Chapter 1 Principles of Economics

• Economics


  The study of how society manages its scarce resources, e.g. how people decide what to buy, how much to work, save, and spend, how firms decide how much to produce, how many workers to hire, how society decides how to divide its resources between national defense, consumer goods, protecting the environment, and other needs
• Microeconomics


  Examines the behavior of basic elements in the economy, including individual agents and markets, their interactions, and the outcomes of interactions. Individual agents may include, for example, households, firms, buyers, and sellers.
• Macroeconomics


  Analyzes the entire economy (meaning aggregated production, consumption, savings, and investment) and issues affecting it, including unemployment of resources (labor, capital, and land), inflation, economic growth, and the public policies that address these issues (monetary, fiscal, and other policies).
• Scarcity


  The limited nature of society's resources
• Economics


  Oikos "house" and Nomos "custom" or "law". Hence, "rules of the house" (hold for good management). Focuses on the behavior and interactions of economic agents and how economies work
• Principle #1 People Face Tradeoffs


  All decisions involve tradeoffs.
• Efficiency


  when society gets the most from its scarce resources
• Equality


  when prosperity is distributed uniformly among society’s members
• Principle #2:The Cost of Something Is What You Give Up to Get It


  Making decisions requires comparing the costs and benefits of alternative choices.
• Opportunity Cost


  whatever must be given up to obtain it. It is the relevant cost for decision making.
• Principle #3 Rational People Think at the Margin


  Rational people - systematically and purposefully do the best they can to achieve their objectives.

  make decisions by evaluating costs and benefits of marginal changes – incremental adjustments to an existing plan.
• Principle #4 People Respond to Incentives


  Incentive - something that induces a person to act

  Rational people respond to incentives.
• Principle #5 Trade Can Make Everyone Better Off


  Rather than being self-sufficient, people can specialize in producing one good or service and exchange it for other goods.

  Countries also benefit from trade & specialization:

  • Get a better price abroad for goods they produce Buy other goods more cheaply from abroad than could be produced at home
• Principle #6 Markets Are Usually A Good Way to Organize Economic Activity

  Market - a group of buyers and sellers (need not be in a single location)

  “Organize economic activity”

  • what goods to produce
  • how to produce them
  • how much of each to produce
  • who gets them
• Market Economy


  allocates resources through the decentralized decisions of many households and firms as they interact in markets.
• The Wealth of Nations (1776) by Adam Smith


  Each of these households and firms acts as if “led by an invisible hand” to promote general economic well-being.
• Price System


  The invisible hand.

  • The interaction of buyers and sellers determines prices.
  • Each price reflects the good’s value to buyers and the cost of producing the good.
  • Prices guide self-interested households and firms to make decisions that, in many cases, maximize society’s economic well-being.
• Principle #7 Governments Can Sometimes Improve Market Outcomes


  Role for Government: enforce property rights.

  People are less inclined to work, produce, invest, or purchase if large risk of their property being stolen.
• Market Failure


  when the market fails to allocate society’s resources efficiently
• Externalities


  when the production or consumption of a good affects bystanders
• Market Power


  a single buyer or seller has substantial influence on market price.
• Public Policy


  Promote efficiency to solve market failure
• Government may alter market outcome to promote equity.
• If the market’s distribution of economic well-being is not desirable, tax or welfare policies can change how the economic “pie” is divided.
• Principle #8 A country’s standard of living depends on its ability to produce goods & services.


  Huge variation in living standards across countries and over time.
• Productivity


  The amount of goods and services produced per unit of labor.

  The most important determinant of living standards.

  Depends on the;

  • equipment
  • skills
  • technology available to workers.
• Principle #9 Prices rise when the government prints too much money.


  The faster the govt creates money, the greater the inflation rate.
• Inflation


  Increases in the general level of prices caused by excessive growth in the quantity of money, which causes the value of money to fall.
• Principle #10 Society faces a short-run tradeoff between inflation and unemployment


  In the short-run (1 – 2 years), many economic policies push inflation and unemployment in opposite directions.

  Other factors can make this tradeoff more or less favorable, but the tradeoff is always present.