Basic Principles of Economics
What Economics Is All About
Scarcity: the limited nature of societys
resources
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
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HOW PEOPLE MAKE DECISIONS
Principle #1: People Face Tradeoffs
All 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.
Protecting the environment requires resources
that could otherwise be used to produce consumer goods.
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HOW PEOPLE MAKE DECISIONS
Principle #1: People Face Tradeoffs
Society faces an important tradeoff:
efficiency vs. equality
Efficiency: when society gets the most from its
scarce resources
Equality: when prosperity is distributed uniformly
among societys 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.
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HOW PEOPLE MAKE DECISIONS
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.
The opportunity cost of any item is
whatever must be given up to obtain it.
It is the relevant cost for decision making.
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HOW PEOPLE MAKE DECISIONS
Principle #2: The Cost of Something Is What You Give Up to Get It
Examples: 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.
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HOW PEOPLE MAKE DECISIONS
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.
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HOW PEOPLE MAKE DECISIONS
Principle #3: Rational People Think at the Margin
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.
When a manager considers whether to increase
output, she compares the cost of the needed labor and materials to the extra revenue.
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HOW PEOPLE MAKE DECISIONS
Principle #4: 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.
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Applying the principles
You are selling your 1996 Mustang. You have already spent $1000 on repairs. At the last minute, the transmission dies. You can pay $600 to have it repaired, or sell the car as is. In each of the following scenarios, should you have the transmission repaired? Explain.
A. Blue book value is $6500 if transmission works, $5700 if it doesnt B. Blue book value is $6000 if transmission works, $5500 if it doesnt
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Answers
Cost of fixing transmission = $600
A. Blue book value is $6500 if transmission works, $5700 if it doesnt
Benefit of fixing the transmission = $800 ($6500 5700). Its worthwhile to have the transmission fixed.
B. Blue book value is $6000 if transmission works, $5500 if it doesnt
Benefit of fixing the transmission is only $500. Paying $600 to fix transmission is not worthwhile.
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Answers
Observations:
The $1000 you previously spent on repairs is
irrelevant (Sunk Cost). What matters is the cost and benefit of the marginal repair (the transmission).
The change in incentives from scenario A
to scenario B caused your decision to change.
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HOW PEOPLE INTERACT
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
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HOW PEOPLE INTERACT
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 means determining what goods to produce how to produce them how much of each to produce who gets them
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HOW PEOPLE INTERACT
Principle #6: Markets Are Usually A Good Way to Organize Economic Activity
A market economy allocates resources through
the decentralized decisions of many households and firms as they interact in markets.
Famous insight by Adam Smith in
The Wealth of Nations (1776): Each of these households and firms acts as if led by an invisible hand to promote general economic well-being.
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HOW PEOPLE INTERACT
Principle #6: Markets Are Usually A Good Way to Organize Economic Activity
The invisible hand works through the price system: The interaction of buyers and sellers
determines prices.
Each price reflects the goods 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 societys economic well-being.
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HOW PEOPLE INTERACT
Principle #7: Governments Can Sometimes Improve Market Outcomes
Important role for govt: enforce property rights
(with police, courts)
People are less inclined to work, produce, invest,
or purchase if large risk of their property being stolen.
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HOW PEOPLE INTERACT
Principle #7: Governments Can Sometimes Improve Market Outcomes
Market failure: when the market fails to allocate
societys resources efficiently
Causes:
Externalities, when the production or consumption
of a good affects bystanders (e.g. pollution) Market power, a single buyer or seller has substantial influence on market price (e.g. monopoly)
In such cases, public policy may promote efficiency.
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HOW PEOPLE INTERACT
Principle #7: Governments Can Sometimes Improve Market Outcomes
Govt may alter market outcome to promote equity If the markets distribution of economic well-being
is not desirable, tax or welfare policies can change how the economic pie is divided.
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HOW THE ECONOMY AS A WHOLE WORKS
Principle #8: A countrys 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 U.S. standard of living today is about
eight times larger than 100 years ago.
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HOW THE ECONOMY AS A WHOLE WORKS
Principle #8: A countrys standard of living depends on its ability to produce goods & services.
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.
Other factors (e.g., labor unions, competition from
abroad) have far less impact on living standards.
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HOW THE ECONOMY AS A WHOLE WORKS
Principle #9: 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.
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HOW THE ECONOMY AS A WHOLE WORKS
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.
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