Principles of Economics
||In the beginning there
is Econ 101 that introduces students to the "Principles of Economics".
Many introductory textbooks use this term in their title (see eg. the widely
used books by
Mankiw and by Frank
& Bernake). There appear to exist several dozens of books with
Not surprisingly, the meaning of the term
"Principles of Economics" varies. There are two main concepts of "Principles":
Economic Principles*, referring to
the idea of "principles of economic life". Mankiw's list of 10 principles
(below) is a good example of this notion. These are
principles of how the economy works (or should work), hence, they refer
to the economy or economic actors. They are thought to parallel the principles
or laws in natural science.
Principles of Economics, referring
to the basic methods and concepts economists use when doing economics,
hence to economic analysis. In this view the term "economics" refers to
the discipline, not to the economy. This type of principles is often interwoven
with the first type in the textbooks. Lists of principles of doing economics
are harder to find. I propose such a list
in order to clarify the basic concepts that make up and shape the analysis
and the thinking of economists.
*) Taken literally, the principles
are not thought to be "economic" themselves --- though, of course, the
employment of "economic principles" can often be economical.
"Ten Principles of Economics"
How People Make Decisions
People Face Tradeoffs. To get one thing,
you have to give up something else. Making decisions requires trading off
one goal against another.
The Cost of Something is What You Give
Up to Get It. Decision-makers have
to consider both the obvious and implicit costs of their actions.
Rational People Think at the Margin.
A rational decision-maker takes action if and only if the marginal benefit
of the action exceeds the marginal cost.
People Respond to Incentives. Behavior
changes when costs or benefits change.
How the Economy Works as A
Trade Can Make Everyone Better Off. Trade
allows each person to specialize in the activities he or she does best.
By trading with others, people can buy a greater variety of goods or services.
Markets Are Usually a Good Way to Organize
Economic Activity. Households and firms that interact in market economies
act as if they are guided by an "invisible hand" that leads the market
to allocate resources efficiently. The opposite of this is economic activity
that is organized by a central planner within the government.
Governments Can Sometimes Improve Market
Outcomes. When a market fails to allocate resources efficiently, the
government can change the outcome through public policy. Examples are regulations
against monopolies and pollution.
How People Interact
A Country's Standard of Living Depends
on Its Ability to Produce Goods and Services. Countries whose workers
produce a large quantity of goods and services per unit of time enjoy a
high standard of living. Similarly, as a nation's productivity grows, so
does its average income.
Prices Rise When the Government Prints
Too Much Money. When a government creates large quantities of the nation's
money, the value of the money falls. As a result, prices increase, requiring
more of the same money to buy goods and services.
Society Faces a Short-Run Tradeoff Between
Inflation and Unemployment. Reducing inflation often causes a temporary
rise in unemployment. This tradeoff is crucial for understanding the short-run
effects of changes in taxes, government spending and monetary policy.
"Ten Principles of Economics (as a Discipline)"
Combining the first four points makes up
for the "rational choice approach" of Neoclassical economics.
Scarcity: Economists study situations
where needs or wants exceed means. Therefore, people have to make choices.
Rationality is assumed to guide people's
choices or decisions. They systematically gauge all pros (benefit or "utility")
and cons ("cost") of all alternatives or options they are facing when deciding.
Preferences: People are equipped with
fixed and given preferences that allow them to assign utilities to all
options, and to choose the option that maximizes (net) utility.
Restrictions: People face constrains
that they cannot change themselves, and thus have to take as given (such
as budgets, input cost etc.). Maximization is always constriaint by restrictions.
10 Principles (in PDF)
Opportunity Cost is induced by scarcity,
and by the need to make choices. All choices always involve opportunity
cost because deciding in favor of one option always means deciding against
some other option(s). There are two main aspects of opportunity cost: 1)
Utility maximizing choices induce opportunity cost to be minimal (static
aspect). 2) Choices may be revised when opportunity cost rises (dynamic
The Economic Principle is the application
of rationality to situations of scarcity: Minimize cost with regard to
a given goal (e.g., level of utility) OR maximize utility for a
given level of cost or input. Hence the "economic principle" frames situations
as a minimizing or a maximizing problem, and allows to assess efficiency.
Do not mix the two formulations! Applying the principle avoids wasting
Efficiency of activities, rules, transactions
or distributions is a basic theme in economic analysis. Efficiency is most
often assessed either in terms of the economic principle (minimize cost
or maximize utility) or the Pareto criterion (with regard to transactions
Marginal Analysis is a typical way
for economists to look at problems. They analyze decisions in terms of
marginal benefits and marginal costs. Marginal thinking is rather uncommon
among non-economists, however.
Equilibrium is a fundamental notion
in economic analysis. Basic economic models deal with the comparison of
two (or possibly more) equilibria (comparative statics). Economist
think in terms of equilibria, which are situations where no one has an
incentive to change his or her behavior. The Nash equilibrium is the most
fundamental formulation of the concept of equilibrium as used in economics.
Game Theory is an approach to study
situations of interdependence where people have incentives to think and
Comment (to follow).................
||Page by Tilman
Slembeck, 6 October 2001, last modified 1 Oct. 2006
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