LESSON 2

10 PRINCIPLES OF ECONOMICS

TOPICS
1. How People Make Decisions
2. How People Interact with each Other
3. The Forces and Trends that Affect How the Economy as a Whole
Works

LEARNING OUTCOMES
At the end of the lesson, you should be able to:
1. Describe how economic trade-offs and social values impact
public/private social policy, and the success or failure of policies to
achieve intended outcomes.
2. Present economic arguments in non-quantitative form.
3. Synthesize the arguments found in both academic and popular
economic media.
TOPIC 1: HOW PEOPLE MAKE DECISIONS

Our decisions are more often

swayed by emotions, social
4 Principles on How People Make Decisions
bias and social influences
than we may like to believe.
Experts even claim that 90%
of all purchasing decisions are People faces trade-offs
not made consciously, but
subconsciously. The cost of something is what you give up to get it

Trade-off is a situation that

involves losing one quality or Rational people think at the margin
aspect of something in return
for gaining another quality or
People respond to incentives
aspect. It often implies a
decision that every individual
constantly facing.

"People face tradeoffs" means “There is no such thing as a free lunch!" or to get one thing, we
usually have to give up another thing.

Example: Efficiency vs. Equity

A society that chooses a high degree of efficiency can seem Darwinian in the
cruelest sense, as the relentless pursuit of efficiency simply ignores the suffering
of those who are unable to keep up. A society that instead chooses a high degree
of equity, or equal distribution of wealth, is much more humane, but will generally
suffer from a high degree of inefficiency.

A special kind of trade-off is the opportunity cost or “The cost of something is what you give up
to get it”. It is the cost of choosing to use resources for one purpose measured by the sacrifice of
the next best alternative for using those resources.
 Example: Sleeping is the opportunity cost of studying for a test

People make decisions by comparing cost and benefits at the margin which is called marginal
analysis. A rational decision maker chooses the level of action where the marginal benefit equals
the marginal cost or if the marginal benefit exceeds the marginal cost. To economists, “marginal”
means “extra,” “additional,” or “a change in.” The event where marginal benefit and cost are
equal, that is the time the maximum profit is attained.

Example: If you buy a used motorcycle, and plan to spend

P79,900, but the motorcycle is only priced at P50,000, would
you still buy it if it needed P30,000 in repairs?

Answer: If you are a rational thinker you will not choose the
used motorcycle because you would end up spending more
than you have planned to.

Incentives is something that induces a person to act. It may be punishment or reward, and people
responds to incentive because people make decision by comparing costs and benefits. Incentive
plays central roles in study of economics and it is crucial to analyzing how market work

Example: If gas becomes more expensive, people adjust their behavior.

Public policies can affect private incentives, often in unintended ways.
 TOPIC 2: HOW PEOPLE INTERACT WITH EACH OTHER

The 3 Principles on How People Interact with Each Other

Trade can make everyone better off

Markets are usually a good way to organize economic activity

Governments can sometimes improve market outcomes

Every decision individual make has an effect with other people or organization. These three
principles of economics are concerned on how people interact with each other.

Trade can make everyone better off. Countries as well as families benefit from the ability to
trade with one another. Trade involves competition, not only in different countries but even
within the community.
Example: When a member of your family looks for a job, he or she competes
against members of other families who are looking for jobs. Families also compete
against one another when they go shopping because each family wants to buy the
best goods at the lowest price.

Trade allows each person to specialize in the activities he or she does best. By trading with others,
people can buy a greater variety of goods or services.

Markets are usually a good way to organize economic activity. We as a consumer chooses what
to buy and whom to work for, while manufacturer or firms decided what to make and whom to
hire.
From the first lesson, economic structure has been discussed, as well as the production process.
In the free market economy as Adam Smith is the proponent of the capitalism theory. He pointed
out that in free market, individuals and firms are guided by the “invisible hand”.

Households and firms look at prices when deciding what to buy and sell, they unknowingly take
into account the social costs of their actions. As a result, prices guide decision makers to reach
outcomes that tend to maximize the welfare of society as a whole.

Governments can sometimes improve market outcomes. Market failures occur when a market
fails to allocate resources efficiently, the government can change the outcome through public
policy. Examples: are regulations against monopolies and pollution.

Market failure may be caused by an externality, which is the impact of one person or firm’s
actions on the well-being of a bystander. Market failure may also be caused by market power,
which is the ability of a single person or firm to unduly influence market prices.
TOPIC 3: THE FORCES AND TRENDS THAT AFFECT HOW THE ECONOMY AS A
WHOLE WORKS

The 3 Principles on How People Interact with Each Other

“A Country’s Standard of Living Depends on its Ability to Produce

Goods and Services”

Prices Rise When the Government Prints Too Much Money

Society Faces a Short-run Trade-off Between Inflation and

Unemployment

“A Country’s Standard of Living Depends on its Ability to Produce Goods and Services”.
The ability of the country to produce goods and services will determine the standard of living.
The gross national product is the total goods and services produced each year, and for the per
capital income of each nation, it is the total goods and services produced over the total
population. The objective of each nation is to increase the standard of living. In comparison of
the nation’s data we simply compute for the GNP and PCI of each country.

Productivity refers to the amount of

output (goods and services) produced
Standard of from each unit of input (factors of
living production).
More goods Productivity is the
and services
with same
result of efficiency,
resources the higher the
Productivity
(efficiency) productivity and
higher the standard
of living.
 Example: some commentators have claimed that increased competition from
Japan and other countries explained the slow growth in U.S. incomes during the
1970s and 1980s. Yet the real villain was not competition from abroad but flagging
productivity growth in the United States.

Prices Rise When the Government Prints Too Much Money.

When a government creates large quantities of the nation's money, the value of the money falls.
As a result, prices increase, requiring more of the same money to buy goods and services.

Inflation is a general increase in the level of

prices in the economy. Too much money
circulating in the market will result to the
increase of prices of commodities. Since
excess does not exist in the market. The
increase in purchasing power leads to the
increase of demand that will lead to inflation.

Society Faces a Short-run Trade-off Between

Inflation and Unemployment. There is an
inverse relationship of inflation and
unemployment when society faces short-run
trade-off. In every increase in Inflation there is a
decrease effect in unemployment.

Some economists describe the short-run effects of monetary injections as follows:

▪ Increasing the amount of money in the economy stimulates the overall level of spending
and thus the demand for goods and services
▪ Higher demand may over time cause firms to raise their prices, but in the meantime, it
also encourages them to increase the quantity of goods and services they produce and to
hire more workers to produce those goods and services.
▪ More hiring means lower unemployment.
▪ This line of reasoning leads to one final economy wide trade-off: a short-run trade-off
between inflation and unemployment.