Ten Principles of Macroeconomics - Key Terms (Vocabulary)

Overview

Topics addressed in this chapter (Chapter 1 of Mankiw, Principles of Macroeconomics, 10th edition):
- What kinds of questions economics addresses
- The principles of how people make decisions
- The principles of how people interact
- The principles of how the economy as a whole works
Core framing: Economics is the study of how society manages its scarce resources (scarcity) to satisfy unlimited wants.
Scarcity and economics definitions:
- Scarcity: the limited nature of society’s resources; society cannot produce all the goods and services people want.
- Economics: the study of how society manages its scarce resources.
Big-picture goal of the chapter: understand the trade-offs and incentives that shape decisions by individuals, firms, and policymakers, and how these decisions interact in markets to determine economic outcomes.
Key recurring theme: trade-offs, opportunity costs, marginal thinking, incentives, and the role of markets and government.

Ten Principles of Macroeconomics (core ideas behind the chapter)

Resources are scarce — scarcity underpins all economic decisions and policy debates.
Economists study:
- How individuals decide how much to work, what to buy, how much to save, and how to invest savings.
- How firms decide how much to produce and how many workers to hire.
- The forces and trends that affect the overall economy: growth in average income, unemployment, and the rate of price increases.
The chapter introduces the ten principles that organize these ideas and guide analysis.

Principle 1: People Face Trade-Offs

Core idea: To obtain one thing, you usually must give up something else (a trade-off).
Everyday examples:
- Party the night before an exam vs. time for studying.
- More money to spend now vs. less time for leisure.
- Working longer hours vs. more leisure.
- Protecting the environment vs. cost to firms and workers.
Trade-offs also apply to resource allocation (e.g., producing consumer goods vs. other uses).
Real-world relevance: policy choices involve choosing between different societal goals (growth, jobs, environment, equity).
In concise terms: decisions involve balancing competing goals due to scarcity.

Example 1A: Society faces trade-offs

If more spending goes to the military (guns) to protect from foreign threats, less may be available for consumer goods (butter), potentially lowering standard of living in some dimensions.
Pollution regulations illustrate a similar trade-off: cleaner environment and better health vs. costs to firms, workers, and customers.

Example 1B: Efficiency vs. Equality trade-offs

Efficiency: maximizing total benefits from scarce resources.
Equality: distributing prosperity uniformly.
Trade-off: achieving greater equality (redistribution) may reduce incentives to work/produce, shrinking the overall economic “pie.”

Principle 2: The Cost of Something Is What You Give Up to Get It

Central idea: Decision-making requires comparing costs and benefits of alternatives.
Consider opportunity costs: the value of the next best alternative forgone.
Formal intuition: to decide whether to take an action, compare the benefit you gain with the opportunity cost of forgoing the next best alternative.
Key definition: Opportunity cost of an item is whatever must be given up to obtain it.
Real-world relevance: decisions (individuals, firms, governments) hinge on evaluating opportunity costs.

Example 2: Opportunity cost

Going to college for a year:
- Costs: tuition, books, fees, foregone earnings. (Not: room and board in this example.)
Going to the movies:
- Cost: movie ticket price plus the value of time spent in the theater.
These illustrate that costs go beyond monetary outlays to include foregone alternatives.

Principle 3: Rational People Think at the Margin

Definition of rationality in economics: people systematically and purposefully do the best they can to achieve their goals given available opportunities.
Decision rule: compare marginal costs and marginal benefits of a small, incremental change (a marginal change).
Marginal analysis: incremental adjustments to a plan of action.
Key concepts: marginal benefit (MB) vs. marginal cost (MC).
Takeaway: act when MB ≥ MC; otherwise, do not take the action.
Real-world relevance: marginal thinking underpins everyday decisions and policy evaluations.

Active Learning 1: Thinking at the margin (practice scenarios)

Scenario A (retailer): hire one more cashier if the marginal benefit (additional sales) exceeds the marginal cost (wages).
Scenario B (subscription decision): decide to watch one more movie given fixed monthly cost; weigh marginal benefits vs. time cost.

Active Learning 1: Answers (summary)

A: If marginal benefit (additional weekly sales) $= $400 and marginal cost (wages) $= $300, hire the cashier (MB > MC).
B: If marginal benefit from one more movie (enjoyment) exceeds the (monetary) cost and the time cost is acceptable, you may choose to watch.

Principle 4: People Respond to Incentives

Incentive: something that induces a person to act.
Incentives can have unintended consequences because rational people respond to changes in costs and benefits.
Example: A higher price for doughnuts reduces demand by consumers and increases supply by producers.
Real-world relevance: policies that alter costs (taxes, subsidies) influence behavior, sometimes in unexpected ways because people respond to incentives.

Example 3: Incentives — gasoline tax

Government raises gasoline tax by $1 per gallon.
Consumer responses: shift to fuel-efficient or electric cars, carpool, use public transit, move closer to work.
Business responses: adjust production, pricing, investment decisions in response to altered demand and costs.

Active Learning 2: Applying the principles (car transmission decision)

Scenario: You’re deciding whether to repair a transmission on a classic car given blue-book values with/without the fix.
You must weigh the repair cost ($1,400) against the increase in value if the transmission works vs. if it doesn’t.

Active Learning 2: Answers (summary)

Case A: If fixed transmission increases value from $11,200 to $14,500, the net benefit is $3,300; repair is worth it.
Case B: If fixed transmission increases value from $11,000 to $12,300, the net benefit is $1,300; repair costs $1,400 → do not repair.

Principle 5: Trade Can Make Everyone Better Off

People benefit from trade: greater variety of goods at lower cost.
Countries benefit from trade: specialization leads to more variety and efficiency.
Connection to real-world relevance: comparative advantage underpins why markets trade and how nations can improve living standards through exchange.

Principle 6: Markets Are Usually a Good Way to Organize Economic Activity

Market: a group of buyers and sellers who determine what to produce, how to produce, and for whom to distribute.
Market economy: resources are allocated through decentralized decisions of many firms and households interacting in markets for goods and services.
The price mechanism:
- Prices reflect buyers’ value for a good and the cost of producing it.
- Adam Smith’s invisible hand concept: prices adjust to guide outcomes toward greater overall well-being.
Real-world relevance: markets coordinate economic activity efficiently in many contexts, though not always perfectly.

Principle 6 (continued) — Market organization in more detail

Prices arise from the interaction of buyers and sellers and guide decisions.
Price signals help allocate resources efficiently in a decentralized way.

Principle 7: Governments Can Sometimes Improve Market Outcomes

Government roles include enforcing property rights, establishing and enforcing rules and institutions essential to markets.
Government intervention aims to improve market outcomes by addressing market failures and/or promoting greater equality.
Market failures and related concepts discussed:
- Externalities: when the production or consumption of a good affects bystanders (e.g., pollution).
- Market power: when a single buyer or seller can influence prices (e.g., monopoly).
Important caveat: Government intervention does not guarantee improvement; it depends on design and implementation.

Principle 7 (continued) — Government and equality

Governments can promote equality through tax or welfare policies, changing the distribution of the economic pie.
Note: Even if intervention can improve outcomes, it does not guarantee it in every case.

Active Learning 3: The government (policy roles)

Scenarios include: public schools, workplace safety, public highways, patent laws for life-saving drugs.
Question: In each scenario, what is the government’s role, and does intervention improve outcomes?

How the Economy as a Whole Works

Principle 8: A country’s standard of living depends on its ability to produce goods and services.
Principle 9: Prices rise when the government prints too much money.
Principle 10: Society faces a short-run trade-off between inflation and unemployment.

Principle 8: Standard of living depends on production capacity

Large variation in living standards across countries and over time.
Examples: 2019 average income around $65,000 in the U.S. vs. around $5,000 in Nigeria.
The U.S. standard of living today is eight times greater than it was 100 years ago.
Growth and productivity:
- Growth rate noted as about 2% per year, which leads to doubling of income roughly every 35 years.
- Productivity (the most important determinant of living standards) is the quantity of goods and services produced per unit of labor input.
- Productivity depends on available equipment, skills, and technology; other factors (labor unions, foreign competition) have less impact on living standards.

Principle 9: Prices rise when the government prints too much money

Inflation definition: an increase in the overall level of prices.
High inflation imposes various costs on society; policymakers aim to keep inflation at a reasonable rate.
In the long run, inflation is usually caused by excessive growth in the money supply, which lowers the value of money.
The faster the money supply grows, the higher the inflation rate.

Principle 10: Short-run trade-off between inflation and unemployment

In the short run, many economic policies push inflation and unemployment in opposite directions.
The exact trade-off can vary with time and other factors, but the trade-off is always present in the short run.

Think-Pair-Share Exercise (illustrative thinking on price changes)

Scenario: A university reduces the price of a campus parking permit from $250/semester to $10/semester.
- The number of students desiring to park will likely increase (demand responds to price).
- The time to find a parking space will likely fall (more competition reduces search time per user, up to capacity limits).
- Will the lower price necessarily lower the true cost of parking? (Consider opportunity cost and other costs borne by students and university resources.)
- Would the opportunity cost of parking be the same for students with no outside employment and students with jobs earning $15/hour? (No—the opportunity cost differs due to alternative uses of time and money for each student.)

Chapter in a Nutshell (key takeaways)

Individual decision making:
- People face trade-offs among alternative goals.
- The cost of any action is measured in forgone opportunities.
- Rational people make decisions by comparing marginal costs and marginal benefits.
- People change their behavior in response to incentives.
Economic interactions among people:
- Trade and interdependence can be mutually beneficial.
- Markets are a good way of coordinating economic activity.
- Governments can potentially improve market outcomes by remedying a market failure or by promoting greater economic equality.
The economy as a whole:
- Productivity is the ultimate source of living standards.
- Growth in the quantity of money is the ultimate source of inflation.
- Society faces a short-run trade-off between inflation and unemployment.
Note on the book’s framing and examples: the slides summarize the core principles and provide real-world illustrations (e.g., opportunity costs in education and leisure, the effect of taxes on incentives, and the role of government in enforcing rights and addressing externalities).