Mental Pivot

Notes and observations from a lifelong pursuit of learning.


Book Notes: “Principles of Microeconomics" - Part 1: Introduction (Mankiw)

This post is the start of a 7-installment series of my personal notes outlining N. Gregory Mankiw’s economics textbook “Principles of Microeconomics” (8th Edition). This text is an excellent introduction to the subject and is used in many undergraduate economics programs across the United States. I firmly believe that a basic knowledge of microeconomics is a critical component for understanding the world and making informed decisions. Mankiw’s book provides both collegiate students and independent learners with that foundation.[1]

I am releasing outlines for each of the 7-parts of the book over the next few weeks along with an index that conveniently links to all of the outlines.

Feel free to use this reference for your coursework or personal edification but know that I make no claims about the accuracy or completeness of these outlines. Also note that my outlines only cover the main body of the book. Sidebars, supplements, end-of-chapter summaries and sample tests are not included.


Index of Outlines for Principles of Microeconomics:
* Part 1: Introduction (Chapters 1-3)
* Part 2: How Markets Work (Chapters 5-6)
* Part 3: Markets and Welfare (Chapters 7-9)
* Part 4: The Economics of the Public Sector (Chapters 10-12)
* Part 5: Firm Behavior and the Organization of Industry (Chapters 13-17)
* Part 6: The Economics of Labor Markets (Chapters 18-20)
* Part 7: Topics for Further study (Chapters 21-22)


Part 1: Introduction

Chapter 1: Ten Principles of Economics

1.0 Introduction

  • The word economy comes from the Greek work “oikonomos” which means “one who manages a household.”
  • Management of resources is important because resources are scarce.
  • Economics studies the ways society manages scarce resources. This includes:

    • Decision-making (what work needs to done? Who will do the work?)
    • How will goods and services produced be allocated?
    • How will people invest their savings?
    • How do people interact with one another?
    • What are the forces that affect and influence an economy?

1.1 How People Make Decisions

Principles about individual decision making (Principles 1-4):

  • Principle 1: People face trade-offs.

    • Example: “guns and butter.” The more a society spends on national defense (guns) has fewer resources available to spend on consumer goods (butter).
    • Example: “clean environment vs. high income.” Laws that require companies to reduce pollution raise the cost of goods and services (resulting in lower profits and reduced buying power).
    • Efficiency vs. equality: Efficiency is the maximum benefit from scare resources. Equality means the benefits are distributed uniformly across society.
    • Many government policies result in conflict between efficiency and equality.
  • Principle 2: The cost of something is what you give up to get it.

    • Making decisions requires a comparison of costs and benefits or alternative courses of action.
    • Opportunity cost of something is what you give up to get that item. Example collegiate athletes can earn much more by foregoing college education to turn professional.
  • Principle 3: Rational people think at the margin.

    • Rational people: People who systematically and purposefully do the best they can to achieve their objectives.

    • Marginal change: A small incremental adjustment to an existing plan of action.

      • Marginal benefit:The maximum amount a buyer is willing to pay for an incremental unit consumption of a good or service. It also represents the utility (or benefit) the buyer associates with consumption of the added unit of that good or service.
      • Marginal cost: The cost added by producing one additional unit of a good or service.
    • Rational people often make decisions by comparing marginal benefits with marginal costs.

  • Principle 4: People respond to incentives.

    • Incentive: something that induces a person to act. Can manifest as a reward or punishment.

    • Incentives are central to understanding economies.

    • Example: If the price of apples rises, people will eat fewer apples. Correspondingly, farmers will hire more workers and harvest more apples.

    • Incentives affect both the buy-side (apple eaters) and the sell-side (apple producers) of the equation.

    • Politicians and their policies frequently manipulate incentives and effectively alter people’s behavior.

    • Policy example: A gasoline tax encourages people to drive smaller, more fuel-efficient cars. It might also encourage carpooling, trips on public transportation and living closer to work.

    • Failure to understand how policies affect incentives results in unintended consequences.

    • Example: How does a seat belt law effect auto safety?

      • Direct effect: probability of surviving an accident increases for seat belt wearer.
      • However, wearing a seat belt alters driver behavior.
      • Seat belts reduce the benefit of driving slowly and carefully (since driver has the benefit of added safety).
      • Sam Peltzman 1975 study concludes that seat belt laws might yield fewer deaths per accident but also leads to more accidents. The result is little change in the number of driver deaths and an increase of pedestrian deaths.

1-2 How People Interact

Principles about human interactions (Principles 5-7)

  • Principle 5: trade can make everyone better off.

    • Competition is inherent to economies.

    • Some people view competition as a zero-sum game (someone wins and someone loses).

    • The reality is that competition is a positive-sum game (everyone can “win”).

    • Trade allows people to specialize in the actives they do best.

    • Trading with others allows people (and countries) to enjoy a greater variety of goods and services at lower cost.

      • The alternative would be to attempt to create all the goods and services yourself in isolation, but this is not feasible.
  • Principle 6: Markets are usually a good way to organize economic activity.

    • Centrally-planned economy: A system in which the government officials allocate the economy’s scarce resources (e.g. communism).

    • Market economy: An economy that allocates resources through decentralized decision-making. Decision-making is made by companies and individuals.

    • Market economies are able to organize economic activity to promote overall economic well-being.

    • Per Adam Smith in “The Wealth of Nations” (1776): markets are guided by an “invisible hand” that leads to desirable market outcomes.

    • Prices are an instrument by which the invisible hand directs economic activity.

      • Per the apple example in section 1.1, prices influence the behaviors of buyers and sellers.
    • Political policies that alter prices can result in market distortions (examples: rent control, taxes, communism).

  • Principle 7: Governments can sometimes improve market outcomes.

    • Governments enforce rules, institutions, and laws that market economies need.

    • Property rights: A market economy needs a way to ensure that individuals can own and control scarce resources.

    • Governments can enact policies to promote efficiency (make the economic pie larger) or to promote equality (change how the economic pie is divided).

    • Market failure: A situation in which a market fails to allocate resources efficiently.

    • Two possible causes of market failure:

      • Externalities: The impact of one person’s actions on the well-being of a bystander. Example: pollution. Free markets are not always effective at accounting for externalities.
      • Market Power: The ability of a single economic actor—person, firm or small group—to exert significant influence on market prices.

1.3 How the Economy as a Whole Works

Principles about the overall economy (8-10)

  • Principle 8: A country’s standard of living depends on its ability to produce goods and services.

    • Variations in living standards between different countries are attributable to differences in productivity.
    • Productivity: The quantity of goods and services produced from each unit of labor input.
    • Productivity is the primary determinant of living standards.
    • Labor unions and minimum-wage laws are not the main drivers of productivity.
    • Public policy implications: Ask: “How will this policy affect our ability to produce goods and services?”
    • Productivity can be raised through education, tools and technology.
  • Principle 9: Prices rise when the government prints too much money.

    • Inflation: An increase in the overall level of prices in an economy.
    • High inflation is undesirable and detrimental to an economy.
    • Low inflation should be an important goal for policymakers.
    • The quantity of money is the culprit behind large or persistent inflation.
  • Principle 10: Society faces a short-run trade-off between inflation and unemployment.

    • Short-term consequences of monetary injections:

      • Increasing money supply boosts overall spending which increases demand for goods and services.
      • Increased demand may lead to higher prices and increased hiring (employment) to produce more goods and services.
      • Hiring results in lower unemployment.
    • Business cycle: Periodic fluctuations in economic activity which impacts employment and production of goods and services.

Chapter 2: Thinking Like an Economist

2-1 The Economist as Scientist

  • The interplay between theory and observation that occurs in science also occurs in the field of economics.
  • In economics conducting experiments is often impractical.
  • Economists, like astronomers and evolutionary biologists, make do with whatever data the world gives them.
  • Economists use assumptions to simplify the complex world and to answer specific questions.
  • Economic models are important tools for understanding the world. These models are often reductive and simplified representations of real-world phenomena.
  • Circular-flow diagram: A visual model of the economy that shows how dollars flow between households and firms in a market.
(Image from Wikipedia.org)
  • The important idea from a circular-flow diagram is how money flows through the system. Example: A household has a dollar and decides to purchase a cup of coffee. The dollar is taken to Starbucks and exchanged for a good (the coffee). The dollar becomes revenue for a firm (Starbucks). The dollar is soon used to purchase more production inputs (i.e. it is used to make more coffee by purchasing more coffee beans, paying workers, buying equipment, etc.). That dollar is then injected back into another household (for instance via wages) and the cycle begins anew.
  • Production possibilities frontier: Another basic economic model. This is a graph that shows various combinations of output for two goods that an economy can produce given available resources and technology (production factors). For instance, in the graph below (image from Wikipedia is equivalent to that found in the Mankiw text), the graph shows all the possible combinations for an economy producing guns and butter. An economy could produce only guns (the top of the curve at the y-axis) or only butter (the rightmost part of the curve at the x-axis) or any combination of guns and butter as represented along or below the curved line. The line itself represents the maximal or optimal use of resources given current production capabilities (the frontier). Points beneath the curve are also possible but represent suboptimal outcomes (from an efficiency standpoint). Points outside of the blue line region—point X in the example—are not possible given the current production capabilities.
(Image from Wikipedia.org)
  • The production possibility frontier illustrates several economic concepts: economic trade-offs, opportunity cost, scarcity of resources, and allocative efficiency.
  • Microeconomics: The study of how households and firms make decisions and interact in markets.
  • Macroeconomics: The study of economy-wide phenomena: including inflation, unemployment, and economic growth.

2-2 The Economist as Policy Adviser

  • “When economists are trying to explain the world, they are scientists. When they are trying to help improve it, they are policy advisers.”
  • Positive statements: Descriptive. Makes a claim about the world, describes the world as it is. Example: “Minimum-wage laws cause unemployment.”
  • Normative statements: Prescriptive. Makes a claim about how the world ought to be. Example: “The government should raise the minimum wage.”
  • The type of comments you hear—positive or normative--will help you understand the underlying role or function an economist is making in a given situation (i.e. as a scientist or policy adviser).
  • Council of Economic Advisers is a United States agency established in 1946 to provide the President of the USA with economic policy advice and write the annual “Economic Report of the President.”

2-3 Why Economists Disagree

  • Two basic reasons economists disagree:

    1. Disagreement about the validity of alternative positive theories of how the world works.
    2. Differing values and priorities result in differing normative views about government policy objectives.

Chapter 3: Interdependence and the Gains from Trade

3-1 A Parable for the Modern Economy

  • Example of a simple economy: World with two goods (meat and potatoes) and two people (a cattle rancher named Ruby and a potato farmer named Frank).
  • Ruby and Frank both want to eat meat and potatoes.
  • Assume that each individual is only producing one good (producing a second good is possible, but costly).
  • Frank and Ruby benefit through specialization. Each produces what they do best and through trade they can each consume more meat and potatoes without working more hours.

3-2 Comparative Advantage: The Driving Force of Specialization

  • Absolute advantage: The ability to produce a good using fewer inputs than another producer. One input to consider is time (i.e. how long it takes to produce one unit of a good).
  • Opportunity cost is another way to look at the cost of producing a good or service (the cost of giving up something else to obtain some item).
  • Comparative advantage: The ability to produce a good at a lower opportunity cost than another producer.
  • It is possible for one person to have an absolute advantage in both goods (Ruby in the above example). However, assuming different opportunity costs, one person will have a comparative advantage in one good and the other will have a comparative advantage in the other.
  • Gains from specialization and trade are based on comparative advantage.
  • When people specialize in producing the good or service for which they have a comparative advantage, total production in the economy rises.
  • “Trade can benefit everyone in society because it allows people to specialize in activities in which they have a comparative advantage.”
  • “For both parties to gain from trade, the price at which they trade must lie between the two opportunity costs.”

3-3 Applications of Comparative Advantage

  • Case Study: Should Serena Williams mow her lawn?

    • She can mow her lawn in 2 hours OR in the same 2 hours she can earn $30,000.
    • Neighbor Forrest Gump can mow Serena’s lawn in 4 hours or work at McDonald’s for $50.
    • Serena Williams has an absolute advantage in mowing lawns because she can do the work with a lower input of time (2 hours compared to Forrest’s 4 hours).
    • Forrest Gump has a comparative advantage in mowing the lawn since Serena’s opportunity cost is $30,000 and Forrest’s is only $50.
    • As long as Serena pays Forrest more than $50 and less than $30,000, both parties are better off.
  • Case Study: Should the United States trade with other countries?

    • Imports: Goods produces abroad and sold domestically.

    • Exports: Goods produced domestically and sold abroad.

    • Hypothetical scenario between USA and Japan concerning two goods: food and cars.

      • American worker produces 1 car/month or 2 tons of food/month.
      • Japanese worker produces 1 car/month or 1 ton of food/month.
      • Japan has a comparative advantage in producing cars.
      • The USA has a comparative advantage in producing food.
    • Conclusion: Through specialization and trade both countries can have more food and more cars.

 
 

[1] For more information on economist N. Gregory Mankiw:
* Archive of Past News Columns (harvard.edu)
* Gregory Mankiw’s Blog (blogspot.com)
* Official Harvard University Page (harvard.edu)
* Wikipedia: Greg Mankiw (wikipedia.org)