So, you want to know about the ten principles of economics. Before learning the ten basic principles of economics, let us first define the economic basics– the term economics itself.
The term economic is derived from the Greek word “OIKNOMOS” which means one who manages the household.
Scarcity is the central theme of economics. Scarcity is the concept that society has limited resources and cannot produce all the goods and services by itself.
Therefore, economics, in simple words, can be defined as the study of how society manages its scarce resources. Economists, also study how people interact with each other and analyze the trends that affect the economy as a whole.
The 10 principles of economics basically show how people make decisions, how they interact with each other, and the impact of their interaction and decision-making on the economy as a whole.
How People Make Decisions
Principle 1 – People Face Trade-Offs
To get something, people must give something. The classic example is guns and butter. For instance, the country must decide how much funds to allocate to defense spending and how much to allocate for public welfare.
Principle 2 – The cost of something is what you give up to get it
Since people face trade-offs, making decisions requires comparing the costs of alternatives. This cost is known as the opportunity cost.
Principle 3 – Rational people think at the margin
Rational people are those who do their best to achieve their objective given the available opportunities. Economists assumed that people are rational. Here, the marginal change is the small incremental adjustments. Rational people make decisions by comparing the marginal cost to the marginal benefit. A rational decision maker takes an action if and only if the action’s marginal benefits exceed marginal costs.
Principle 4 – People respond to incentives
An incentive (reward/punishment) is something that induces a person to take action.
How People Interact
(How an individual’s decision affects other people)
Principle 5 – Trade can make everyone better off
Trade allows each person to specialize in those activities that he or she does best. By trading, we get more variety at lower costs.
Principle 6 – Markets are usually a good way to organize economic activity
Previously, government played an active role in planning the economy. Thus, there was the concept of central planning of the economy. Government usually organized economic activities to promote the well-being of all.
With the passage of time, a much better concept of the market economy (decentralized economy) has taken over.
Now the role of the central planner is replaced by firms and households. Both these entities interact in a marketplace where prices and self-interest guide their decision. This concept was first introduced by Adam Smith in 1776 in his book “The Wealth of Nations” (invisible hand). The prices are the instrument with which the invisible hand directs economic activities. Buyers usually look at price to determine demand, and sellers look at the price to determine supply.
Principle 7 – Governments can sometimes improve market outcomes
The invisible hand can only work its magic if the government enforces the rules and regulations and maintains the institutions that are key for the market economy. The government may also need to promote efficiency or equality to protect the rights of the public.
Efficiency – the maximum benefits from resources
Efficiency: The government needs to interfere in market affairs in order to improve the efficiency of the market. In three cases, the government must interfere to improve the market outcomes.
- In case of market failures, the government must intervene to produce an efficient allocation of resources.
- In the case of externalities. For example, pollution from industry affects the health of the public. The government must take action to protect the rights of the bystander.
- And in the case when one person or a group accumulates market power to influence the market prices.
Equality – the equal distribution of benefits
The invisible hand does not assure that everyone has sufficient food, clothing, and healthcare. Therefore, it’s the government’s job to make sure that each member of society gets adequate food, clothing, and healthcare along with other necessities of life.
How the Economy as a Whole Works
Principle 8 – Trade can make everyone better off
All variation in living standards is attributed to differences in the level of productivity. Productivity is the number of goods and services produced from each unit of labor input. When thinking about how any policy will affect living standards, the key question is how it will affect the productivity of a country.
Principle 9 – Prices rise when the government prints too much money
When there is an increase in the overall level of prices in the economy, we say that there is inflation.
Principle 10 – Society faces a short-term trade-off between inflation and unemployment
When government prints money it raises the prices in the long run. However, in the short term, it stimulates
- The overall level of spending, increasing the demand.
- With increased demand, the prices for products and services also rise. However, there is also a shortage of products and services from the increased demand. Therefore, there is increased hiring.
- More hiring means lower unemployment.
Here, the term “business cycles” is defined as the fluctuations in economic activities such as employment and production. Thus, the short-run trade-off between inflation and unemployment plays a key role in the analysis of business fluctuations.
The ten basic principles of economics gave us an idea about the nature of the study of economics. The whole economy revolves around these 10 principles. In other words, these ten principles are aggregated into three basic concepts: hope people make decisions, how people interact, and how their decisions and interactions affect the economy as a whole.