In this chapter,
look for the answers to these questions:
•What kinds of questions does economics
address?
•What
are the principles of how people make decisions?
•What
are the principles of how people interact?
•What
are the principles of how the economy as
a whole works?
a whole works?
•Economics
has two main branches:-
•Micro
economics and Macro economics
What Economics Is All About
§Scarcity:
the limited nature of society’s resources
§Economics:
the study of how society manages its scarce resources, e.g.
§how people decide what to buy, save
§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
§The first 6 principles relate with
micro economics while the rest relate to macro economics
The principles of
HOW PEOPLE
MAKE DECISIONS
how many workers to hire
HOW PEOPLE
MAKE DECISIONS
PRINCIPLE #1:
People
Face TradeoffsAll decisions involve tradeoffs. Examples:§Going to a party the night before
your midterm leaves less time for studying.§Having more money to buy stuff
requires working longer hours, which leaves less time
for leisure.
for leisure.§Protecting the environment requires
resources
that could otherwise be used to produce
consumer goods.
that could otherwise be used to produce
consumer goods.
§Society faces an important
tradeoff:
efficiency vs. equality
efficiency vs. equality
§Efficiency:
when society gets the most from its scarce resources
§Equality:
when prosperity is distributed uniformly among society’s members
§Tradeoff: To achieve greater equality,
could redistribute income from wealthy to poor.
But this reduces incentive to work and produce, shrinks the size of the economic “pie.”
could redistribute income from wealthy to poor.
But this reduces incentive to work and produce, shrinks the size of the economic “pie.”
PRINCIPLE #2:
The Cost of Something Is
What You Give Up to Get It
The Cost of Something Is
What You Give Up to Get It
§Making decisions requires comparing the
costs and benefits of alternative choices.
§The opportunity cost of any item is
whatever must be given up to obtain it.
whatever must be given up to obtain it.
§It is the relevant cost for
decision making.
Examples:
The opportunity cost of…
The opportunity cost of…
…going
to college for a year is not just the tuition, books, and fees, but also the
foregone wages.
…seeing a movie is not just the
price of the ticket, but the value of the time you spend in the theater
PRINCIPLE
#3:
Rational People Think at the Margin
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.
Examples:
§When a student considers whether to
go to college for an additional year, he compares the fees & foregone wages
to the extra income
he could earn with the extra year of education.
he could earn with the extra year of education.
§When a manager considers whether to
increase output, she compares the cost of the needed labor and materials to the
extra revenue.
PRINCIPLE
#4:
People Respond to Incentives
People Respond to Incentives
§Incentive: something
that induces a person to act, i.e.
the
prospect of a reward or punishment.
§Rational people respond to
incentives.
Examples:
§When gas prices rise, consumers buy
more hybrid cars and fewer gas guzzling SUVs.
§When cigarette taxes increase,
teen smoking falls.
teen smoking falls.
The principles of
HOW PEOPLE
INTERACT
HOW PEOPLE
INTERACT
PRINCIPLE
#5:
Trade Can Make Everyone Better Off
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.
people can specialize in producing one good or service and exchange it for other goods.
§Countries also benefit from trade
and 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
Markets Are Usually A Good Way to
Organize Economic Activity
§
§Market:
a group of buyers and sellers
(need not be in a single location)
(need not be in a single location)
§“Organize economic activity” means determining
§what goods to produce
§how to produce them
§how
much of
each to produce
§who gets them
§The invisible hand works through
the price system:
§The interaction of buyers and
sellers
determines prices.
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
Governments Can Sometimes
Improve Market Outcomes
§Important role for govt: enforce
property rights
(with police, courts)
(with police, courts)
§People are less inclined to work,
produce, invest, or purchase if large risk of their property being stolen.
§Govt may alter market outcome to
promote equity.
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
A Country’s Standard of Living Depends on Its Ability to Produce Goods & Services
§Huge variation in living standards across
countries and over time:
§Average income in rich countries is
more than ten times average income in poor countries.
§The
standard of living today in some developed countries is about eight
times larger than 100 years ago.
§The most important determinant of
living standards: productivity, the amount of goods and services
produced per unit of labor.
§Productivity depends on the
equipment, skills, and technology available to workers.
PRINCIPLE
#9:
Prices Rise When the Government Prints Too Much Money
Prices Rise When the Government Prints Too Much Money
§Inflation:
increases in the general level of prices.
§In the long run, inflation is
almost always caused by excessive growth in the quantity of money, which causes
the value of money to fall.
§The faster the govt creates money,
the greater the inflation rate.
the greater the inflation rate.
PRINCIPLE
#10:
Society Faces a Short-run Tradeoff Between Inflation and Unemployment
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.
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.
SUMMARY
The
principles of decision making are:
•People face tradeoffs.
•The cost of any action is measured
in terms of foregone opportunities.
•Rational people make decisions by
comparing marginal costs and marginal benefits.
•People respond to incentives.
The principles of interactions among
people are:
•Trade can be mutually beneficial.
•Markets are usually a good way of
coordinating trade.
•Govt can potentially improve market outcomes
if there is a market failure or if the market outcome is inequitable.
The
principles of the economy as a whole are:
•Productivity is the ultimate source of
living standards.
•Society faces a short-run tradeoff
between inflation and unemployment.