Mankiw’s First Seven Principles of Economics

If you take another economics class, you will undoubtedly study the same theories and principles, but at a deeper level. Regardless of the complexity and depth at which you study, you will see the same recurrent themes. Mankiw lists 10 principles of economics that are foundational to the study and that provide a solid framework for thinking about economic problems. In this class, we will return to these principles repeatedly.

People face trade-offs

A trade-off occurs when you have to make a choice. You usually always have to give something up to get something. While this idea seems very simple, people don’t generally always recognize this. Here’s a very good example of what I mean.

I was at the University of Montana to hear the 13th Chief of the USDA Forest Service speak about forestry. It was a big event and the auditorium was packed. Because not all of society agrees with how forests are managed, in both Canada and the US, it was expected that there would be protesters. And, sure thing, there were many.

Just as the Chief was beginning his address, several people at the back of the room stood up waving a five-metre banner and loudly chanting, “no more logging?” They were vehemently opposed to all logging in the National Forest.

Many people will see one side of the argument or other. Either you are opposed to logging because you believe it is damaging to the environment (and in some cases irresponsible logging is detrimental), or you support logging (in spite of some ecological damage) because forest products are made from renewable resources and provide jobs for timber-dependent communities.

I have a different take on the issue. Consider this: what do you think the protesters’ banner was made from? If you guessed paper, you’d be correct. Do you see the irony of situation? While it is understandable that not all people are in favour of logging, to use a product of the logging/forestry industry demonstrates that they were not aware of the trade-offs they were espousing. The trade-off is either to ban all logging and forego paper, or allow logging and have paper. You cannot have both. The same is true for using products made of metals and eschewing mining; flying but wanting to reduce carbon emissions; driving but not wanting oil and gas development.

A more reasonable approach might have been to request a logging ban in a specific location, or during a specific time of year. All-or-nothing decisions are rarely tenable.

Whiteboard Activities are an opportunity to participate the topics discussed. Answer the questions as you come across these activities throughout the course modules.

Click on the  in the lower left hand corner of the whiteboard to get a new card. Then double click on the card to edit the text. Place the card on an open spot of the whiteboard with your answer.

The cost of something is what you give up to get it

Economists call this type of cost an “opportunity cost.” The value associated with the opportunity lost is the value that you give up. Most of the time we measure costs in terms of what we have to pay. Buy a new pair of shoes and the cost is $75. But there’s a less visible cost – the most highly valued alternative that you’ve given up. What else could you have bought for $75?

In the news recently has been a lot of discussion and debate about new pipelines taking oil from where it is produced in Canada (Alberta, for example) to the United States, or to the west coast of Canada for shipment to Asia and other parts of the world. The debate has been controversial because the proposed routes are planned for natural areas that are highly suitable for wildlife habitat, recreational activities, food production, ecosystems that supply drinking water, historical areas that include burial grounds and sacred sites, and a host of other possible uses. Some areas could be used for several purposes, whereas others are suitable only for one other activity.

Let’s assume that protesters win the right to prevent the pipeline from crossing a piece of land that can be used only for a recreation park. You must calculate the cost of the development for the park. It’s reasonable to assume there will be labour costs, machinery and maintenance, legal costs, environmental assessments, campsites, recreation facilities and amenities, etc. These are all expenditures that are highly visible. But are we missing some costs? What are we, as a society, giving up if we approve the recreation area and say no to the pipeline? Because this piece of land is suitable for the pipeline, we must add to the cost the value of the opportunity we are giving up. Opportunity costs are reciprocal, so that’s not the end of the story. What is the opportunity cost of saying “yes” to the pipeline? Society would give up the value of the recreation area.

You will likely have noticed that these first two economic principles are somewhat related. We have trade-offs in the pipeline case (recreation area instead of a pipeline, or a pipeline/no recreation area). The trade-off requires that we make a decision regarding how to use land. We cannot have both. The opportunity cost is a measure of what we are trading off.

You might consider the opportunity cost of going to school. You likely made a trade-off with your time choosing education for the next while over work. The costs are easy to calculate – books, and tuition for example. But is there a hidden cost? What could you be doing with your time? What’s the highest valued opportunity you are giving up? You should note that each individual in this class will likely have a different opportunity cost.

Rational people think at the margin

In economics classes you will hear the term “marginal” repeatedly. Economists calculate marginal costs, marginal revenues, marginal revenue product, etc. But what does this really mean? Thinking at the margin requires that we look at issues incrementally: “more” or “less.” Decision making becomes very clear when we think at the margin. It helps us to determine how many people to hire, whether to expand our business, whether to have one more beer, or one more bite of pizza.

Let’s consider that you’re the manager of a horticulture operation and you must hire summer students to pick fruit. You wonder if you should hire 10 or 20 students, or maybe more: it’s unclear what the total should be. How would you approach this problem?

You know that you have to pay each student $120/day and you know they will each pick fruit that goes to market and generates revenue for you. Thinking at the margin can help you to determine how many students to hire. Think of each student as a marginal cost: one more student = $120/day. And each student produces revenue for you. Let’s say Student #1 generates $500 in revenue. Do you hire that student? The answer is yes, because you earn more money than you pay out ($500 - $120 = $380).

Still thinking at the margin, you consider hiring Student #2. You pay them $120/day, but this person generates only $400 in revenue. While the amount is less, do you hire one more student? The answer again is yes because it results in $280 in profit for you. For each hire, you do not ask whether you need five, seven or 10 students, you ask, “do I hire one more student?” which is an example of thinking at the margin.

Now your work force has five students and you wonder if you should Student #6. You will pay them $120, but they will pick fruit that’s valued at $100. In this case, the marginal cost ($120) is less than the marginal revenue ($100). If you hired one more student, you would lose money. You can now see that the first three principles are related. You face trade-offs as a manager in the example above (hiring more students, or perhaps buying more equipment), and that your decision making will be better when you think at the margin.

People respond to incentives

Incentives are “reasons” people do things, or don’t do things in the case of “disincentives.” The most basic incentive in the study of economics is price. If you are a consumer and the price of your favourite product goes down, what are you likely to do? If you answered, “buy more,” you would be correct. Prices not only work on consumers, but on producers, but in the opposite manner. Think about organic produce. A quick trip to the grocery store should indicate that the cost of organic produce is much more. Because prices are high for organic products, we see increasingly more farms converting to organic production (in spite of the cost of doing so). High prices signal to producers that they should make more because they likely will increases their revenues and profits.

There are many examples of pricing incentives in the market to get consumers to purchase more, or to commit to purchases sooner. Just tonight as I was writing this section, I got a quote from a company to resurface my driveway. I was told that if I committed to pay before the end of the month, I would save the tax (roughly 10%). That’s a substantial incentive for me to choose this company over competitors.

Recycling programs are a good example of how incentives work to promote environmental outcomes. An incentive of just 10 cents/can or bottle is substantial enough to get people to return recyclables for a refund, which leads to reuse of metal and glass, and keeps such products out of the ditch and landfills. Many government policies also rely on incentives to get people to behave in a certain manner. Consider the move to renewable energy, the production of biofuels, and even tax breaks for charitable giving.

A disincentive would be a penalty, tax or fine that is levied for “bad behaviour.” Companies that pollute might be charged fees for dumping; higher taxes on cigarettes and alcohol are used to reduce consumption of those products; and people who speed run the risk of getting speeding tickets.

Trade can make everyone better

Where would we be without trade? Personally, I would be much worse off. Without the ability to trade, I would have to make my own clothes, for example. Actually, I would also have to make the fabric, which means growing cotton or raising sheep, or somehow figuring out how to turn trees into rayon. I would also have to invent and build a sewing machine. Come to think of it, sewing machines are made of metal, so I’d have to figure out how to mine and refine the ore and then work out how to make the parts… The list is endless.

On a personal level, it’s easy to see why trade is important. We all specialize these days and focus on doing one thing really well. We get paid, and then use our funds to purchase goods and services that we ourselves, don’t offer for sale or make. Trade is important locally and globally for the same reasons.

Think of Canadian society and how we benefit from trade. What are the products and services we import from other countries that make our lives better? Take a look around your home, your office, or the city/town in which you live? It’s amazing to see that many things you’ve purchased or that you use that are not made in Canada. The same is true for other countries that benefit from what we produce in Canada.

Markets are usually a good way to organize economic activity

Markets are mechanisms that bring together buyers and sellers, or consumers and producers. Economists find that they are very good ways to organize exchange because in a free market (free from government controls and manipulation) the prices fluctuates according to how much is available for sale (supply) and how much consumers want to purchase (demand). If there are very many products, the price will often fall to encourage consumers to buy more so there aren’t leftovers. If goods are scarce, meaning there are very few available for a large consumer group, the price will rise so only those people who value the products very highly will purchase them. In this way, the market clears.

Today we have markets for all kinds of goods and services. Additionally, new markets arise daily as technology evolves to more efficiently bring together buyers and sellers. Consider online markets such EBay and Amazon.com, even Kijiji. The Kijiji website enables you as a buyer to search for very specific items that individuals have for sale. Usually there is a price listed, which is often negotiable. The website brings together the buyer and seller, negotiations take place, a final price is agreed upon and the market clears. There is very little cost to the transaction (listing on the website is free), so it’s considered an incredibly efficient way to make an exchange.

Governments can sometimes improve market outcomes

After having talked about how markets are a good way to organize activity, we have to recognize that sometimes they don’t work as well as they should. I will explain this later in much more detail. For now, all you need to know is that government intervention can help make markets work better by helping producers and consumers meet their needs.

This is particularly true where the environment is concerned. Sometimes, for example, industry produces more than just goods and services. They produce pollution as a by-product and it’s often difficult to make them stop. This is an example where the government can impose a tax (as a disincentive to pollute), or offer a subsidy (an incentive) to help the company use cleaner technology. In both cases, only government can help solve to problem of too much pollution.

The seven key principles are closely related and often overlap. When you consider how the principles work together, you will be able to make sense of what’s going on around you, to recognize how and why others are making decisions based on these principles, and how to make informed decisions.