Wednesday, December 30, 2009

The Ten Principles of Economics - Mankiw

Sydney Morning Herald writer Ross Gittens summarises Greg Mankiw’s ten principles in this short, easy to read piece. The trick is understanding the full implications and applying these consistently.

Here's a never-to-be-repeated holiday special: all you need to know about economics in 10 easy steps. They come courtesy of the best-selling introductory economics textbook by Gregory Mankiw of Harvard University (with Joshua Gans and Stephen King co-authors of the Australian edition).

Economics is the study of how society manages its scarce resources, where ''scarce'' means there are fewer resources than we'd like to be able to use.

The first four of Mankiw's 10 principles concern the way people make decisions, and the first is: people face trade-offs. That is, to get one thing we like we usually have to give up another thing we like.

Economics is about the trade-offs people - and societies - have to make, and about helping people improve the trade-offs they're making.

One common trade-off society faces is between efficiency and equity. Efficiency in the allocation of resources means society getting the most it can from its scarce resources. Equity means the benefits from those resources are distributed fairly among the members of society. Often, the things we could do to make the cake bigger (efficiency) make the slices of the cake more unequal (equity) and vice versa.

The second principle is: the cost of something is what you give up to get it. That is, its ''opportunity cost''. Economics is about comparing the costs and benefits of alternative courses of action. The benefits of doing something or buying something are usually pretty obvious, but they need to be weighed against the costs involved to see whether option A is superior to other options.

The cost of going to university full time is not the cost of accommodation and food (because you'd face those even if you didn't go to uni), nor even just the cost of the uni fees and textbooks. The biggest cost is the income you lose by not being able to work full-time - a classic opportunity cost.

Third, rational people think at the margin. Marginal changes are incremental adjustments to a plan of action. Say you're running a short course for 10 students at a total cost of $10,000 - that is, an average cost of $1000 per student.

Now say an extra student wants to join the course. How much should you charge him - $1000? No. The first question is: what's the marginal cost of adding an extra student? It's probably quite small - say, $50 for the extra set of course notes.

This means that any price you charge above the marginal cost of $50 will leave you ahead on the deal. But if you name a price that's too high and the student decides not to pay it, you're worse off to the extent that the amount he would have been willing to pay (marginal revenue) exceeded $50.

Fourth, people respond to incentives. Because people are assumed to make decisions by comparing costs and benefits, their choices may change when the costs and benefits change. If so, they're responding to incentives.

When Cyclone Larry caused the price of bananas to skyrocket in 2006, most people ate fewer bananas and more apples and pears. They were responding to changed incentives.

The next three principles concern the way people interact. The fifth is: trade can make everyone better off. Trade between Australia and China is not like a sporting contest where one side wins and the other loses.

Rather, trade makes both sides better off (though not necessarily equally better off), which is why it happens. Trade between countries is merely an extension of all the trade that goes on within countries between businesses and households.

Sixth, markets are usually a good way to organise economic activity. A market economy is ''an economy that allocated resources through the decentralised decisions of many firms and households as they interact in markets for goods and services''.

The other main way to organise economic activity is to have central planners make all the decisions about what goods and services are produced, how many are produced, who does the producing and who gets to buy what's produced. It doesn't work.

Seventh, governments can sometimes improve market outcomes. Government intervention in markets may be justified in cases of ''market failure'' - ''a situation in which a market, left on its own, fails to allocate resources efficiently''.

One common cause of market failure is the existence of an ''externality'', where a transaction between a buyer and a seller affects - whether favourably or unfavourably - the well-being of third parties.

Another cause is ''market power,'' where one or a small group of firms is able to substantially influence market prices (and thus make profits well in excess of the opportunity cost of the capital they have put up and the risks they are taking).

The last three principles concern how the economy as a whole works. The eighth is: a country's standard of living depends on its ability to produce goods and services. The value of a country's production of goods and services during a period is measured by gross domestic product.

A simple measure of its material standard of living is its GDP divided by the size of its population. Income per person is very much higher in the developed countries than the developing countries. Why? Mainly because the rich countries have higher productivity - each hour of a worker's time produces more goods and services.

Why? Because the rich countries' workers are better educated and trained (''human capital'') and have better equipment to work with (''physical capital'').

Ninth, prices rise when the government prints too much money. This proposition is usually true, but it doesn't apply when - as now in the United States and Britain - the demand for goods and services is falling far short of the available supply of goods and services.

Tenth, society faces a short-run trade-off between inflation and unemployment. Usually, the things governments do to reduce inflation have the effect of increasing unemployment and the things they do to reduce unemployment have the effect of increasing inflation.

This relationship is known as the ''Phillips curve'' after the Kiwi who invented it, but in the long run the trade-off breaks down and if you push it too hard you can end up with high inflation and high unemployment. If you can get people's inflation expectations down, however, you can enjoy the best of both worlds.

If you've followed me this far you've passed the course. Your reward: look up the economics professor and stand-up comedian Yoram Bauman on YouTube and watch his send-up of these 10 principles.

Ross Gittins is the Herald's Economics Editor.

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