Chapter 1: Ten Principles of Economics

the principles of how people make decisions

• people face trade-offs

• the cost of something is what you give up to get it

• rational people think at the margin

• people respond to incentives

the principles of how people interact

• trade can make everyone better off

• markets are usually a good way to organize economic activity

• governments can sometimes improve market outcomes

the principles of how the economy as a whole works

• a country’s standard of living depends on its ability to produce goods and services

• prices rise when the government prints too much money

• society faces a short-run trade-off between inflation and unemployment

people face trade-offs

to get one thing you want, you have to give up another thing you want

classic trade-off examples

(1) “guns and butter”: the more a society spends on the military, the less it can spend on consumer goods

(2) clean environment and income level: laws requiring firms to reduce pollution may raise the cost of producing goods and services. because of these higher costs, the firms are likely to earn smaller profits, pay lower wages, charge higher prices, or some combination of these thingse

efficiency

when society gets the most it can possibly get out of the resources it has using the technology it has available

**society is getting the greatest benefits from its scarce resources

**refers to the SIZE of the economic pie

equality

the benefits obtained from resources are being uniformly distributed among society

**refers to the SIZE of the slices of the economic pie

efficiency vs equality trade-off

Ex. government policies aimed at reducing inequality i.e. welfare or unemployment benefits help the members of society most in need whereas others i.e. personal income tax require the financially successful to contribute more than others to support the government. these policies increase equality but may decrease efficiency.

when the government redistributes money from the rich to the poor, they may be lowering the incentive to work hard for people are all income levels —> resulting in people working less and producing less and fewer goods

**when the government cuts the economic pie into more equal slices, the pie sometimes shrinks

opportunity cost (principle 2: the cost of something is what you give up to get it)

the cost of something is what you give up to obtain it

important assumption that economists make about people

that they’re rational

rational people

systematically and purposefully do the best they can to achieve their goals, given the available opportunities

**make decisions by comparing marginal benefits and marginal costs

marginal change

an incremental adjustment to an existing plan of action

marginal thinking example q:

Ex. deciding whether to watch a movie tonight: you already pay $30 a month for a streaming service that gives you unlimited access to its film library, and you typically watch 5 movies a month. what cost should you consider when deciding to stream another movie?

cost to consider = opportunity cost

marginal thinking process: you already pay $30 a month, and that money is already gone. it doesn’t matter how many movies you watch, it still costs that much so there's no marginal cost. however, the opportunity cost is the time that you’re giving up to watch the movie when you could be working, spending time with friends, etc. But, the marginal benefit is that watching the movie will likely bring enjoyment.

marginal cost

the extra money you have to pay for something OTHER than what you’ve already paid

**in marginal thinking, DON’T consider payments you’ve already made, think about what you would have to pay now

when do rational decision makers take an action?

if and ONLY if the action’s marginal benefit exceeds its marginal cost

incentive

something that induces a person to act i.e. the prospect of a punishment or reward

Ex. being taxed on cigarettes —> likely won’t buy them

Ex. getting tax breaks if their company pollutes less —> more likely to try to develop cleaner technologies

what happens when policymakers fail to consider incentives

the policies they enact may have unintended consequences

economics is best defined as the study of

how society manages its scarce resources

your opportunity cost of going to a movie is

the total cash you spend needed to go to the movie plus the value of your time

a marginal change is one that
a. is not important for public policy

b. incrementally alters an existing plan

c. does not influence incentives

d. makes an outcome inefficient

b. incrementally alters an existing plan

is trade like a context where one side wins and the other loses?

no - trade between two countries can make each country better off, even when trade is competitive it can lead to a win-win outcome for both countries

**trade allows countries to specialize in what they do best and to enjoy a greater variety of goods and services

communist economy

central planner decides what goods and services are produced, how much is produced, who produces them, and who consumes them

**theory = government needed to organize economic activity to ensure equality

market economy

decisions of a central planner are replaced by the millions of decisions by households and firms, firms and households interact in a market place

**based on decentralized decision making and self-interested decision makers but is still successful

firms

decide who to hire and what to produce

households

decide where to work and what to buy with their incomes

invisible hand theory

firms and households in competitive markets act like they’re guided by an invisible hand that leads them to desirable outcomes

how are prices related to the invisible hand?

invisible hand is directed by prices: sellers look at the price when deciding how much to supply and buyers look at price when deciding how much to demand

result = price reflects both seller’s cost of production and the value of the good to the buyers

**prices adjust to guide market participants to reach outcomes that typically maximize the well-being of society as a whole

what impedes the invisible hand

invisible hand is impeded when a government prevents prices from adjusting to supply and demand. this stops the invisible hand from coordinating the decisions of the firms and households that make up an economy

**this explains the adverse effect of most taxes on efficiency

if the invisible hand is so great, what is left for a government to do in an economy?

the invisible hand only works if the government enforces the rules and maintains the institutions required for a market economy:

• property rights - so individuals can own and control scarce resources

  • film companies won’t produce movies if it’s legal for people to pirate copies

• invisible hand is NOT omnipotent

two broad rationales for a government to intervene in the economy and change the allocation of resources that people would choose on their own:

to promote efficiency

to promote equality

market failure

when the market doesn’t produce an efficient allocation of resources on its own

causes of market failures

(1) externalities

(2) market power

externality

the impact of one person’s actions on the well-being of a bystander

Ex. pollution

when the production of a good pollutes the air and creates health problems for those who live near the factories, the market may fail to take this cost into account

market power

the ability of a single person or firm/group to have a monopoly and therefore get to be in charge of the market price of an entire market

Ex. there’s only one well in town owned by one person so that person has the power to significantly increase those prices

invisible hand and equality

when the invisible hand yields efficient outcomes, it can leave large disparities in well-being. a market economy rewards people according to their ability to produce things that other people are willing to pay for

**the invisible hand does not ensure that everyone has enough food, shelter, healthcare, etc. —> requires government intervention

what is the single largest factor accounting for differences across living standards in different countries and over time?

productivity - the amount of goods and services produced by each unit of labor input

higher productivity = higher standard of living

lower productivity = lower standard of living

what determines the growth rate of a nation’s average income

the growth rate of a nation’s productivity

productivity ^^ = average income ^^ = living standards ^^

what are some important but less significant factors in determining the standard of living in a country

labor unions, increasing minimum wage, etc.

why did the US experience such a great increase in living standards in the 1970s?

bc of a significant increase in productivity

what is the key to thinking about how any policy will affect living standards

think about how the policy will affect the economy’s ability to produce goods and services

to boost living standards, policymakers need to raise productivity by ensuring that workers are well trained and have access to the best technological advancements

inflation

the value of $1 goes down due to an increase in the money supply which normally happens when a government prints more money

short-run effects of inflation

• increased amount of money in the economy stimulates the overall level of spending and therefore the demand for goods and services

• higher demand, will, over time, cause firms to raise their prices but in the short term encourages them to hire more workers and produce a larger quantity of goods and services

• lower unemployment**

business cycle

fluctuations in economic activity measured by the productions of goods and services or unemployment/employment rates

**does NOT refer to the level of growth in the money supply

is there such a thing as an abundant resource

no, all resources are scarce - saying scarce resource and resource is the same thing

when was the last time the US experienced high inflation (according to the textbook)

1970s

productivity

the quantity of goods and services each unit of labor can produce

**important concept used by economists