Part A.

Principles of Microeconomics

Chapter A1.
Basic Principles of Economics

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Introduction: What is Economics?

• The word Economy originated from “oikonomos” (Greek)

– Which means “one who manages a household”

• Household - many decisions:

– How to allocate time, money, effort, desire, etc …

• Society - many decisions:

– How to allocate resources, such as labor, land, buildings, machines,
etc.
– How to allocate outputs, such as the goods and services produced

• Economics is about the allocation of scarce resource

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Introduction: What is Economics?
• Resources are scarce

• Scarcity
– means that society has limited resources and therefore cannot
produce all the goods and series people wish to have.

• Economics
– is the study of how society manages its scarce resources
– In most societies, resources are allocated not by an all-powerful
dictator but through the combined actions of millions of households
and firms.

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Basic Principles of Economics
I. How individuals and firms make decisions
– 1. People face trade-offs, and the cost of something is what you give
up to get it.
– 2. Rational people think at the margin, and they respond to
incentives.
II. How people interact with each other
– 3. Trade can make most people better-off.
– 4. Markets are usually a good way to organize economic activities,
but government interventions are sometimes necessary.
III. How the economy works at the macro level
– 5. Society’s standard of living is determined by its ability to produce
goods and services.
– 6. An economy faces a short-run trade-off between inflation and
unemployment.

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I. How individuals and firms make decisions

Principle #1: People face trade-offs, and the cost of

something is what you give up to get it.

• Making decisions
– Trade off one goal against another
– Student – time
• E.g., study vs. play, or study vs. work
– Parents – income
– Society
• National defense vs. consumer goods
• Environment protection vs. high level of income

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I. How individuals and firms make decisions

• Trade-off: Efficiency vs. equality

• Efficiency
– the property of society getting the most it can from its scarce
resources
– Also called the “Size of the economic pie”
• Equality
– the property of distributing economic prosperity uniformly among the
members of society
– Also called “How the pie is divided into individual slices”
• Ideal situation– the economic growth is both efficient and
equal
– But they are usually contradictory
– Government policy matters

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I. How individuals and firms make decisions

• People face trade-offs

– Make decisions: compare the costs and benefits of alternative
choices

• Example: decision to go to college

– Benefits: more knowledge; better job opportunities, etc.
– Costs? tuition, books, living expenses? Anything else?

• Issues need to be considered:

– Some expenses are not really costs of going to college
• Living expenses: still incurred even if you do not go to college
• Should not affect your decision
– The largest cost of going to college: Time
• For most students, the earnings they give up to attend school are the
single largest cost of their education
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I. How individuals and firms make decisions

• Opportunity cost
– The opportunity cost of an item is what you give up to get that
item.

• When making decisions

– Be aware of the opportunities associated with each possible
action
– In most cases, opportunity cost of a choice does not equal the
explicit expenses that you pay out of pocket
• An expense is not opportunity cost if you still need to pay for it no
matter what decision you make (living expenses in the above
example)
• Opportunity cost includes what you have to give up for your
decision, even if you do not directly pay for it (time)
– Another example:
• Professional athletes’ opportunity costs of attending college
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I. How individuals and firms make decisions
Principle #2: Rational people think at the margin, and they
respond to incentives.

• Rational people
– Are people who systematically & purposefully do the best
they can to achieve their objectives.
– One of the fundamental assumptions in economics.
• Marginal changes
– Marginal means additional.
– Marginal change means a small incremental adjustment to a
plan of action.
– Marginal benefits: additional benefits
– Marginal costs: additional costs
• Rational decision makers
– Take action if and only if: Marginal benefits > Marginal costs
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I. How individuals and firms make decisions
• Examples:
– Example 1: suppose you are buying hamburgers for lunch, and you
feel that consuming the first hamburger will provide a value of $15 to
you. Then the second hamburger only values $5, and the third and
more hamburgers will value $0 to you since you are already full. If a
hamburger sells for $10, how many will you buy for lunch?
• The first one: marginal benefit ($15) > marginal cost ($10)
• The second one: marginal benefit ($5) < marginal cost ($10)
• …

– Example 2: Why is water so cheap, while diamonds are so

expensive?
• Water is essential, but the marginal benefit of an extra cup is small
because water is plentiful.
• By contrast, no one needs diamonds to survive, but because diamonds
are so rare, people consider the marginal benefit of an extra diamond to
be large.
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I. How individuals and firms make decisions

• Rational people respond to incentives

– Incentive means something that induces a person to act

• Such as reward, penalty, or expectations of them.

– Higher price
• Buyers - consume less
• Sellers - produce more

– Public policy
• Change costs or benefits
• To change people’s behavior

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how do income and job security expectations
affect people’s decisions about education?

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Basic Principles of Economics
I. How individuals and firms make decisions
– 1. People face trade-offs, and the cost of something is what you give
up to get it.
– 2. Rational people think at the margin, and they respond to
incentives.
II. How people interact with each other
– 3. Trade can make most people better-off.
– 4. Markets are usually a good way to organize economic activities,
but government interventions are sometimes necessary.
III. How the economy works at the macro level
– 5. Society’s standard of living is determined by its ability to produce
goods and services.
– 6. An economy faces a short-run trade-off between inflation and
unemployment.

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II. How people interact with each other
Principle #3: Trade can make most people better-off.

• Two reasons:
– (1) Trade allows each person to specialize in the
activities he or she does best. And specialization can
make people more efficient and productive
– (2) Enjoy a greater variety of goods and services at
lower cost

• Trade can increase a country’s total (net) welfare

– But the distribution of trade’s benefits is highly uneven among
different industries, regions, and groups of people.
– Government policies matter.
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II. How people interact with each other
Principle #4: Markets are usually a good way to organize
economic activities, but government interventions are
sometimes necessary.

• Market economy - allocates resources

– Through decentralized decisions of many firms and households
– Guided by prices and self interest
– Price:
• Serves as a signal of the market
• Helps individuals and the society to decide how to allocate resources

• Adam Smith’s “invisible hand”

– The most famous metaphor for the mechanism of market economy
– Self-interest people and firms interacting in markets
• Leads them to desirable market outcomes, where the total social
welfare is maximized. Act as if they are guided by an “invisible hand”
– Corollary: In appropriately designed policies may distort prices and
thus misled the decisions of households and firms. 15
II. How people interact with each other
• Government interventions are sometimes
necessary
– one of the most important purposes of studying
economics, is to better understand the roles that
government policies can play in the economy.
• Market economies need the government to
enforce rules and maintain the institutions
– proper rules and institutions are indispensable for a
market economy to function well
– Market economies need institutions to enforce
property rights
• So that individuals can own and control scarce resources
• We all rely on government-provided police and courts to enforce our
rights over the things we produce
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II. How people interact with each other

• Two broad reasons for a government to intervene in

the economy and change the allocation of
resources:
– to promote efficiency
– to promote equality
• Government policies can promote market efficiency
by avoiding market failures
– Market failure: a situation in which a market left on its own
fails to allocate resources efficiently
– Example of market failure: environmental pollution,
market monopoly, etc.
– In the presence of market failures, well-designed public
policies can enhance economic efficiency. 17
II. How people interact with each other

• Government policies can promote equality in society

– Even when the invisible hand yields efficient outcomes, it can
nonetheless leave sizable disparities in economic well-being
– A market economy rewards people according to their ability to
produce goods and services,
– but it does not ensure everyone has sufficient necessities to
consume.
– many public policies aim to achieve a more equal distribution of
economic well-being.
• such as the income tax and the welfare system

• The government can improve on market outcomes does

not mean that it always will
– Public policy is made not by angels but by a political process that
is far from perfect.
– As you study economics, you will become a better judge of when a
government policy is justifiable.
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Basic Principles of Economics
I. How individuals and firms make decisions
– 1. People face trade-offs, and the cost of something is what you give
up to get it.
– 2. Rational people think at the margin, and they respond to
incentives.
II. How people interact with each other
– 3. Trade can make most people better-off.
– 4. Markets are usually a good way to organize economic activities,
but government interventions are sometimes necessary.
III. How the economy works at the macro level
– 5. Society’s standard of living is determined by its ability to produce
goods and services.
– 6. An economy faces a short-run trade-off between inflation and
unemployment.

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III. How the economy works at the macro level
Principle #5. Society’s standard of living is determined by its
ability to produce goods and services.

• Changes in living standards over time are also large.

– Average income in U.S. has historically grown about 2% per year.
– Over the past century, average U.S. income has risen about eightfold. 20
III. How the economy works at the macro level

• Almost all variation in living standards is attributable to

differences in countries’ productivity
– Productivity: the amount of goods and services produced by each
unit of labor input.
– Countries with higher productivity enjoy higher living standards.

• Productivity is the primary determinant of living standards,

and other explanations must be of secondary importance
– Why living standards of workers in the U.S. (and also many other
countries in the world) over the past century have improved so
much?
– The real hero is their rising productivity
– Other things, like labor unions, minimum-wage laws, or even
import tariffs, play secondary roles.

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III. How the economy works at the macro level
Principle #6: An economy faces a short-run trade-off between
inflation and unemployment.

• Inflation: an increase in the overall level of prices in the

economy.
– Not the price of a limited number of commodities, but the general
price level of a basket of products in the market.
– Expressed in percentage (%), as a measure of annual change of
general price levels.
– The opposite is called deflation.
• A mild inflation is good or even necessary.
– Mild and controllable price rises can stimulate economic growth.
– For example, according to the U.S. Federal Reserve, the long-term
inflation goal of the country is 2%.
– Large and persistent inflation leads to market panic and chaos.

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III. How the economy works at the macro level
• The primary cause of inflation is the government prints too
much money
– In most countries and regions, only the government has the
authority to print and supply money to the market.
– If for some reason the government sends more money than what
is needed to the markets, then the price levels will rise.
• Examples:
– Germany in the 1920s
– U.S. in the 1970s (high inflation) and in the 2010s (low inflation)
– Zimbabwe in early 2000s
• In 2008, the inflation rate of Zimbabwe was 231,000,000%
• The greatest value of bank note in human history-- one hundred trillion
Zimbabwe dollars (pictures below), which valued one hundred US dollars

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III. How the economy works at the macro level
• The short-run effects of inflation
– First, the increased amount of money stimulates spending, and thus
the demand for goods and services gets higher
– Second, higher demand cause firms to raise prices, hire more
workers, and produce more goods and services
– Third, unemployment in the economy drops (i.e., employment rises)

• Therefore, society faces a short-run trade-off between inflation

and unemployment
– Over a period of a year or two, many economic policies push inflation
and unemployment in opposite directions
– Typical tools that policy makers can use to influence total demand in
the economy, and hence the inflation and unemployment:
• Government spending; tax rates; money supply; etc.

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III. How the economy works at the macro level
• Example #1: COVID-19 and economic policies in the U.S.
– In the first two years, the U.S. Federal Reserve injected large amount of
money, into the market
– Higher demand, lower unemployment rate, and higher price levels
– Inflation became unacceptably high since mid-2021
– Then, policy makers raised interest rates and drew money out of the
economy
– Inflation finally tamed since mid-2023
• Example #2: Financial Crisis 2008
– Problems in the financial system, caused by bubbles in the housing market,
spilled over into the entire economy
– Results: falling incomes and rising unemployment
– Policies reactions: White House’s stimulus package of reduced taxes and
increased government spending; Federal Reserve’s increased money supply
– Effects: lowered unemployed rate, but concerns about long-term inflation
• Economic policies, inflation, and unemployment:
– subjects of never-ending debates
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III. Summary and Conclusion

• We will develop more insights, ideas, and theories in future Chapters to help
you fully understand these principles.
• Don’t forget, economics is primarily about “decision making”. Try to utilize
economic thinking in your everyday lives.
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End of this Chapter

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