Chapter 1: Ten Principles of Economics

Scarcity: Society has limited resources; cannot produce all goods/services people wish to have Economics (Greek for "one who manages a household"): Study of how society manages its scarce resources How people make decisions How people interact with one another Analyze forces/trends that affect the economy as a whole How People Make Decisions: Principle 1: People face tradeoffs Tradeoff: Spending time, effort, money on one goal means less for the other "No such thing as a free lunch" EXAMPLES: "Guns vs. butter": More money spent on national defense (guns) = less spent on consumer goods (butter) Clean environment vs. high level of income: Laws requiring firms to reduce pollution result in lower efficiency, and thus smaller profit margins Efficiency vs. Equality Efficiency: Society gets maximum benefits from its scarce resources Size of the economic pie relative to the pan Equality: Distributing economic prosperity equally among members of society How the pie is sliced EXAMPLE: Welfare system, unemployment insurance, individual income tax, etc. redistribute wealth from rich to poor (equality) Reward for working hard is reduced, thus, causing a reduction in productivity as well (efficiency) Principle 2: The cost of something is what you give up to get it Opportunity cost: Whatever must be given up to obtain some item (not simply monetary worth) EXAMPLES: Time spent on college education could be spent on working, etc. College athletes might drop out to pursue professional athletic careers; opportunity cost of education is too high Principle 3: Rational people think at the margin Rational people: Those who systematically and purposefully do the best they can to achieve their objectives Weighs marginal costs vs. marginal benefits Marginal change: Small increment/adjustment to a plan of action EXAMPLE: One hour more of studying instead of TV (marginal change), rather than only studying or only TV (all-ornothing approach) EXAMPLES: Airlines will always sell cheap tickets to fill seats because the monetary benefit of the passenger's money will always outweigh cost of adding one more passenger Why diamonds cost more than a cup of water: Benefit of obtaining one more diamond (rare) outweighs benefit of obtaining one more cup of water (plentiful)

 Principle 4: People respond to incentives Incentive: Something that induces action, such as a reward or punishment EXAMPLES: A higher price in market gives incentive for buyers to consume less and sellers to produce more Increased gasoline prices c camels (India), carpooling, public transportation, living closer, online schooling, more fuel-efficient automobiles (in U.K. as result of gasoline tax; Airbus/Boeing aircraft) Policies on auto-safety: Seatbelt laws more reckless driving Fewer deaths per accident, but more accidents and pedestrian deaths How People Interact: Principle 5: Trade can make everyone better off Trade allows specialization in what one does best, and thus can be mutually beneficial Principle 6: Markets are usually a good way to organize economic activity Market economy: Decisions to allocate resources are made by millions of firms and households Their interactions for goods and services dictate the economy Despite decentralized decision-making and self-interested decision-makers, market economies are remarkably successful Adam Smith's "Invisible Hand" (1776): Households/firms interacting in economy (buyers look at price to determine demand, sellers look at price to determine supply) are guided by an "invisible hand" (perfect balance of supply/demand) that leads to desirable market outcomes as a whole Corollary: When government prevents natural adjustment of supply/demand (taxes and policies that directly control prices), impedes invisible hand's ability to maximize society's well-being Principle 7: Governments can sometimes improve market outcomes Reason 1: Invisible hand can only work if government enforces rules and maintains institutions that are key to a functioning economy Property rights: Ability to own and exercise control over scarce resources Reason 2: Government should intervene and change allocation of resources to promote either: Efficiency: Market failure: When a market fails on its own to allocate resources efficiently Market power: The ability of an individual/single group of economic actors to have a substantial influence on prices Externality: Influence on actions of a by-stander EXAMPLE: Pollution presents both environmental consequences and costs for clean-up Equality: Invisible hand often leaves large economic disparities between wealth classes How the Economy as a Whole Works: Principle 8: A country's standards of living depend on its ability to produce goods and services Productivity: The quantity of goods produced per unit labor Explains large differences in living standards among countries and over time Living standards depend exclusively on productivity:

Implications: Slow growth of U.S. incomes during 70s and 80s was due to flagging productivity, NOT increased competition from Japan Increasing productivity, NOT labor unions/minimum wage laws, explain rising living standards over past century Policy-making aimed at increasing living standards should boost productivity (education/technology) Principle 9: Prices rise when the government prints too much money Inflation: An increase in the overall level of prices in the economy Avoided by policymakers as much as possible Culprit is almost always growth in quantity of money Principle 10: Society faces a short-run tradeoff between inflation and unemployment Short-run effects of monetary injections into economy: 1.) Increasing amount of money in economy stimulates overall level of spending and thus, demands for goods and services 2.) Higher demand may cause firms to raise prices, but in the meantime, it encourages them to hire more workers and produce a larger quantity of goods and services 3.) More hiring means lower unemployment Business cycle: Irregular/largely unpredictable fluctuations in economic activity, as measured by the production of goods and services Policymakers can influence overall demand for goods and services by changing the amount the government spends, taxes, and amount of money it prints EXAMPLE: President Obama created a stimulus package of reduced taxes and increased government spending, while the Federal Reserve increased the supply of money Goal was to battle unemployment by "bad bets" on the housing market and the resulting financial downturn

Chapter 2: Thinking Like an Economist

Microeconomics: How households/firms make decisions in markets Macroeconomics: Study of economy-wide phenomena (unemployment, inflation, economic growth, etc.) Scientific method: Interplay between observation and theory Economists cannot experiment; rather, they are limited by the natural "experiments" of history Assumptions: Economists simplify problems by making assumptions EXAMPLES: International trade only two countries producing two goods each Studying short-run effects of policy prices fixed Studying long-run effects of policy prices flexible Economic Models: Circular-flow diagram: Visual model that shows how dollars flow through markets among households and firms Decision-makers: Firms: Outputs: Goods and services Inputs: Factors of production: Households: Labor, land, and capital Inputs:

 Goods and services Factors of production Outputs: Markets: Markets for goods and services: Markets for factors of production: Buyers: Buyers: Households Firms Sellers: Sellers: Firms Households EXAMPLE: Dollar bill used at Starbucks revenue to rent to landlord/wages for workers money goes back to household cycle repeats Production possibilities frontier: Shows combinations of output that economy can produce Assumption is that only cars and computers are produced Any combination outside frontier is not feasible given economy's scarce resources Illustrates several principles of economics: People face tradeoffs: Once we have reached efficient points on the frontier, producing more of one good means producing less of the other The cost of something is what you give up to get it: Opportunity cost of one good is measured in terms of the other good Cost of one car (x) in terms of computers (y) is slope of line (y/x) Economic growth: Technological advance enables more computers to be produced for any given number of cars Shift in production possibilities frontier along y-axis Spillover effect to car industry, assuming computers are being produced Bowed-shape can be explained by fact that industry always tries to retain best workers Thus, if economy is using most of its resources to make computers, the cost of giving up a bad computermaker is low Opportunity cost of a car (converting computer-maker to a car-maker) is low and frontier is flat If the economy is using most of its resources to make cars, only a limited number of computer-makers are left and all are good Opportunity cost of a car (converting computer-maker to a car-maker) is high and frontier is steep