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Ten Principles of Economics: Understanding Economics Made Easy

May 26, 2021

The word “economics” has originated from a Greek Word “oikonomos” which means “one who manages the households. From managing households to managing business, to managing the economy, the subject has increased its scope over a period of time, with contributions from many known and not so known economists. Over a period of time, economics has expanded its scope to other disciplines like mathematics, statistics, finance, psychology, etc. Economics has emerged as decision science, knowledge of economics helps in making decisions in the right direction which in turn help in making optimum use of available resources. Objective of this article is to understand economics as a subject and its role in the most simplified manner. In this direction, we will use ten principles of economics as suggested by Prof. Gregory Mankiw. Basic understanding of these ten principles will help us in understanding the importance of the subject and its scope.

First Principle: People Face Trade-Offs

While making decisions we face trade –offs. In order to get something we must give up something, “there are no such things as free lunch”. In order to get one thing we usually have to give up another thing. As a student you need to allocate your time across various subjects, study and leisure. If you allocate more time to leisure, you are sacrificing your time on study. For a family, if more income is spent on education, less is left for retirement planning.  For a country, if more budgets are allocated for defense, budget on other sectors like agriculture, education, health etc. is sacrificed. Thus there are competing goals, while making decisions, there trade-off needs to be taken into account.

Second Principle: The Cost of Something Is What You Give Up to Get It

Decision making required comparing the costs and benefits of competing choices. In many cases costs are not explicitly visible. For example when you attend college, the benefits are in terms of knowledge enrichment, job opportunities and social status. The cost of education not only includes fees that you paid and spending on education including transportation, books, etc. it also includes cost in terms of loss of income which you  could have earned, if decided not  to study but  to work. The cost in terms of time spent on study must also be counted. In economics these costs are known as opportunity costs. The concept of opportunity costs helps us in making cost benefit analysis in its true sense.

Third Principle: Rational People Think at The Margin

Economics is based on the assumption of “Rationality”. People are expected to behave rationally, attempting to achieve maximum out of resources and opportunities available to them. Consumers are trying to maximize their satisfaction while producers are trying to maximize their profit. Rational people know that decisions, in real life, are hardly in black and while rather there is gray shade. For example, the decision by students is about whether or not to study, but whether to spend extra hours for study or not. In economics this is known as marginal concepts. Decisions and choices are taken based on comparison between marginal benefits and marginal costs involved in a particular decision.

Fourth Principle: People Respond to Incentives

Incentives are in the form of either reward or punishment which induces an individual to act in particular manner. Since rational people make decisions based on marginal costs and marginal benefit, they respond to incentives. The Incentive system plays an important role in economics.  When the price of the product is reduced, it is an incentive for the buyer to purchase, the seller has an incentive to produce and sell more if demand for the product increases. Taxes and subsidies provided by the government also work as incentives, stakeholders respond to these incentives, resulting in changes in production, consumption, employment and investments. Policies designed without taking into account incentives usually fail in achieving desired outcomes.

Fifth Principle: Trade Can Make Everyone Better Off

Trade is not limited to businesses and countries, even family members are competing with each other. When one member in the family is looking for a job, he is competing with members of other families who are also looking for a job. Companies are competing with each other to sell the product to the same customers. Countries are competing with each other to trade. No one individual, family, society or country can survive in isolation. Trade makes everyone better off. Trade promotes specialization, resulting in better quality, efficient allocation of resources and lower costs.

Sixth Principle: Principle 6: Markets Are Usually a Good Way to Organize Economic Activity

For the allocation of scarce resources of the country in order to get maximum benefit for its people, there are three approaches, allocation by government, allocation by market and mixed model. In economics, it is said that the market usually is a good way of organizing economic activities. In market based economies, decisions are taken by millions of households and firms, called “invisible hands”, rather than the government. Decisions are taken in the market place under the guidance of price mechanism, which benefits all stakeholders. Any intervention by the government in market mechanisms, by way of taxes or subsidies, usually creates distortions, resulting in inefficient allocation of resources.

Seventh Principle: Government Can Sometimes Improve Market Outcomes

Invisible hands will work and create efficient allocation of resources, only in the presence of government. Government has a major role to play in terms of enforcement of rule, maintenance of institutions, protection of property rights etc. Market forces, left on its own, may sometimes fail to allocate resources in the most efficient manner, popularly known as market failure, may be due to externalities or market power. In such a situation intervention by the government will improve the market outcome.

Eight Principle: Country’s Standard of Living Depends on Its Ability to Produce Goods and Services

There are marked differences in living standards of people across the world. In particular, living standards change over a period of time. This living standard of the population in a particular country depends on ability to produce goods and services, defined as the amount of goods and services produced by workers per period of time. Countries where workers are more productive enjoy higher standard of living as compared to countries with low productivity. This relationship has far reaching implications for policy makers. In order to improve the living standard of people, policy makers need to design and implement policies which increase the productivity of labour.

Ninth Principle: Price Rise When Government Prints Too Much Money

All the countries have faced a situation of inflation for some or the time, including hyper inflation by some. The question that needs to answer is what causes inflation. Among all other reasons, one of the main reasons for inflation is more money printed by the government. When the government prints more than the required quantity of money, countries face situations where too much money chasing too few goods, resulting in price rise. Therefore it is essential for the government to maintain balance between growth in production and growth in money supply.

Tenth Principle: Society Faces a Short-Run Trade-off between Inflation and Unemployment The principle states that twin objectives of low unemployment and low level of inflation is not possible to attain by the country. There is a tradeoff between unemployment and inflation. Countries have to make a choice between them, either unemployment or inflation. In the short run period, higher prices provide an incentive for the producer to produce and sell more, resulting in a number of jobs and low levels of unemployment.  Policy makers exploit the tradeoff between unemployment and inflation with the help of fiscal and monetary policies. With the right combination of fiscal and monetary policy tools, the government can achieve balance between unemployment and inflation.

Dr. Kishor Bhanushali, Director, Academic Administration, Unitedworld School of Business (UWSB)

Disclaimer: The opinions / views expressed in this article are solely of the author in his / her individual capacity. They do not purport to reflect the opinions and/or views of the College and/or University or its members.

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