation to improve its productivity levels and hence its standard of living.

Principle 9: Excessive Printing of Money by the Government Results in Rising Prices

Excessive printing of money by the government of a nation results in the loss of value of that currency. The purchasing power goes on reducing, resulting in a constant and spiraling price rise of goods and services. The rise in prices results in inflation in the economy. And due to reduced purchasing power, more and more money is required to buy the same quantity of goods and services. Therefore, a government needs to have a strict control mechanism regarding printing and the supply of money in the economy. And this is to ensure that inflationary trends in the economy are temporary and stay under control.

Learn more @ Principle 9: Prices Rise When The Government Prints Too Much Money

Principle 10: Trade-Off between Unemployment & Inflation     

Every country experiences a short-term trade-off between inflation and unemployment. Inflationary trends in the economy result in higher demand for goods and services. This is due to the excess money supply in the hands of the people. Higher demand results in a further increase in prices as well as pressure on the producers to supply more. In order to supply more, they hire more people. Therefore, the unemployment level goes down in the economy.

The level of demand for goods and services usually remains in the control of the government and its policymakers. By tweaking various policies, they can alter the spending levels, taxation levels, the money supply in the market, etc., to influence the demand for goods and services. A change in demand will also affect the trade-off between inflation and unemployment.

Continue reading: Principle 10: Trade-Off between Unemployment & Inflation

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