Principles of Economics | Easy Summary

principles of economics

A principle is a self-evident truth that is readily understood and accepted by most people, such as the principle of gravity. These are generally accepted principles :

1. Trade-offs are everywhere and unavoidable

Economics is all about making choices. Whatever we do, there is always a trade-off because resources are limited and can be used in different ways. Society faces trade-offs. To get something we want, we usually need to give up something else. In selecting one alternative, we forego others. Every choice involves trade-offs. Every choice brings different outcomes. A student, say, has to choose between the subjects to study at a particular time. Understanding trade-offs is an essential part of good decision making. Ignoring trade-offs results in regret and loss. Trade-offs are closely related to another important principle in economics, opportunity cost. E.g., production possibility frontier and consumer equilibrium.

2. The cost of the action foregone

Economists remind us that there's no such thing as "free lunch." A product that looks free of cost actually has a cost. Every choice we make comes with a cost. Economists call it opportunity Costs - whatever must be given up to obtain an item or the cost of the second-best alternative. The opportunity cost of a choice is the value of the opportunities lost. It is the cost of something you sacrifice to get something else. Opportunity costs help in making logical and rational decisions. To acquire something, we use resources that could have been used to obtain something else. Opportunity cost measures this trade-off. E.g., Production Possibility curve

3. Thinking at the margin

Thinking on the margin is just making choices by thinking in terms of marginal benefits and marginal costs. On what basis a shopkeeper decides whether to open his store for one more hour or not? Such decisions are based on 'marginal' changes. Marginal means 'additional'-small incremental changes to a plan of action. This principle is based on a comparison of the marginal benefits and marginal costs of a particular activity. The marginal benefit of an activity is the additional benefit resulting from a small increase in the activity. Similarly, the marginal cost is the additional cost resulting from a small increase in some activity. By applying this principle, the shopkeeper should stay open for one more hour if the marginal benefit (the additional revenue )is at least equals to the marginal cost (additional cost), that is, additional expenses for workers and utilities for that hour. We should increase the level of a plan as long as its marginal benefit greater than its marginal cost and choose the level at which the marginal benefit equals the marginal cost. Thinking on the margin is also useful for understanding how consumers and producers make decisions. E.g., marginal cost marginal revenue, marginal tax rates, consumption, and production.

4. Benefits of the Trade

Trade occurs whenever two or more people/ nations exchange valuable goods or services. Trade between the two countries can make each country better off. Trade facilitates better use of resources and enables every country to be specialized in which they can do best. The real power of trade is the power to increase production through specialization. Trade also allows us to take advantage of economies of scale and reduce costs created when goods are mass-produced. By specializing, a country can become even more skilled and productive. Trade brings competition, which means better goods and services, and more of them. The comparative advantage theory says that when people or nations specialize in goods in which they have a relatively low opportunity cost, they can trade to get mutual benefit. All of the conveniences and luxuries are available to us only because people trade with each other. 

China...continue...economic and rate cooperation...with other countries...deliver mutual benefits.- China-US Trade

5. People respond to incentives

Incentives are everywhere. We do things because of self-interest. To determine an action is desirable or not, a good decision compares its benefits and costs. Benefits provide incentives to take action; costs provide disincentives. Since people respond to incentives, change in prices tends to change people's choices. An increase in the price of good results in a disincentive to buy because it increases the buying costs but provides an incentive to sell because it raises the benefits of selling. And, a reduction in the price of a good provides an incentive to buy, because it reduces the cost of buying but provides a disincentive to sell because it reduces the benefits of selling. A price increase reduces the number people want to buy and increase the number of people who want to sell. A price reduction has the opposite effect - these relationships form the basis for supply and demand curves. Public policies provide incentives to people to take certain actions or to avoid certain actions. But sometimes, policymakers fail to think through all those incentives as a result of which some policies sometimes have unintended consequences.

  

principles of economics|easy summary

6. Markets- alignment of interests and better resource allocation

Market economy is directed by the firm's and households' individual decisions as they interact in the market for goods and services. These decisions are decentralized. The market economy achieves economic well being and is a good way to organize the market activity. Markets allocate resources efficiently. It is a remarkable finding of economics that markets align self-interest with social interest under the right conditions. In a market, buyers need sellers and vice versa. The market price is determined by balancing supply and demand. Price falls when supply exceeds demand and rises when demand exceeds supply. Hence, the market price reflects both demands as well as supply. Adam Smith said that when markets work well, those who pursue their own interest end up promoting the social interest as if led to do by an "invisible hands." E.g., The supermarket where a large number of sellers work in self-interest, resulting in social interest as well. Markets, however, do not always align self-interest with social interest. When self-interest aligns with the social interest, we get good outcomes, but when self -interest and social interests are at odds, we get adverse outcomes. 

7. Government can sometimes improve on resource allocation

Sometimes the "invisible hand" is absent, not just invisible. Market economies have many advantages; they are not perfect. Markets sometimes fail to allocate resources to their best uses. When a market fails, government intervention can be beneficial. There are several types of market failure. Market failure is a situation in which the market fails to allocate its resources efficiently. It can happen due to two reasons. (a)when a person has an uncompensated impact on the society known as externalities. (b)A single person or group of persons has the power to influence the market price, known as market power. Free markets can create inequality across consumers. Sometimes, the market price of a good doesn't accurately reflect its costs and benefits to all consumers and producers on the margin. In such cases, the government has to intervene to secure economic well-being through better resource allocation. When markets don't properly align self- interest with the social interest, government can sometimes improve the situation by changing incentives with taxes, subsidies, or other regulations. It is important to remember that government policy-making is imperfect and that interventions can also fail. 

8. Prices rise when government prints too much money

Inflation is one of the most common problems in macroeconomics. Inflation means the increase in the overall level of prices in the economy. To keep the inflation low is the goal of the economic policymakers. Inflation is caused when governments increase the quantity of money. When the quantity of money increases, it's value falls, which leads to an increase in prices of goods and services. When people have more money, they spend it, and without an increase in the amount of goods, prices must rise. Inflation causes a decrease in the real value of money. The real value of money is measured in terms of the quantity of goods the amount of money can buy.

...some countries with...debt...tried printing money....this type of policy leads.....high rates of inflation...ends in economic ruin

9. The economic booms and busts

No economy grows at a constant pace. Economics advance and recede, rise and fall, boom, and bust. In a recession, wages fall, and many people are thrown into miserable unemployment. We cannot avoid all recessions. Booms and busts are part of an economy with respect to changing economic conditions, but not all booms and busts are normal. The tools of monetary and fiscal policy can reduce swings in unemployment and GDP. When these tools are used poorly, monetary and fiscal policy can make a recession worse and the economy more volatile.

Reducing inflation results in an increase in the level of unemployment. As per Philips Curve, there is a trade-off between inflation and unemployment, and it takes a year or two to push inflation in opposite directions through economic policies. Therefore, there is a temporary rise in unemployment.

10. Economic growth for better standard of living

Economists observe that people's standard of living in a country is relatively better when they can produce goods in a relatively efficient manner. GDP per capita and productivity determine the living standard. People in countries with higher GDP per capita tend to have happier, more satisfying lives. The countries where workers can produce a large quantity of goods and services per unit of time; most people enjoy a high living standard. Wealthy countries have a lot of physical and human capital per worker, and they produce things in a relatively efficient manner by using the latest technology. Entrepreneurs, investors, and savers need incentives to save and invest in physical capital, human capital, innovation, and efficient organization. Such economies encourage new ideas by providing institutions for supporting good incentives such as property rights, political stability, honest government and legal system, and competitive markets.

11. Diminishing returns

Suppose the output is produced with two or more inputs and we increase one input while holding the other input or inputs fixed. Beyond some point- called the end of diminishing returns- output will increase at a decreasing rate. It is important to emphasize that diminishing returns occur because one of the inputs to the production process is fixed. When a firm varies all its inputs, including the size of the production facility, the principle of diminishing returns is not relevant.

Read also: Positive and Normative Economics

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