What should everyone know about economics?

Answer by Roshan Cariappa:

These are the ten principles of Economics, as listed by Gregor Mankiw, in his fascinating book, Principles of Macroeconomics

A. How people make decisions

1. People face trade-offs: "There is no such thing as a free meal." To get one thing that we like, we usually have to give up another thing that we like,

Micro economic: A student deciding whether to study Economics or Psychology.

Macro economic: If the Defence budget increases, there will be a decrease in other budget heads, such as Education or Healthcare.

2. The cost of something is what you give up to get it: As a result of point 1, we tend to compare costs and benefits of our choices. So, the Opportunity Cost of an item is what you give up to get that item.

Micro economic: A student deciding whether to go to college or take up a job.

Macro economic: If the government decides to buy more ballistic missiles for the army, it probably could have built a new metro station at that cost. 

3. Rational people think at the margin: Individuals and firms make better decisions by thinking at the margin. A rational decision-maker takes an action if and only if the marginal benefit of the action exceeds the marginal cost.

Micro economic: So, most often, it's not a choice between blowing off your exams or studying 24 hrs a day, but whether you spend an extra hour revising concepts instead of watching TV. 

Macro economic: The government does not forego a budget for Education in lieu of its spending on Defence. Rather, decisions are closer, say between increasing the number of schools by x% versus increasing the number of fighter planes by y%.

4. People respond to incentives: People make decisions by comparing costs and benefits, their behavior may change when the costs or benefits change.

Micro economic: When the price of apples rises, people eat fewer apples. When the price of pears decreases, they consume more pears.

Macro economic: If the government decides to subsidize the price of fuel, then auto manufacturers have less incentive to build fuel efficient cars.

B. How people interact

5. Trade can make everyone better off: 'Competition' in economics is not like a sports contest, and can make everyone better. 

Micro economic: We do not, generally, grow our own food or build our houses. Instead, we hire experts to do it for us.

Macro economic: A country exports goods/services that are in abundance and imports goods/services that are scarce. Ex: India exports coffee and imports oil.

6. Markets are usually a good way to organize economic activity: In general, the idea is to have less regulations and allow demand-supply to take its natural course in terms of pricing. (However, it is rarely as simple.)

In a market economy, the decisions of a central planner are replaced by the decisions of millions of firms and households.

Adam Smith describes an "invisible hand" of the marketplace, which guides self-interest into promoting general economic well being.

Micro-Macro economic: If a family's average consumption of broccoli increases, the price of broccoli will go up. (As against, the Dept. of Agriculture fixing the price of broccoli. Essentially, such a decision will not be flexible to demand-supply.)

7. Governments can sometimes improve market outcomes: Sometimes the invisible hand fails (called a market failure).

It maybe due to an 'externality', which is the impact of one person's / institution's actions on the well-being of an outsider.
Ex: If a chemical factory does not bear the entire cost of the smoke it emits, it will likely emit too much. Here, the government can raise economic well-being through environmental regulation. (An externality can be beneficial as well. For instance, a remarkable scientific discovery which causes the Govt. to increase funding for research).
 
Another possible cause is 'market power', which refers to the ability of a single person / institution to unduly influence market prices.
Ex: Suppose that everyone in town needs water but there is only one well. The owner of the well has market power—in this case a monopoly—over the sale of water. The well owner is not subject to the rigorous competition with which the invisible hand normally keeps self-interest in check.

This calls for government intervention. The government can promote efficacy and equity. That is, enlarge the economic pie or change how the pie is divided.

C. How the economy as a whole works

8. A country's standard of living depends on it's ability to produce goods and services: The reason that living standards in the US are better off in, say, Ethiopia – 'productivity'.

To boost living standards, policymakers need to raise productivity by ensuring that workers are well educated, have the tools needed to produce goods and services, and have access to the best available technology.

9. Prices rise when the Government prints too much money: In Germany in January 1921, a daily newspaper cost 0.30 marks. Less than two years later, in November 1922, the same newspaper cost 70,000,000 marks. All other prices in the economy rose by similar amounts. This episode is one of history’s most spectacular examples of 'inflation', an increase in the overall level of prices in the economy.

Because high inflation imposes various costs on society, keeping inflation at a low level is a goal of economic policymakers around the world.

10. Society faces a short-run tradeoff between Inflation and Unemployment: Simply put, the two are inversely proportional (explained by the Philip's curve), meaning a decrease in inflation will, in the short term, cause an increase in unemployment.

When the government reduces the quantity of money, for instance, it reduces the amount that people spend. Lower spending, together with prices that are stuck too high, reduces the quantity of goods and services that firms sell. Lower sales, in turn, cause firms to lay off workers. Thus, the reduction in the quantity of money raises unemployment temporarily until prices have fully adjusted to the change.

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Note- The following I have come to realize with my romance with economics:
a. It is good to assume, people are selectively rational
b. There is no clear cause-effect. Generally, there are several underlying causes. (Economics is the only field in which two people can win the Nobel Prize for saying totally contrasting things.)

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I have quoted/reproduced information from the book only because it is extremely lucid and interesting. This book first kindled my interest in economics. I implore anyone who wants to understand economics and the world in general to read the book.

Also, you might want to check out Irwin A Schiff's – How an Economy Grows and Why It Doesn't. Another fascinating read!

PS – This answer has been selected for an essay contest. You can vote here- What should everyone know about economics?

What should everyone know about economics?

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What should everyone know about economics?

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