Econ 5, Foldvary.

Lectures. Mankiw, chapter 1. Ten Principles

Remember: WDYM and HDYK.

The textbook provides an organizational framework and much of the content, but it is not an authority. I too am not an authority.

The author and I are experts, but not authorities.

Propositions in economics are true not because Mankiw or I say so, but because they are warranted or justified. What are the warrants? How do we know what we know?

Logic and evidence.

I don't want you to believe anything in this course without understanding why it is true.

Feel free to disagree with the book or with what I say, but if you do, you should be prepared to explain why, and if you know, what the alternative is.

Definitions, however, e.g. for "demand", must simply be accepted as a convention.

Sometimes I will have a definition or theory or normative view that differs somewhat from Mankiw.

For exams, the lectures will be assumed to dominate the textbook. If you disagree with my definition or concept or theory, it is your responsibility to explain why in class, otherwise I will assume agreement.

However, you are of course free to disagree with my ethical or normative views.

I happen to think that theft is immoral and evil, but if you think stealing is good, if that is your norm, you are entitled to your opinion, and I won't ask normative questions on an exam.

I happen to favor policies that increase the efficiency of an economy and raise the standard of living for most folks, but if you think otherwise, that's your prerogative.

Mankiw talks about households and society.

Household: people who live together and make many joint decisions as consumers and as owners of assets.

Society: individuals in come context.

In the context of an economy, the society is unorganized.

Society is distinct from the governments which have jurisdiction.

A household is an organization. Society consists of individuals.

Who decides, individuals or groups?

Only individuals can think and decide.

Group decision is voting or consensus by individuals in an organization.

Sometimes one individual will decide as a dictator.

P. 3 "a society faces many decisions." But societies don't decide.

The government faces many decisions, some of which the voters might decide on.

But many economic decisions are also made by individuals.

Two ways of operating an economy:

1. Voluntary action. 2. Force. Who uses force? Thieves and governments.

P. 4: some resources are scarce.

What is scarcity? A good is scarce if when it is available free, the quantity that people want to have is greater than the amount available.

Is time a scarce resource?

Principles of decision making.

1. People face tradeoffs.

Are most people totally satisfied with what they have, or do most always want more?

A major axiom or premise of economics is that human desires are unlimited.

Scarcity and unlimited desires imply that we can't get everything we want, so we must choose.

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

Opportunity cost: the best alternative given up when one makes a choice.

Are all costs are opportunity costs? Yes.

The economic cost of buying lunch is not the money you pay but the best things you could have bought if you did not spend it for lunch.

Therefore, for scarce resources, there are tradeoffs.

Another basic concept: efficiency. Various types.

Technical efficiency: ratio of outputs to inputs.

An efficient economy or machine implies maximum efficiency.

If a person, organization, or economy is operating inefficiently, it is possible to have more goods without giving up anything.

When you spend time or money or other resources, you usually face tradeoffs.

To study more, you give up the next most important thing you could have done.

In an economy, economists use "guns and butter" as symbols of the tradeoff between civilian goods and military goods.

Some choices seem like tradeoffs, but the real tradeoff is between efficient and inefficient uses of resources.

Example: environment.

Relative to today, is it economically possible to have both a better environment and an economy with more output? Yes, if the economy is more efficient. We can have more of both.

Another example: economic output versus social equity (a more equal distribution of income).

Can we have both? Yes. How? With more efficient taxation.

Redistribution reduces efficiency, but a shift in distribution can increase efficiency.

In making decisions, need to take into account the opportunity costs as well as the benefits.

3. Optimal decisions use marginal analysis.

"Optimal" means the best.

Mankiw says "rational people think at the margin".

What does "rational" mean in the economic context?

It means economizing.

A fundamental premise of economics is that people economize.

They maximize benefits or else minimize costs.

Rational decisions focus on the future rather than the past.

"Marginal" means extra or additional. Usually marginal analysis involves a small amount of the extra or one more unit.

The "marginal product" of labor is the extra output we get when we add one more worker.

The marginal cost of something is the cost of an additional unit of input or the extra cost of producing one more unit of output.

The marginal benefit of something is the extra benefit from increasing some activity.

The marginal benefit implies that the next unit is for the least important use.

For example, the marginal benefit of one more gallon of water might be for washing your car.

Usually, marginal costs increase and marginal benefits decline.

For example, does an extra hour of study usually give more or less benefit than the previous one?

Sample exam question:

A rational decision maker takes an action only if

a. the marginal benefit is greater than the marginal cost.

b. the marginal benefit is less than the marginal cost.

c. the average benefit is greater than the average cost.

d. the marginal benefit is greater than both the average cost and the marginal cost.

ANSWER: a. the marginal benefit is greater than the marginal cost.

4. People respond to incentives.

Folks tend to increase an activity when the cost is reduced and reduce it when the cost is more.

For example, if movies are cheaper, more people go to see movies.

Why? Because more is better.

If we reduce the cost of labor, more labor is employed.

How people interact

5. Trade is mutually beneficial (covered in chapter 3)

If voluntary exchange did not benefit all parties involved, they would not do it.

Why do people trade?

Another axiom or premise of economics: values are subjective.

Subjective values differ. Example of trading stamps.

6. Markets are efficient.

What is a "market" in economics?

A pure market consists of voluntary production, exchange, and consumption.

Why study the "pure market" since no economy has one?

The concept of a pure market helps us understand actual markets and government policy.

What does it mean for an act to be "voluntary"?

It means that there is no restriction other than to prohibit coercive harm to others.

Harm consists of an invasion, rather than a mere offense.

In a truly free society, there are no legal restrictions other than to prohibit coercive harm to others, and no cost imposed on peaceful and honest action.

In a pure market or truly free market, all action is voluntary.

Note that if the concept of voluntary action has a universal application,

this implies a universal, objective, rational ethic for humanity.

A country has liberty when its laws prohibit only coercive harm to others and do not impose arbitrary costs on peaceful and honest action.

Consumers are free to buy what pleases them, and producers need to make what the consumers want if they want to stay in business.

In a pure market, NOT "anything goes".

What about taxes? No arbitrary costs, hence no income, sales taxes.

Public revenue from: user fees, rents for resources owned by the people. (Parking meters.)

A pure market economy includes clear and enforced property rights to all resources.

Competition reduces costs to the efficient minimum.

That is why a pure market economy is as efficient as we can possibly get.

Adam Smith's term the "invisible hand" in the Wealth of Nations (p. 10).

Government plays three different roles in an economy.

First, government operates enterprises, like the post office.

Second, government enforces laws prohibiting and punishing coercive harm to others,

such as theft, murder, trespass, kidnaping, and fraud.

Third, governments have interventions: taxes, subsidies, and restrictions that interfere with voluntary action, reducing economic efficiency.

Mankiw discusses reason for the government to "intervene".

Does he define "intervene" or "intervention"? No.

Intervention: Government policy which imposes costs and restrictions on peaceful and honest action. "Peaceful" means the action does not coercively harm others.

Honest: no fraud or failure to honor a contract.

Intervention changes what people would otherwise voluntarily do.

Intervention hampers the market process by skewing prices and profits, thereby misallocating resources.

Examples? Price controls, farm restrictions, trade restrictions, substance prohibitions, taxation.

See page 10.

Actual economies are mixed economies, or interventionist.

7. Governments can sometimes improve market outcomes.

This is one proposition that is controversial.

It depends on how one defines "markets".

Shows the importance of asking WDYM and HDYK.

Market failure: the systematic inability of firms to provide the goods that consumers want.

The market therefore fails to allocate resources efficiently.

Market failure has to be distinguished from entrepreneurial failure.

Why would a market fail?

Mankiw says one possibility is external effects, or externalities.

An "externality" is an activity which involves uncompensated costs or benefits to others.

Can be positive (beneficial) or negative (harmful). Examples?

A prime example of a negative externality is pollution.

Pollution imposes damage on others; it invades their property.

Is this voluntary? No. So is uncompensated pollution part of the market?

No. If it is allowed by the government, it is in effect a subsidy to the polluter and a tax on those negatively affected.

The term "tax" has two meanings.

A tax in substance is an arbitrary cost imposed by government.

A tax in form is a payment made to government.

So an income tax is a tax both in form and in substance.

The military draft? A tax in substance. Jury duty, ditto.

Back to pollution. If the government allows cars or factories to pollute, without compensating the victims, is this a tax in substance? Yes. So it is not part of the market.

Uncompensated pollution is therefore not a market failure.

It is a government failure: the failure of government to make those who do damage compensate their victims. It is legalized theft.

When the government requires polluters to compensate their victims, it internalizes the externality and helps to establish a market economy.

I would not call this "improving a market outcome" but rather establishing the very preconditions of a market economy.

Another alleged type of market failure is that the pure market is accused of not distributing income fairly, and of leaving some people poor.

Do you agree?

What is a "fair" distribution? What criterion?

In a pure market: ethical rule: self-ownership.

One owns one's body, life, and time. Therefore one owns one's labor and its wages.

Market ethical rule: To the creator belongs his or her creation.

Mankiw "a market economy rewards people according to their ability to produce things that other people are willing to pay for."

True. But are all things "produced"?

What about resources that were not created by human action?

Two possibilities: 1) homesteading (first claimant owns it);

2) equal ownership of the benefits, as reflected in the market rent.

Self-ownership does not extend to what nature has produced.

#2 based on the moral premise of human equality.

#1 based on a rejection of equality with respect to the gifts of nature.

Rights of possession are necessary for markets, but rent is a surplus not needed to put land to its best use.

We cannot simply look at today's allocation of wealth and make conclusions about a free market, because today's outcomes are also the result of intervention.

So we need to analyze whether it is interventions such as subsidies that create more inequality and poverty than would be the case in a pure market.

In judging policy, we also need to take into account government failure.

Even if government could improve an outcome, that does not imply it actually will.

See page 11.

How the economy as a whole works.

8. The standard of living depends on production.

Seems obvious, yet this is often ignored in policy preferences.

Some think that if we just print more money, it will help the economy.

Or some think that the government can help the economy with public works, but this can just shift production rather than increase production.

Some think that legislation such as a minimum wage can increase living standards.

Such policies can increase incomes for some, but not overall.

What explains differences in living standards in different countries?

Productivity: the amount of output obtained from an amount of inputs, such as land and labor.

The main determinant of productivity growth is economic policy.

Theory and evidence shows a strong correlation between the degree of economic freedom and economic growth. See

Other explanations are of less importance.

US average income $35,000.

Long-run growth 2%.

Seems obvious, yet this is often ignored in policy preferences.

Some think that legislation such as a minimum wage can increase living standards.

Such policies shift income, but they decrease productivity and decrease overall income.

Productivity comes from:

1) natural resources

2) technology embedded in human capital and capital goods

3) an absence of imposed costs and restrictions

What explains differences in living standards in different countries?

The main determinant of productivity growth is economic policy.

Theory and evidence shows a strong correlation between the degree of economic freedom and economic growth. See

9. Excessive money expansion causes price inflation.

Monetary inflation: growth of the money supply times velocity, greater than the increase in the demand to hold money.

Price inflation: a continuous increase in the price level.

Price inflation is usually caused by monetary inflation.

Today, money is fiat, issued by central banks such as the Federal Reserve system.

When money is a commodity, monetary inflation is much less likely.

10. There is a short-run trade-off between inflation and unemployment.

If the central bank unexpectedly expands the money supply, there can be a temporary expansion of the economy, and therefore also of employment.

But then prices rise, and the expansion stops, and the inflation creates distortions that create a waste of resources and a future recession.

Questions, p. 16.

#3: Is the marginal benefit of a gallon of water large or small?

Problem set #3: Q#5, p. 16.