10 Principles of Economics | 12 Principles of Economics

 

 

 Basic Principles of Economics

Both microeconomics and macroeconomic analysis are based on a set of some basic principles.

An economic principle or an economic law is a very well-tested and widely accepted theory relating to economic behaviour or the economy.

 

According to C.R. McConnell, S.L. Brue and S.M. Flynn, “Economic principles are very useful in analyzing economic behaviour and understanding how the economy works.”

 

There are some tools for finding out cause and effect (action and outcome) within the economic system.

Good theories do a good job of explaining and predicting.

They are supported by facts relating to how individuals and institutions actually behave in producing, exchanging and consuming goods and services.

 

Principles of Economics listed in the table apply to three levels of economic activity.

First, we study how individuals make choices;

Second, we study how these choices interact

Third, we study how the economy functions on the whole.

 

In other words, the economic principles are presented here are divided into three groupings:

How people make decisions

How peoples interact

How the economy as a whole work

 

 

10 Principles of Economics | 12 Principles of Economics | Microeconomics

Gregory Mankiw outlines ten principles of economics in his principles of economics 

Paul Krugman and Robin Wells outline twelve principles of economics in their principles of economics. 

Most of them are similar in sense but some are different.

These principles of economics are explained below:

 

Gregory Mankiw	Paul Krugman and Robin Wells
How People Make Decisions (Principles of Individual Choice)
Principle 1: People face trade-offs (dilemma).	Principle 1: People must make choices because resources are scarce.
Principle 2: The cost of something is what you give up to get it.	Principle 2: The opportunity cost of an item is its true cost.
Principle 3: Rational people think at the margin	Principle 3: How much decisions require to trade-offs at the margin.
Principle 4: People respond to incentives	Principle 4: People usually respond to incentives.
How People Interact (Principles of the Interaction of Individual Choices)
Principle 5: Trade can make everyone better off	Principle 5: There are gains from trade.
Principle 6: Markets are place to organize economic activity,	Principle 6: Because people respond to incentives, markets move towards equilibrium.
Principle 7: Governments can sometimes improve market outcomes.	Principle 7: Resources should be used as efficiently as possible to achieve society’s goals.
	Principle 8: Because people usually exploit gains from trade, markets usually lead to efficiency.
	Principle 9: When markets do not achieve efficiency, government intervention can improve society’s welfare.
How the Economy as a whole work (Principles of Economy wide Interactions)
Principle 8: A country’s standard of living depends on its ability to produce goods and services.	Principle 10: One person’s spending is another person’s income.
Principle 9: Prices rise when government prints more money.	Principle 11: Overall spending sometimes gets out of line with the economy’s productive capacity.
Principle 10: Society faces a short-run trade-off between inflation and unemployment.	Principle 12: Government policies can change spending.

 

 

How People Make Decisions: The Principles of Individual Choices

Principle 1: People face trade-offs | People must make choices because resources are scarce

Everyone has to make choices about what to do and what not to do.

Individual choice is the basis of economics.

In economics, choices must be made because resources are scarce.

Here, resource is used to produce something else.

Major resources are land, labour (workers), capital (machinery, buildings and other man-made productive assets) and human capital (the educational achievements and skills of workers).

A resource is scarce when there is not enough of the resource available to satisfy all the ways a society wants to use it.

Economies are limited by human supplies and natural resources.

Individuals have limited choices by money and time.

 

There are many scarce resources.

These natural resources are mineral, wood and petroleum etc.

There is a limited quantity of human resources, such as labour, skill and intelligence.

In a growing world of economy, human populations are increasing, so clean air and water have become scarce resources.

 

 

Principle 2: Cost of something | The true cost of something is its opportunity cost

People choose among limited alternatives; each choice involves opportunity cost.

The opportunity cost is the value of a goods or service for that people must sacrifice something to get that item.

In decision making, decision makers should be aware of the opportunity costs that go or come with each possible action.

Decision makers need to compare the costs and benefits of alternative courses of action.

 

In several examples, the cost of an action is not as clear as it might first appear.

Suppose your decision is to go to college to pursue a bachelor’s degree in business management.

The major benefits are knowledge improvement and a lifetime of better job opportunities.

But the calculation of costs does not complete just in adding up the money you spend on college fee, tuition fee, books, room arrangements, food and beverage arrangement.

This total cost does not truly represent what you give up to spend a year in a college.

 

There are two problems with this calculation.

First, it includes some things that are not really costs of going to college.

Even if you leave the college, you need a place to sleep and food to eat.

 

Room and foods are costs of going to college only to the limit.

They are more expensive at college than elsewhere if the students have to accommodate in hostel or rented room.

Second, this calculation ignores the largest cost of time; a student spends in college in listening lectures, reading textbooks and writing papers.

You cannot spend that time working at a job.

For most students, the earnings they give up to attend colleges are the single largest cost of their college education.

 

 

Principle 3: Rational people think at the margin | How much decisions require to trade-offs at the margin

A very common assumption in economics is that people are rational.

Rational people are those who have the ability to analyse or think before making decision.

These people systematically and intentionally do the best to achieve their objectives from available opportunities.

In making decision on questions involving how much, rational people often make comparison of marginal benefits and marginal costs.

Some examples of how much are how much to spend on some goods, how much to produce and so on.

 

The term margin means doing a bit more or a bit less.

According to N. Gregory Mankiw, “Economists use the term marginal change to describe a small incremental adjustment to an existing plan of action.

 

Here, margin means edge; so, marginal changes are adjustments around the edges of what you are doing.”

 

Margin in buying and production decisions; a rational decision maker takes an action if and only if the marginal benefit of the action exceeds the marginal cost.

Thus, the use of marginal approach plays a central role in economics.

 

 

Principle 4: People respond to incentives | People usually respond to incentives

An incentive is stimulation that encourages people to work.

Incentive either is a reward or punishment.

Incentives play a central role in the study of economics.

Let us consider the effect of price change in the market; a higher price in a market provides an incentive for buyers to consume less but an incentive for producers to produce more.

The effect of prices on the behaviour of consumers and producers is crucial in understanding how a market economy allocates scarce resources.

 

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How People Interact (Principles of the Interaction of Individual Choices)

Principle 5: Trade can make everyone better off | There are gains from trade

Individuals interact through trade because there are gains from trade.

By engaging in the trade of goods and services, the members of an economy can be better off (wealthy).

Specialization in the task is the source of gains from trade.

Trading partners gain additional output through specialization of production and exchange of goods and services.

 

 

Principle 6: Markets are place to organize economic activity | Market move toward equilibrium

People respond to incentives but markets move toward equilibrium.

Equilibrium is a situation in which no individual can make himself or herself better off doing a different action.

According to Paul Krugman and Robin Wells, “Markets usually reach equilibrium via changes in prices, which rise or fall until no opportunities for individuals to make themselves better off remain.”

 

The concept of equilibrium is really helpful in understanding economic interactions.

Because it provides a way of penetrating the sometimes complex information of those interactions.

Whenever there is a change in price or change in demand or supply or in both demand and supply, the situation will ultimately move to equilibrium.

Markets move toward an equilibrium that is why we can depend on them to work in a predictable way.

 

 

Principle 7: Governments can improve market outcomes | Resources should be used efficiently

This principle gives us a standard to use in evaluating an economy’s performance.

It helps to know how well a market economy is doing.

As resources are scarce, society should use them as efficiently as possible as to achieve society’s goals.

Usually, people achieve gains from trade and markets lead to efficiency.

Here, efficiency means society is getting the maximum benefits from its scarce resources.

Therefore, resources should be used as efficiently as possible to achieve society’s goals.

 

According to Paul Krugman and Robin Wells, “An economy is efficient if it fully utilizes all options to make some people better off without making other people worse off.”

 

Therefore, when an economy is efficient, it is producing the maximum gains from trade possible given the resources available.

This is because there is no way to rearrange the use of resources in a way that can make everyone better off.

Once an economy is efficient, one person can be made better off by rearranging the use of resource only be making someone else worse off.

 

 

Principle 8: Markets usually lead to efficiency

People habitually exploit gains from trade, markets usually lead to efficiency.

Markets are usually a good way to organize economic activity.

Market economy allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services.

 

According to N. Gregory Mankiw, “In a market economy, the decisions of a central planner are replaced by the decisions of firms and households.

 

Firms decide whom to hire and what to make.

Households decide which firms to work for and what to buy with their incomes.

These firms and households interact in the marketplace, where prices and self-interest guide their decisions.”

Individuals are free to choose what to consume.

 

 

Principle 9: When markets do not achieve efficiency, government intervention can improve society’s welfare

Markets usually result in efficiency but with a few clearly-described exceptions.

Market failure occurs when resources are misallocated or allocated inefficiently.

In other words when the assumptions of a perfect competition market do not hold; free and unregulated markets will produce an efficient allocation of resources ends.

The result is waste or lost surplus.

When markets fail and do not achieve efficiency, government intervention can improve society’s welfare.

 

What are the sources of market failure?

Major sources of market failure are:

(1) Imperfect completion or noncompetitive behaviour

(2) The existence of public goods

(3) The presence of external costs and benefits

(4) Imperfect information.

 

In an imperfectly competitive market, single firms have some control over price and competition.

Imperfect competition is a major source of market inefficiency because prices do not certainly equal marginal cost.

Public or social, goods give collective benefits to members of society.

Because the benefits of social goods are collective; people cannot be excluded from using them.

Here, the private firms usually do not find it profitable to produce public goods.

Thus, the need for public goods is another source of market inefficiency.

 

 

How the Economy as a Whole Work (Principles of Economy Wide Interactions)

Principle 10: Standard of living | One person’s spending is another person’s income

People in a market economy generate income by selling goods.

In these goods their own labour is including.

Here, one person’s spending becomes another person’s income.

 

If some group in the economy decides to spend more, the income of other groups will rise.

Instead, if some group decides to spend less, the income of other groups will fall.

As a result, changes in spending behaviour of individuals can spread throughout the economy.

 

Changes in the spending behaviour of people have chain of effects that spread all over the economy.

For example, cut in investment spending in Corona Pandemic reduced family incomes.

When families reduce consumer spending, this leads to another round of income falls and so on.

These consequences are mush helpful in our understanding of recessions and recoveries.

 

 

Principle 11: Overall spending sometimes gets out of line with the economy’s productive capacity.

Overall spending in the economy can fail to the economy’s productive capacity.

Spending below the economy’s productive capacity leads to a recession.

Spending in excess of the economy’s productive capacity leads to inflation.

During the Corona Pandemic, business spending in market-based capitalist economies decreased.

Consumers and businesses spending on the purchase of goods and services were insufficient relative to the productive capacity of the economies.

A major outcome of this shortage in spending was high unemployment of the workforce.

 

It is also possible for overall spending to be too high.

In this case, the economy experiences inflation (a rise in prices all over the economy).

This rise in prices occurs because when the quantity of output exceeds its supply.

Producers can increase their prices and still find willing buyers.

Therefore, the insufficient spending and excess spending brings the economic fail.

 

If the governments want to overcome on this situation by printing more money; the prices of goods and services rise.

 

 

Principle 12: Inflation and unemployment | Government policies can change spending

Society has to face a short-run trade-off between inflation and unemployment.

Governments have the capacity to affect overall spending and make effort to drive the economy between recession and inflation.

As a matter of fact, the government itself does lots of spending on all things from education to military equipment and it can choose to do more or less in these activities.

The government can also alter the amount of tax collection from the public, which in turn affects how much income is left with consumers and businesses to spend.

In addition, the government’s control of the quantity of money in circulation gives it one stronger tool with which it affects total spending.

Government spending, taxes and control of money are the tools of macroeconomic policy.

 

Modern governments use these macroeconomic policy tools in an effort to manage overall spending in the economy, trying to handle it between the threats of recession and inflation.

In spite of these policy efforts, recession and inflation still occur.

 

 

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