yuenseng

Principles of Economics

Chapters 1-3, Principles of Economics (9th ed.), Mankiw 2020.

24 May 2024

The word economy comes from the Greek word oikonomos, which means "one who manages a household." Applying this idea to the entire society, we can say that economics is the study of how society manages its scarce resources. In most societies, resources are allocated not by a single central planner but through the combined actions of millions of households and firms. How do these agents interact and make decisions?

Mankiw lists down ten principles of economics that drive the decisions making process of individuals, groups, and whole economies:

People face trade-offs: different options often optimise for different outcomes.
People face opportunity costs: the cost of an action includes what you give up to pursue it.
People think at the margin: decisions are often made incrementally.
People respond to incentives: people are motivated by rewards (and punishments).
Trade makes everyone better off: specialisation and trade can increase the productivity of all parties due to comparative advantage.
Markets are usually a good way to organise economic activity: it is scalable because it allows for decentralised decision making without a central planner, and efficient because it is based on self-interest.
Governments can sometimes improve market outcomes: governments are responsible for maintaining institutions and rules that are essential for a market economy to function properly (e.g. property rights), and for addressing market failures due to externalities.
A country's standard of living depends on its ability to produce goods and services: welfare improves when productivity increases.
Inflation is caused by an oversupply of money: when the government prints too much money, the value of money falls.
Society faces a short-run trade-off between inflation and unemployment: governments address unemployment by increasing the money supply to stimulate the economy and increasing spending, but this also leads to inflation.

The economist works like a scientist: they observe economic phenomena, develop models to explain them, and use data to evaluate these models. Models are simplified versions of reality that allow us to understand complex phenomena. One model that economists use is the circular-flow diagram, which shows how money and goods flow through the economy:

Firms hire and use factors of production (land, labour, and capital) to produce goods and services. These goods and services are purchased and consumed by households, who in turn provide the factors of production to firms.
Households spend money to buy goods and services, which generates revenue for firms. Firms use this revenue to pay for factors of production (wages, rent, and profit), which generates income for households.

Economics can be studied at different levels: microeconomics studies the behaviour of individual actors (e.g. households and firms), while macroeconomics studies the behaviour of the economy as a whole.

Economic statements are often expressed as either positive or normative statements. A positive statement describes the world as it is, while a normative statement describes how the world should be. The crucial difference between the two is that positive statements can be tested against data, while normative statements are based on value judgments. Thus, when two economists disagree, it is often because they have different values or different beliefs about the validity of the underlying positive analysis.

Economists often make normative statements when they act as policy advisors for governments. However, their advice is not always followed due to other factors such as political considerations and public opinion.

The basis of an economy is the trading of goods and services. A person in an economy can either produce everything they need or produce a subset of what they need and trade with others to get the rest. Economists agree that it is always better to engage in trade because it allows for specialisation and division of labour, which increases the total quantity of goods and services produced in the economy.

Even if one person is better at producing everything, he still has to face opportunity costs: the person has to decide what to produce because his resources are scarce (time, money etc.). Now, how does he decide what to produce? By choosing the good that he has a comparative advantage in. A producer has a comparative advantage in producing a good if he can produce that good at a lower opportunity cost than others. Essentially what this means is that the producer can produce more of the good in the same amount of time or with the same amount of resources. Now, if everyone in the economy produces the good that they have a comparative advantage in, then the total quantity of goods and services produced in the economy will be maximised. As more goods and services are brought to market, the degree of consumption increases, and the standard of living improves.

The principle of comparative advantage has many practical applications. Consider the decision of whether to perform a task yourself or to hire someone else to do it. The answer depends on whichever party can do the task at a lower opportunity cost. If you can earn more money doing something else (your opportunity cost is higher) and there is someone who is willing do the task for you at a price lower than your opportunity cost, then you should hire that person. There are of course other factors to consider, such as the quality of the work (future cost?), but the principle of comparative advantage is a good starting point for making decisions.