This document contains all the required readings for the Principles of economics midterm; namely, chapter 1-9 and 14.
The notes are extensive:
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- a, b, c, d... denotes sub-headings
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Besides extensive notes, these note...
Book: N. Gregory Mankiw and Mark P. Taylor - Economics, summary Y2Q1
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Universiteit van Amsterdam (UvA)
Economie
Principles of Economics (6012B0303Y)
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Table of Contents
CHAPTER 1: Ten Principles of Economics ................................................................................................ 1
CHAPTER 2: Thinking like an economist .................................................................................................. 3
CHAPTER 3: The Market Forces of Supply and Demand .......................................................................... 7
CHAPTER 4: Elasticity and Its Applications ............................................................................................ 16
CHAPTER 5: Background to demand: The theory of consumer choice ................................................... 24
CHAPTER 6: Background to supply: Firms in competitive markets......................................................... 35
CHAPTER 7: Consumers, producers, and the efficiency of markets ........................................................ 46
CHAPTER 8: Supply, demand and government policies ........................................................................... 51
CHAPTER 9: The tax system and the costs of taxation ............................................................................. 56
CHAPTER 14: Market structures I: Monopoly ......................................................................................... 61
CHAPTER 1: Ten Principles of Economics
1. What is economics
Oikonomos = The one who manages the household:
- The household has a lot in common with the economy; most decide how to allocate the scarce resources
taking the efforts/desires of the various members into account
a. The economic problem
Three questions that any society faces:
- What goods/services should be produced?
- How should these be produced?
- Who should get what is produced?
Three broad categories of resources:
- Land: Natural resources; iron ore, food products
- Labour: Human (physical/mental) effort in production
- Capital: Equipment and structures used to produce goods/services; machinery, computers, ovens
b. Scarcity and choice
Management of society’s resources is important as resources are scarce => Economics is the study of how society
manages its scarce resources; economists study:
- How people make decisions
- How people interact with one another; i.e. how multitude of buyers decide the price
- The forces and trends that affect the economy as a whole
2. How people make decisions
An economy is any group (EU, India, the world) interacting with each other; all the production and exchange
activities. Economic activity is how much buying and selling goes on in an economy over a period of time. Next four
principles, therefore, concern individual decision-making.
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, a. Principle 1: people make trade-offs
To get one thing we desire, we give up another such thing. Some of the biggest trade-offs are between national
defence and consumer goods; between higher incomes and cleaner environments (i.e. through pollution regulation);
between efficiency and equity (resources distributed to maximise scarce resources vs. fair distribution; when a
government redistributes it reduces the incentives to work hard; cutting the cake into more equal pieces results in a
smaller cake).
=> Acknowledging trade-offs is important; only when we understand the options available can we make good
decisions.
b. Principle 2: the cost of something is what you give up to get it
The opportunity cost: What you give up to get that item (the value of the benefits sacrificed); i.e. three years of time
(otherwise spent on working for wages) to earn a university degree.
c. Principle 3: rational people think at the margin
Marginal changes: Small incremental adjustments to an existing plan of action; adjustments around the “edges” of
what you are doing; i.e. spending an extra hour studying. People make best decisions around the margins; comparing
the marginal costs and marginal benefits (i.e. of another hour studying).
=> A rational decision maker takes the action if the marginal benefit exceeds the marginal cost.
d. Principle 4: people respond to incentives
Behaviour may change when cost and benefits change; people respond to incentives. The effect of price on buyers and
sellers is crucial.
Through policies, public policymakers can, therefore, alter behaviour; higher tax on petrol may cause more people to
use public transport, move closer to their work etc. When governments fail to consider all the incentives incurred by
their policies, they often end up with results they did not intend.
3. How people interact
The next three principles concern how people interact with one another.
a. Principle 5: Trade can make everyone better off
Trade is not like a sports-match; not a zero-sum game (i.e. where the US wins and China loses); rather, trade between
two economies can make each better off. By trading, people can buy a greater variety of goods/services at a lower
cost.
b. Principle 6: Markets are usually a good way to organise economic activity
Central planning (communism): government guided economic activity and answered the three questions above; the
government organised economic activity in a way that promoted the well-being of the country as a whole.
Market economy (decentralised): Economic activity is guided by the multitude of decisions of people and firms; prices
and self-interest guide these decisions. Although self-interest is the building block, market economies have been
successful in promoting the overall well-being of the country.
Adam Smith and the invisible hand:
- Individuals are usually best left to their own devices, without government guiding their activity (in line with
enlightenment thinking)
- The invisible hand: leads the self-interest into promoting the public interest; by no means the actual intention
of the individual.
=> Prices are the instrument at which the invisible hand is directed.
c. Principle 7: Governments can sometimes improve market outcomes
However, the government is still needed to protect the invisible hand; markets work only if property rights can be
enforced. Moreover, there are two broad reasons for governments to intervene in the economy:
- To promote efficiency: enlarging the cake
o Market failure: a scenario in which the market, on its own, fails to produce an efficient allocation of
resources.
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, o i.e. because of an externality; a third-party incurs a cost on a bystander (i.e. through pollution)
o i.e. because of market power; ability of an individual/small group to unduly influence market prices
- To promote equity: changing how the cake is divided
o The invisible hand does not ensure that everyone has adequate food, clothing etc.
o Income tax and social security schemes offer a more equitable distribution of resources
4. How the economy as a whole works
The last three principles concern the workings of the economy as a whole.
5. Microeconomics and macroeconomics
Microeconomics: The study of how households and firms make decisions and how they interact with specific
markets.
Macroeconomics: The study of economy-wide phenomena (i.e. inflation, unemployment, econ growth)
- Economic growth = The percentage increase in the number of goods and services in an economy over a period
of time.
a. Principle 8: An economy's standard of living depends on its ability to produce goods
and services
Gross domestic product per capita (head) = The market value of all goods and services produced within a country in a
given period of time divided by the population.
Standard of living = The amounts of goods/services that can be purchased by the population of a country.
=> Almost all variations in living standards are attributable to differences in countries’ productivity; in countries that
can produce a large quantity of goods/services per unit of time, the living standard tends to be higher.
=> Ergo, for policies to elevate the standard of living, the policies must target the ability to produce.
The growth rate of a nation determines the growth rate of its average income.
b. Principle 9: Prices rice when governments print too much money
Inflation = an increase in the overall level of prices in an economy.
=> Keeping inflation low is a goal of economies, as inflation incurs a lot of costs on society. Inflation is linked to
growth in the quantity of money.
c. Principle 10: Society faces a short-run trade-off between inflation and unemployment
The Phillips Curve:
- Shows the short-run trade-off between inflation and unemployment
- Controversial among economists
- Policies push inflation and unemployment in opposite directions
The business cycle: Fluctuations in econ activity such as employment and production
- The irregular and often unpredictable fluctuations in econ activity
6. Conclusion
The ten principles are building blocks in the study of economics!
CHAPTER 2: Thinking like an economist
1. Introduction
Abstract qualities: Having no tangible qualities; not concrete nor real (i.e. markets, efficiency etc).
Thinking like an economist often requires you to think counter to common-sense; ideas may be counter-intuitive.
This chapter explores the field of economics’ methodology.
2. The economist as a scientist
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, Can economics be a science? => It deals with human behavior. But any science must follow the scientific method (the
development and testing of theories of how the world works), and so does the inquiry of economic analysis.
a. Empiricism
Any statement (i.e. printing money => inflation) requires empirical evidence. Empirical = observation, formulation of
a hypothesis, testing the hypothesis.
i. Inductive and deductive reasoning
Inductive = Observation leads to theory.
Dedeuctive = Theory leads to observation.
ii. Theories
Theories seek to explain and make predictions. Theorising on its own (that is, without any rigorous data) is a tradition
within the rationalist paradigm; logic, reason, induction are used to arrive at conclusions (i.e. based on a lot of
assumptions; i.e. that consumers act rationally in the theory of consumer behavior, although observations suggests that
consumers do not act rationally).
New observation may at any time subject the hypothesis to revision; this is a never ending story.
b. The scientific method: Observation, theory, more observation
A challenge for economists when performing the scientific method; experiments are difficult; economists have to do
with whatever data the world happens to give them.
Historical episode may act as natural experiments for economic scientist; they allow the scientist to evaluate economic
theories of the present.
c. Empiricism or rationalism?
When prices rise, the amount purchased will fall => This is a generalizable statement; we can extend the reasoning to
most good.
d. The role of assumptions
Assumptions simplify the complexity of the world, making it easier to understand. The art, however, is to decide
which assumptions to make => Different assumptions are appropriate to answer different questions.
Assumptions are subject to testing to see whether they are reasonable.
e. Experiments in economics
Two major fields of experimentation in economics:
- Laboratory: i.e. observations on individual or group behavior, interviews/surveys, data on wages/stocks/prices
=> The conclusions of which are ‘generalizable’—able to be extended outside the lab => As such, it
can provide the basis for prediction
- Natural experiments: the study of a phenomena determined by natural conditions outside the control of the
experimenter
=> How two variables can be linked to cause and effect
=> Correlation does not mean causation!
f. Models in economics
Models that simplify reality are often used by economists; i.e. graphs and diagrams => Through simplification, we
increase our understanding. But one should not confuse these models with reality as they omit many details.
Dependent variables ó Endogenous variables; value is affected by other variables in the model.
Independent variables ó Exogenous variables; affecting the value of other variables in the model.
g. Our first model: The circular flow diagram
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