Introduction
. . . The word economy comes from a Greek
word for one who manages a household.
A household, a manager and an economy
face many decisions:
Who will work?
What goods and how many of them should be
produced?
What resources should be used in production?
At what price should the goods be sold?
Introduction
Society and Scarce Resources:
The management of societys resources is
important because resources are scarce.
Scarcity. . . means that society has limited resources
and therefore cannot produce all the goods and
services people wish to have.
Economics is the study of how society manages its
scarce resources.
TEN PRINCIPLES OF
ECONOMICS
How people make decisions.
People face tradeoffs.
The cost of something is what you give up to get it.
Rational people think at the margin.
People respond to incentives.
TEN PRINCIPLES OF
ECONOMICS
How people interact with each other.
Trade can make everyone better off.
Markets are usually a good way to organize
economic activity.
Governments can sometimes improve economic
outcomes.
TEN PRINCIPLES OF
ECONOMICS
The forces and trends that affect how the
economy as a whole works.
The standard of living depends on a countrys
production.
Prices rise when the government prints too much
money.
Society faces a short-run tradeoff between inflation
and unemployment.
Principle #1: People Face Tradeoffs.
To get one thing, we usually have to give up
another thing.
Guns v. butter
Food v. clothing
Leisure time v. work
Efficiency v. equity
Making decisions requires trading
off one goal against another.
Principle #1: People Face Tradeoffs
Efficiency v. Equity
Efficiency means society gets the most that it can
from its scarce resources.
Equity means the benefits of those resources are
distributed fairly among the members of society.
Principle #2: The Cost of Something Is What
You Give Up to Get It.
Decisions require comparing costs and benefits
of alternatives.
Whether to go to college or to work?
Whether to study or go out on a date?
Whether to go to class or sleep in?
The opportunity cost of an item is what you
give up to obtain that item.
Principle #3: Rational People Think at the
Margin.
Marginal changes are small, incremental
adjustments to an existing plan of action.
People make decisions by comparing
costs and benefits at the margin.
Principle #4: People Respond to Incentives.
Marginal changes in costs or benefits motivate
people to respond.
The decision to choose one alternative over
another occurs when that alternatives marginal
benefits exceed its marginal costs!
Principle #5: Trade Can Make Everyone
Better Off.
People gain from their ability to trade with one
another.
Competition results in gains from trading.
Trade allows people to specialize in what they
do best.
Principle #5: Trade Can Make Everyone
Better Off.
Example: 2 Countries, produce only 2 products
Country
Bread
Shirt
1 hour per pound
2 hours per shirt
6 hours per pound
3 hours per shirt
Country A has `Absolute Advantage in
producing both products.
Principle #5: Trade Can Make Everyone
Better Off.
Now in terms of opportunity cost:
Country
A
B
Bread
1/2
2
Shirt
2
1/2
For country A, opportunity cost of bread in terms of shirt is .
This table indicates that country A has comparative advantage
in producing bread whereas country B has comparative
advantage in producing shirt.
Principle #5: Trade Can Make Everyone
Better Off.
Now, assuming that, total labor in country A: 160 and in B: 300.
Assuming further that each labor works only one hour daily.
Now, in the absence of trade:
Country
Bread
Shirt
GDP
80
40
120
25
50
75
105
90
195
Principle #5: Trade Can Make Everyone
Better Off.
Now, in the presence of trade:
Country
Bread
Shirt
GDP
160
160
100
100
160
100
260
Country A specializes in Bread and country B in Shirt.
Total (Global) production of Bread and Shirt increased
GDP for both countries also have been increased sharply.
Principle #6: Markets Are Usually a Good
Way to Organize Economic Activity.
A market economy is an economy that allocates
resources through the decentralized decisions of
many firms and households as they interact in
markets for goods and services.
Households decide what to buy and who to work
for.
Firms decide who to hire and what to produce.
Principle #6: Markets Are Usually a Good
Way to Organize Economic Activity.
Adam Smith made the observation that
households and firms interacting in markets act
as if guided by an invisible hand.
Because households and firms look at prices when
deciding what to buy and sell, they unknowingly
take into account the social costs of their actions.
As a result, prices guide decision makers to reach
outcomes that tend to maximize the welfare of
society as a whole.
Principle #7: Governments Can Sometimes
Improve Market Outcomes.
Market failure occurs when the market fails to
allocate resources efficiently.
When the market fails (breaks down)
government can intervene to promote efficiency
and equity.
Principle #7: Governments Can Sometimes
Improve Market Outcomes.
Market failure may be caused by
an externality, which is the impact of one person or
firms actions on the well-being of a bystander.
market power, which is the ability of a single
person or firm to unduly influence market prices.
Principle #8: The Standard of Living Depends
on a Countrys Production.
Almost all variations in living standards are
explained by differences in countries
productivities.
Productivity is the amount of goods and
services produced from each hour of a workers
time.
Principle #8: The Standard of Living Depends
on a Countrys Production.
Standard of living may be measured in different
ways:
By comparing personal incomes.
By comparing the total market value of a nations
production.
Principle #9: Prices Rise When the
Government Prints Too Much Money.
Inflation is an increase in the overall level of
prices in the economy.
One cause of inflation is the growth in the
quantity of money.
When the government creates large quantities
of money, the value of the money falls.
Principle #10: Society Faces a Short-run
Tradeoff Between Inflation and
Unemployment.
The Phillips Curve illustrates the tradeoff
between inflation and unemployment:
Inflation Unemployment
Its a short-run tradeoff!
Summary
When individuals make decisions, they face
tradeoffs among alternative goals.
The cost of any action is measured in terms of
foregone opportunities.
Rational people make decisions by comparing
marginal costs and marginal benefits.
People change their behavior in response to the
incentives they face.
Summary
Trade can be mutually beneficial.
Markets are usually a good way of coordinating
trade among people.
Government can potentially improve market
outcomes if there is some market failure or if
the market outcome is inequitable.
Summary
Productivity is the ultimate source of living
standards.
Money growth is the ultimate source of
inflation.
Society faces a short-run tradeoff between
inflation and unemployment.
