Principles of Economics——by N Gregory MankiwPrinciple #1 People Face TradeoffsWe face tradeoffs everyday.Tradeoffs occur when constraints such as budget or time force us to give up one thing in order to get something else.John is a high school senior facing a trade-off whose outcome will help to guide the course of his life. John is trying to choose the right college. His grade point average and SAT scores have placed him in the upper percentile of his class and have made him a very attractive prospect for any college. For John, a number of factors determine his ultimate choice. He has to compare the advantages and disadvantages of each institution. In this way, he can make appropriate tradeoffs to reach an informed decision.One possibility for John is a commuter college close to his home. If John chooses this school, he will live at home and have a lower tuition cost. Each of these factors will keep the overall cost of his education affordable. But John has his heart set on a career as an architect and the commuter college has limited course work in this area. John’s next option is a private university in another part of the country. This university will provide him with a degree in architecture and also has an international reputation, one that will give John greater credibility when he applies to graduate school. But the school may also be prohibitively expensive. Also, leaving home may provide freedom but will also be a less structured environment than he is used to. John has a third choice: a state school. The state school offers a possible compromise between the commuter college and the private university. It also offers John a degree in architecture where he will be reasonably close to home and friends and his tuition costs will b e lower than the private school. But the private school’s architecture program has an international reputation and its average class size is much smaller and therefore more personal.John must now evaluate each of these factors based on his own needs and desires. For example, John’s first priority is getting the best possible education. He knows that competition for a graduate degree in architecture will be very stiff and he wants his best foot forward when the times comes. His second priority is where he lives. John wants to stay near home where he can be near his friends and family. In the final analysis, though, John’s decision will have to first take into account his budget constraints.John must now compare his priorities with an eye toward these constraints. As John makes his tradeoffs, he is practicing one of the basic principles of economics: There’s no such thing as a free lunch. To get one thing that we want we usually have to give up something else that we want.Since his parents have told him that they do not want to pay for the private school, John must strike it from his list. He must now make appropriate tradeoffs between the commuter college and the state school in order to arrive at the right choice.John’s next tradeoff is between th e quality of life that each will offer and the quality of its education.John has already made two important decisions. He defines “quality of life” as living at home near friends while his definition for “quality of education” is a degree in architecture. By comparing the two schools on these bases, John is able to arrive at the best possible tradeoff.Like all of us, John was able to establish his own priorities, then determine which tradeoffs were necessary to arrive at the best possible outcome.By understanding our options and making appropriate tradeofs, we were able to make the best decisions for our own lives.Principle #2 The Cost of Something is What You Give Up to Get ItWomen's roles in our society have changed tremendously in the last hundred years. This change has impacted the opportunity costs for women as they consider whether to work inside or outside the home.The opportunity cost of an item is what you give up in order to get it. Similarly, the opportunity cost of an activity is what you give up in order to do it.Your choices depend on opportunity costs which in turn depend on many factors including money, time, and quality of experience.In earlier, pre-industrial generations, women received most of their social prestige for their roles as wife and mother, while their labor was needed literally to keep the home fires burning. The kinds of jobs open to them, on the other hand, were limited and paid poorly. The opportunity cost of working outside the home was often too high to be worthwhile given the importance of their responsibilities at home.As barriers to women entering certain professions have fallen, more women have sought preparation for those professions. In 1968, women received 8% of the medical degrees, 3% of the MBAs and 4% of the law degrees granted that year.By 1986, women were awarded 31% of the MD’s and MBAs, and accounted for 39% of the law degrees. Today, the figures continue to climb, with women composing 43% of law school enrollment.The broader, more lucrative career fields open to women today require the careful evaluation of changed opportunity costs when choosing whether or not to work outside the home.For example, let us consider a couple who currently work full time, eachmaking $50,000 a year. what is the opportunity cost of choosing to work? What is the opportunity cost of choosing to stay at home?Suppose the couple has a child, and no options for free child care. They willhave to purchase equivalent child care from a baby sitter, day care center, or give up one of their salaries and stay home. Child care will require an annual cash outlay of $15,000.They have limited free time each week, and find that house cleaning rarely gets done. They can employ a professional house cleaning service or stay home to do the cleaning themselves.The opportunity cost of working is the value they place on their time if they did not work. One of them could provide child care worth $15,000 and house cleaning worth $1,200.Assuming these are the only benefits foregone by working, the opportunity cost of working is the $16,200.They both have highly lucrative job skills so the financial benefits of working We get the same answer y aski ng the question: “What is the opportunity cost of staying at home?” By staying at home, one forgoes the opportunity to work, thus giving up an income of $50,000 a year. The opportunity cost of staying home is $50,000. The monetary benefit of staying at home to take care of the household tasks and care for the child is $16,200. Although there are financial benefits to staying at home, these benefits have a lower monetary value than the opportunity cost of forgoing their salary.These considerations reflect important aspects of opportunity cost. Understandably, as possibilities for women to work outside the home have multiplied, the opportunity costs for women to remain at home have increased.Of course, there may be non-monetary costs to working that we have not yet considered. Often a worker will turn down overtime even though it pays one and a half times the normal hourly wage. Why? The worker places more value on free time than the extra 50% the employer is offering.This non-monetary opportunity cost is harder to measure. If it were strictly dollars and cents, our couple’s decision would be easy.But they both place a great deal of value on the quality of life for their child and they both love the time they spend with their child. So the opportunity cost of working may be much higher than the financial cost of $16,2000.In 1979, the hourly earnings of women were only 62% of the wages earned by their male counterparts. By 1992, that percentage had risen to 74%As women’s salaries become comparable to men’s, the opportunity cost for women staying at home has become closer to the opportunity cost for men.The decision to stay home with the children is no longer the sole responsibility of the woman.As men and women reassess the changing nature of work both inside and outside the home, their shifting priorities will give them a new understanding of opportunity cost and help them find a new balance between family and career.Principle #3 Rational People Think at the MarginRay is considering a very tempting offer. A few weeks back, Ray heard that his favorite band was coming to town. He was so excited he was willing to spend twenty-five dollars for the best seat in the house.He kept calling the box office but the overwhelming number of callers made it nearly impossible to get through. When he finally did, he had to settle for a ten dollar ticket in the restricted view section.Now, on the night of the concert, Ray is approached by Scott, a ticket scalper. Scott wishes to sell Ray a twenty-five dollar ticker with and unrestricted view for twenty dollars.How will Ray make this decision? Not by saying, “No, because I already have a ticket,” or “Yes, because it’s a good ticket.” He will apply the principles of marginal thinking. Ray will weigh the incremental benefits of each choice in light of incremental costs.Ray must determine if the marginal improvement in his seat will justify the added expense. In order to do this, he will analyze the marginal benefit of the better seat. In other words, Ray must ask himself if a better seat is worth twenty dollars to him. Ray’s analysis tells him that the marginal benefit of a better seat is that he will enjoy the concert much more. Therefore, the marginal improvement over his original seat justifies the additional expense. Ray quickly accepts the offer.This is clearly a good deal for Ray but what about Scott the scalper? Surely he can’t make profit selling twenty-five dollar tickets for twenty dollars, can he?As soon as they went on sale, Scott purchased fifty tickets at twenty-five dollars each. This gave him a total out-of-pocket expense of one thousand, two hundred and fifty dollars. He was gambling that he could sell these tickets at a profit.Sure enough, when Scott arrives at the stadium three hours before show time, he finds dozens of disappointed fans willing to pay more than face value for his tickets. He quickly sells thirty tickets at forty dollars apiece. This makes back one thousand and two hundred dollars of his original investment.After the first hour, though, Scott experiences a sharp decline in sales and he finds that he can no longer sell tickets above face value. During the next hour and forty minutes he is only able to sell ten tickets, all at their face value of twenty-five dollars. Did Scott’s gamble pay off?This two hundred and fifty dollars, when added to his first hour sales gives him a total of one thousand, four hundred and fifty dollars. Scott now has a two hundred dollar profit on his original one thousand, two hundred and fifty dollar investment.However, Scott now wishes he had only bought forty tickets. He still has ten tickets left at twenty minutes to show time. What should he do with these ten tickets? Since he’s recouped his sunk cost, Scott realizes its better to sell them for something rather than nothing. He how offers the remaining tickets for twenty dollars apiece and finds several willing buyers, including Ray. Even though he’s taking a loss on these last tickets, marginally he’s better off selling them at t hat price rather than throwing them away.Ray and Scott are not the only winners in this transaction. Kim is another fan, one who is willing to gamble that Scott’s price will come down even more. By five minutes to show time Scott has sold all but two of his remaining tickers for twenty dollars. Scott now has total sales of one thousand, five hundred and thirty dollars which gives him a profit of two hundred and eighty dollars over his original one thousand, two hundred and fifty dollar investment.As soon as Scott is down to two tickets and there’s no time left before the start of the show, Kim makes her move. Knowing that Scott doesn’t want to be with tickets so close to show time, Kim offers the scalper five dollars for the final two. Since Scott has nothing to lose and ten dollars to gain by unloading the last two tickets, they make a deal.As the concert begins, Ray is able to get a better seat and Scott is able to maximize his profits, all by applying the principles of marginal thinkingPrinciple #4 People Respond to IncentivesFor many people, graduation from high school is an exciting time, filled with renewed possibilities and challenges. Some will choose to directly enter thework-force. Others will decide to continue their education by attending college. Inevitably, the decision will be an economic one.When financial resources are limited, people must consider the prices of goods and services they wish to purchase, including the price of a college education. And because of budget constraints, they often face tradeoffs. At a time like this, people are very prone to respond to incentives.Alan and Sarah, two recent high school graduates, are perfect examples of how incentives can affect choices. Both have decided to attend college immediately after graduation.Sarah’s family has saved fifteen thousand dollars for tuition at one of the finest private schools in the country. Alan’s family has saved seven thousand dollars for college, and he plans on attending his state university. The next step is for them to figure out the most effective ways to finance their education.Alan discovers that the cost of tuition at the state school, plus other expenses, is higher than he had anticipated -- ten thousand dollars a year.He could postpone his college plans and get a job to help pay for his tuition. But he might only be qualified for low-paying jobs, which would greatly reduce his saving power for college.In Sarah’s situation, the cost of private schooling is much higher than she had thought. With the cost being twenty thousand dollars a year, she has to choose her state university.In times like these, people like Alan and Sarah are looking for better options. The government can possibly help them by offering incentives, such as a tuition tax credit.A tuition tax credit is a deduction off the tax owed on a person’s tax return.For example, if the tax credit is thirty percent, the family can deduct thirty percent of the total cost of tuition from the taxes owed on their tax return. In the case of a college tuition tax credit, the income is designated to pay for tuition only.Given the introduction of a college tuition tax credit, Alan is now able to afford state university directly after graduation. The annual cost of attending the university is ten thousand dollars. He can use his parents’ seven thousand dollars and add the money from the three thousand dollar tax credit to pay the remainder.A tuition tax credit will also enable Sarah to attend the private school she originally chose.Tuition for that school is twenty thousand dollars a year. With her parents’ contrubution of fifteen thousand dollars and a tax credit of six thousand dollars she can now afford tuition there.Many people think that our society would only benefit from the education that government incentives make possible. But although we know that people respond to incentives, such policies can also create unexpected negative ramifications.For example, a government tax credit increases the disposable income of middle and upper income families. Meanwhile, lower income families, the ones most in need of extra money for education, are less affected.College tuition tax credit can also have a negative ramification in the education market as a whole. With extra money available, more people can afford to attend college. In other words, the “demand” for college education increases.But it takes time for schools to increase their capacity to accommodate the extra students. Most universities have an established system with a set number of campus buildings, faculty, and administration. In other words, even though “demand” for college education increases, the “supply” remains constant.In this situation, schools respond to the increased demand by raising tuition to cover the costs of adding classrooms, dormitories, teachers, and administrations. These market-wide tuition increases may partially reduce the effectiveness of the original tax credit.Ultimately, incentives such as tuition tax credits can have a positive effect on society. But, as with any government policy, consideration must be given to the direct effects as well as the indirect effects that the incentives create.Policymakers must fully understand these differing principles in order for the incentives to cause the positive effects on society that they intend.Principle #5 Trade Can Make Everyone Better OffTrade. We do it every day of our lives. People trade money for goods. So do businesses... And nations... Trade is the lifeblood of international economy. Every nation grows stronger and its economy improves as it exercises the principles of international trade.There are two elements to a well-balanced trade relationship: comparative advantage and specialization.Economists use the term “Comparative Advantage” when describing the opportunity cost of two producers. The producer who has the smaller opportunity cost is said to have a comparative advantage in producing that good.To see the benefit of comparative advantage, let us examine two countries, America and Japan, and two goods, food and cars.For our example we will assume that both countries produce cars and grow food. In both the U.S. and Japan, a worker can each produce one car per month. Because America has more land it is more efficient at producing food than Japan. A U.S. worker can produce two tons of food per month, whereas a Japanese worker can produce only one ton per month.If America is as efficient as Japan at car manufacturing and better at food production, why do we need to trade with her?Because the opportunity cost of producing a car is two tons of food in the U.S., but only one ton of food in Japan. So, Japan has a comparative advantage over the U.S. in producing cars.Because it is less expensive for America to import cars than to produce them domestically and more profitable to export our surplus food than to try and consume it all internally, the U.S. has a comparative advantage in food production.Once this comparative advantage has been determined, each country recognizes the need to specialize.Japan can now spend more time producing cars and less time growing food while the U.S. can spend more time in the production of food and less time on the automobile assembly line.Each country is now specializing in the production of a good in which it has a comparative advantage. In order to receive the good it is not producing, it must trade with the other. This trade relationship benefits both partners.Such a relationship breeds an interdependence among trading partners.In many ways, we as Americans tend to view the Japanese as our competitors in the global marketplace. After all, we both produce automobiles and food and are competing for the biggest possible market share of each.But is it right to view this competition as a sports contest, where one side wins and the other side loses?No. Such a limited view tends to ignore the positive benefits of interdependent trade to both countries. In fact, the opposite is true: Trade between two countries makes each country better off.During the pa st thirty years, Japan’s comparative advantage and specialization is the manufacture of automobiles has led it to become a leading industrial power. Many believe that this growth has come at the expense of the American economy. But how true is this?As Japan built up its comparative advantage in auto assembly, the United States was freed up to specialize in other markets where it could built up its own comparative advantage. These markets included finance, high technology and the manufacture of auto parts. Each of these markets are fundamental to the delivery of goods and services including the production of automobiles. By specializing in the areas of their comparative advantage, America and Japan are able to complement each other’s production.By working together in trade, each side can guarantee that the final product is sold at the best price for the consumers of both countries. This allows for a greater number of purchasers for both the Japanese and American firms. Further, the more of these goods that are sold, the stronger the economy will be in each of the partner nations. Such interdependent relationships are becoming more and more common as the global marketplace expands. This expansion of trade guarantees better economies and a brighter future for all nations involved.Principle #6 Markets are Usually a Good Way to Organize Economic ActivityIn any free market economy, the prices of goods and services are determined by the laws of supply and demand.The prices and quantity sold of goods and services reach equilibrium by responding to the behavior of buyers and sellers. The force that moves price and quantity to equilibrium is called “The Invisible Hand,” a phrase coined by Adam Smith in the 1700s.In a marketplace that is heavily regulated by the government, this invisible hand can no longer work, because prices reflect political policy rather than the consumer’s choice.Before 1978, America’s airline industry was a regulated marketplace where prices were determined by the government. Consumers had little choice in terms of fare, airline, or quality of service.After five decades of regulation, prices could not adjust naturally to free market forces. Because fares were set by planning committees, airlines had no incentive to compete for customers or to run efficiently.Airlines had become so inefficient and polluting that the problem came to the attention of the U.S. Congress.Congress reasoned that by setting market forces loose in the airline industry, airlines would soon compete with one another for passengers.In 1978 Congress passed the Airline Deregulation Act with the support of President Carter. They speculated that the invisible hand of a free market was still a good way to organize the economic activity.By opening more routes to competition, more suppliers entered the market. They hoped that this would lead to lower airfares, better efficiency, technological advances, and greater choices for travelers.In the years following deregulation, the invisible hand of the marketplace has benefited all kinds of travelers.Take Amy, for example, who wants to fly our to visit her boyfriend for the weekend.In a regulated market, she would have the choice of one or two carriers and a fare that is fixed by the government. But in a free market, she can choose from a range of fares and companies. All that is required is a call to her travel agent, who can compare the prices of all the major airlines.If she can travel with one airline at an off-peak time, for example, she can save hundreds of dollars off the full fare of another. A regulated marketplace would probably now allow this kind of flexibility.Deregulation has forced airlines to become innovative in competing with one another.This graph demonstrates the hub and spoke system developed by the airlines as a outgrowth of deregulation. As small regional airports, or spokes, feed into larger hubs in a major city, passengers are routed to their destination from the hub. Large airlines can control the terminals at their hub airports and charge other airlines to use them. United Airlines, for instance, often routes passenger traffic through their Chicago hub. They then service smaller airports with economical propeller planes and save large jets for longer routes that have more passengers. For this reason, Amy might make a stop at a large airport before continuing on to her destination.Southwest Airlines is a good example of a company that has benefited by deregulation. It began as a small commuter airline which served markets ignored by larger companies.Flying short and low-maintenance routes enabled Southwest to quickly establish itself as a price leader.Since shorter routes require less maintenance and smaller crews, Southwest streamlined operations. They have developed passenger routing and baggage loading techniques that allow them to turn a plane around in thirty minutes. They save time and money, the keys to survival in the airline business.This efficiency translates into savings on fuel, labor, insurance and other expenses that get passed on to the consumer.Efficiency is the outstanding advantage that Southwest uses over its competitors. To fill an undersold flight, Southwest can add passengers for literally the price of peanuts.Other airlines have tried to mimic Southwest’s success. As they enter the market the increased competition keeps prices in check. This prevents any one airline from monopolizing the market.Some airlines, however, were not able to survive after deregulation. Giants of the past like Pan Am and Eastern airlines folded in 1991 because they were unable to streamline operations and match the lower fares of their competitors. Instead, expenses took there toll as labor unions resisted wage cuts.Other airlines were forced to make trade-offs in their quest for efficiency. Compromises in safety have been uncovered as airline cut expenses to stay competitive. Or some airline are forced to fly an aging fleet longer in an effort to avoid expenditures and keep air fares down.Yet overall, deregulation of the airline industry has been a windfall to the consumer. The US General Accounting Office reports that on average, air fares are down almost 10 percent at small, medium, and large airports since deregulation.The increased number of flights, savings in travel time, and overall efficiency of the hub-and-spoke system has saved US consumers 10.3 billion dollars a year. Deregulation has also spurred overall advances in safely. The accident rate per one hundred thousand departures has dropped 90%.By removing barriers to free competition, the government has allowed the airline industry to demonstrate one of the basic principles of economics: that markets are a good way to organize economic activity.Principle #7 Governments Can Sometimes Improve Market OutcomesThe American public education system has long been a model for the free world. Why is our government concerned with education? Wouldn’t the system work better if left to the free market?There are two reasons why the government stays involved in education - the same two reasons that motivate it to intervene in other markets. The first is to promote equity, and the second is to promote efficiency.The original intent behind the establishment of a public school system was to promote equity for all citizens. Historically, private schools have offered an excellent education. Unfortunately, this education is expensive and therefore is out of the reach of many citizens.The public school system was established to address this inequity by offering a reasonably standardized curriculum with equal access to all. Therefore, all students can gain the opportunities that education makes possible.Primarily viewed as extending from kindergarten through the twelfth grade, this system also reaches into the higher education years with community colleges and state universities.In addition, the government assists higher education through various policies which help students to afford attending private and public institutions. These programs include Pell grants, student loans and government sponsored scholarships, which make higher education more affordable to a large number of citizens.Dale’s education reveals the role of government action in promoting equity and efficiency.For example, a few years back, Dale’s public high school r eceived a Department of Education grant to build a computer lab with Internet access. Computer labs in elementary and high schools ensure that all students have a chance to learn how to use computers.This program not only gave Dale access to the information super-highway, it also helped to ensure that his public school would be able to give him skills equal to the private school graduates. It did this by allowing the school to offer a program that only the private schools had previously been able to afford. In this way, the government-funded computer lab helped to equalize the opportunities available to citizens.When he enters college in the Fall, Dale will be taking pre-med courses to prepare himself for a career in medical research.Dale will finance his education through a series of government-sponsored loans, grants and tuition tax credits. These government programs are necessary because many banks do not give student loans. These private institutions fear that students will be unable to pay back the loans once they leave school.The government also wants the loan to be repaid but knows that society receives other benefits from Dale’s education through positive externalities.A positive externality occurs because the benefits of one person’s education extend to other individuals in society. Since the market does not take account of these externalities, and so does not provide a sufficient level of education, there is a market failure. These externalities are the second reason that governments intervene to promote education.。
