Principles of Economics: Key Concepts and Graphs for Students

Principle 1

People Face Trade-offs - Choices involve sacrificing one goal for another (e.g., efficiency vs. equality; guns vs. butter). Society must balance competing objectives like a clean environment and high income.

Principle 2

The Cost of Something Is What You Give Up to Get It - Opportunity cost is the value of the next-best alternative forgone (e.g., college costs include forgone wages, not just tuition).

Principle 3

Rational People Think at the Margin - Decisions involve small incremental changes (marginal benefits vs. marginal costs). Rational people act if marginal benefit exceeds marginal cost (e.g., airlines sell cheap standby tickets because marginal cost is low).

Principle 4

People Respond to Incentives - Behavior changes with costs/benefits (e.g., seat belt laws reduce accident deaths but increase accidents via riskier driving; high gas taxes encourage fuel-efficient cars). Unintended consequences arise when incentives are overlooked.

Principle 5

Trade Can Make Everyone Better Off - Specialization and trade benefit all parties (e.g., families and countries gain from exchanging goods/services, not isolation).

Principle 6

Markets Are Usually a Good Way to Organize Economic Activity - In market economies, decentralized decisions via prices (Adam Smith's 'invisible hand') allocate resources efficiently, unlike central planning (e.g., communism's failure).

Principle 7

Governments Can Sometimes Improve Market Outcomes - Governments enforce property rights and address market failures (e.g., externalities like pollution; market power like monopolies) or promote equality (e.g., taxes/welfare), but interventions can distort incentives.

Principle 8

A Country's Standard of Living Depends on Its Ability to Produce Goods and Services - Productivity (output per labor unit) drives living standards; policies boosting education/tools/technology raise productivity.

Principle 9

Prices Rise When the Government Prints Too Much Money - Inflation results from excessive money supply growth (e.g., Germany's 1920s hyperinflation; U.S. 1970s inflation).

Principle 10

Society Faces a Short-Run Trade-off between Inflation and Unemployment - Policies increasing demand (e.g., money printing) reduce unemployment but raise inflation short-term (business cycle fluctuations); long-term, money growth mainly causes inflation.

Opportunity Cost

The value of the next-best alternative forgone when making a decision.

Marginal Benefit

The additional benefit received from consuming one more unit of a good or service.

Marginal Cost

The additional cost incurred from producing one more unit of a good or service.

Incentives

Factors that motivate individuals to make decisions or take actions.

Productivity

Output per labor unit, which drives living standards.

Inflation

The rate at which the general level of prices for goods and services rises, eroding purchasing power.

Market Failures

Situations in which the allocation of goods and services is not efficient, often due to externalities or market power.

Externalities

Costs or benefits incurred by a third party who did not choose to incur those costs or benefits.

Monopolies

Market structures where a single seller controls the entire market for a good or service.

Economic Activity

The production, distribution, and consumption of goods and services.

Scientific Methods in Economics

Economists use scientific methods and models to study the economy, acting as scientists or policy advisers.

Scarcity

The limited nature of society's resources.

Economics

The study of how society manages its scarce resources.

Efficiency

The property of society getting the most it can from its scarce resources.

Equality

The property of distributing economic prosperity uniformly among society's members.

Rational People

People who systematically and purposefully do the best they can to achieve their objectives.

Marginal Change

A small incremental adjustment to a plan of action.

Incentive

Something that induces a person to act.

Market Economy

An economy that allocates resources through decentralized decisions of firms and households in markets.

Property Rights

The ability of an individual to own and exercise control over scarce resources.

Market Failure

A situation in which a market left on its own fails to allocate resources efficiently.

Externality

The impact of one person's actions on the well-being of a bystander.

Market Power

The ability of a single economic actor (or small group) to have a substantial influence on market prices.

Business Cycle

Fluctuations in economic activity, such as employment and production.

Circular-Flow Diagram

A visual model showing how dollars flow through markets among households and firms.

Production Possibilities Frontier (PPF)

A graph showing combinations of output an economy can produce given available factors and technology.

Microeconomics

The study of how households and firms make decisions and interact in markets.

Macroeconomics

The study of economy-wide phenomena, including inflation, unemployment, and growth.

Positive Statements

Claims that describe the world as it is (testable).

Normative Statements

Claims that prescribe how the world should be (value-based).

Circular-Flow Diagram (Figure 1)

Shows economy with households (buy goods/services, sell factors) and firms (sell goods/services, buy factors). Inner loop: inputs/outputs; outer loop: dollars. Illustrates resource allocation via markets.

Production Possibilities Frontier (PPF) (Figure 2)

Bowed-out curve (e.g., cars vs. computers). Points on curve: efficient; inside: inefficient; outside: infeasible. Slope = opportunity cost (varies; steeper = higher cost). Shows trade-offs, scarcity, efficiency.

Shift in Production Possibilities Frontier (Figure 3)

Outward shift (e.g., tech advance in computers) expands possibilities. Economy can produce more of both goods (e.g., from point A to G). Represents growth.

Types of Graphs (Figure A-1)

(a) Pie chart: Shares (e.g., U.S. income sources). (b) Bar graph: Comparisons (e.g., income across countries). (c) Time-series: Trends over time (e.g., U.S. productivity 1950-2010).

Coordinate System/Scatterplot (Figure A-2)

Plots points (x: study time; y: GPA). Shows positive correlation (upward trend: more study = higher GPA).

Demand Curve (Figure A-3)

Downward-sloping line (quantity demanded vs. price; e.g., novels). Negative relationship; movement along curve from price changes.

Shifting Demand Curves (Figure A-4)

Shifts right (D1 to D2) with income increase (more quantity at each price); left (to D3) with decrease. Illustrates non-price factors (e.g., income).

Calculating Slope of a Line (Figure A-5)

Slope = Δy/Δx (e.g., -2/8 = -1/4 for demand curve). Measures responsiveness (steeper = less responsive).

Graph with Omitted Variable (Figure A-6)

Upward curve (lighters vs. cancer risk). Misleads on causality; omits smoking (true cause). Warns against correlation implying causation.