Chapter 1: Ten Principles of Economics Theory

What is the Greek word for economy and what does it mean?

(1) oikonomos, one who manages a household

What is economics all about?

(1) decision making

(2) coordination

(3) big central incentive system

(4) behavior of an economy reflects the behavior of the individuals within it

What is fundamental economic problem?

(1) scarcity

What is scarcity?

(1) human wants are unlimited, resources are limited, choices must be made

Economics is the study of…

(1) [the study of] how society manages its scarce resources

(2) human behavior

3 Main Areas of the Scope of Economics

(1) How people make decisions (personal decision-making)

(2) How people interact (interpersonal economics)

(3) How the economy as a whole works (the big economic machine)

What are the 4 principles under personal decision-making?

(1) Trade offs

(2) Opportunity costs

(3) Marginal analysis

(4) Incentives

What are trade offs?

(1) trading one choice over another choice

(2) trading off one goal for another

(3) to get the thing you want, you have to give up another thing you want

*(for every action there is an equal and opposite reaction?)

What are opportunity costs?

(1) what you give up in order to obtain something else, assuming resources are limited

(2) the opportunity cost of an item is the cost that you give up to get the item

(3) what you miss out on because you chose something else

(4) if you can only pick one, the thing you didn’t pick is the cost

(5) giving up the next best alternative

Synonym of Margin

(1) edge

Definition of Marginal Change

(1) small adjustments around the edges of what you are doing

(2) describes an incremental adjustment to an existing plan of action

(3) incremental change to a plan of action

What is the definition of marginal analysis?

(1) decision-making method that looks at the additional benefits and additional costs of doing one more unit of an activity

(2) the process of comparing marginal benefits (MB) and marginal costs (MC)

Rational Decision

(1) a rational decision maker compares the marginal benefits and the marginal costs and takes an action only if the (marginal) benefits exceeds its (marginal) costs

(2) benefits outweigh the costs

What is an incentive?

(1) something that induces a person to act (such as the prospect of a punishment or reward)

The Incentive Principle

(1) considering that people are rational, they then respond to incentives

(2) people respond to incentives

(3) people’s decisions may change in response to changes in costs and benefits

(4) incentives are at the root of all behavior

(5) all behavior is a response to incentives

What are the 3 principles under interpersonal interaction?

(1) Trade

(2) Market Economy

(3) Government Policy

Benefits of Trade

(1) allows entities to specialize in the activities they do best

(2) trading allows variety of goods and services at a lower cost

Zero Sum Game

(1) any gains by me are definite losses by somebody else

Positive Sum Game

(1) all walk away and have gained from it

2 Types of Economic Systems

(1) Centrally Planned Economy

(2) Market Economy

Centrally Planned Economy

(1) government are central planners who allocate the economy’s scarce resources

(2) government officials are in the best position to allocate the economy’s scarce resources

(3) the government organizes economic activity to ensure the well-being of the country and of like-minded nation

(4) planned economy, the government controls the means of production

Market Economy (2-Part Answer)

(1) firms decide whom to hire and what to make; households decide where to work and what to buy with their incomes

(2) firms and households interact in the marketplace where prices and self-interest guide their decisions

Competitive Market

(1) contain many buyers and sellers of numerous goods and services, all of them interested primarily in their own well-being

Who coined the invisible hand theory?

(1) Adam Smith

What book did Adam Smith write?

(1) An Inquiry into the Nature and Causes of the Wealth of Nations

The Invisible Hand Theory

(1) people are guided by self-interest, the invisible hand suggests that prices adjust to guide market participants to reach outcomes that maximize the well-being of society as a whole

(2) at first glance, the success of market economies may seem puzzling because no one appears to be looking out for the well-being of society as a whole

(3) firms and households in competitive markets act as if they are guided by an “invisible hand” that leads them to a desirable outcome

(4) the idea that individuals pursuing their own self-interest unintentionally promote the overall good of society through market forces (prices and competition)

(essentially our economy is a paperclip maximizer)

According to Adam Smith, what primarily motivates the participants in our economy?

(1) self-interest

What are prices? What are they used for?

(1) in a competitive market, sellers look at the price when deciding how much to supply, and buyers look at the price when deciding how much to demand

(2) the price reflects both the sellers’ costs of production and the value of the good to the buyers

(3) prices are the instrument with which the invisible hand directs economic activity

The Government Price Control Corollary

(1) when policies dictate prices; when a government prevents prices from adjusting to supply and demand, it impedes the invisible hand’s ability to coordinate the decisions of the firms and households that make up an economy

Examples of Government Price Control

(1) Taxes

(2) Rent Control

(3) Communism — prices were not set in the market place, but by central planners

What is government policy?

(1) actions and decisions made by the government (laws, regulations, taxes, and spending) to influence how the economy and society operate

The Importance of Government Policy

(1) when the government enforces rules and maintains the institutions that are key to enhance efficiency in a market economy

(2) rules and institutions include: government-provided police and courts to enforce property rights

Property Rights

(1) enforced by a government, the ability of an individual to own and control scarce resources (private property)

The Efficiency-Equity Trade-off

(1) the idea that policies which increase economic efficiency (getting the most output from resources) may reduce equality (fairness in income or opportunity), and policies that increase equality may reduce efficiency

(2) policies can aim either to enlarge the economic pie or to change how the pie is sliced

Economic Efficiency (The Efficiency Conversation, Promoting Efficiency)

(1) market forces dictate the economy

(2) focuses on maximizing total surplus and getting the most output from scarce resources

(3) maximizing the size of the economic pie

Flaw of Pure Efficiency

(1) in real life there are market failures

Market Failure

(1) a situation in which a market left on its own does not allocate resources efficiently

Sources of Market Failure

(1) Externality

(2) Market Power

Externality

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

Examples of (Negative) Externalities

(1) Pollution

(2) Industrial waste

(3) Overfishing

Market Power

(1) the ability of a single economic actor (or small group of actors) to have a substantial influence on market prices

(2) the ability of a single person or firm (or a small group of them) to unduly influence market prices

Examples of Market Power

(1) Water Well Example

Describe the Water Well Example

(1) if everyone in town needs water but there is only one well, the owner of the well does not face the rigorous competition with which the invisible hand normally keeps self-interest in check; the well owner may take advantage of this opportunity by restricting the output of water and charging a higher price

Economic Equity (The Equity Conversation, Promoting Equity)

(1) the fairness with which economic benefits and burdens are distributed across society

(2) distributing the economic pie fairly

What solves economic inequity? What may large inequalities in a market economy call for?

(1) government intervention

Give examples of public policies that aim to achieve a more equal distribution of well-being

(1) income tax

(2) welfare system

Quality of Life

(1) is the overall well-being of a person or group, considering physical health, psychological state, level of independence, social relationships, and relationship to the environment

(2) is how comfortable, happy, healthy, and fulfilled someone feels in their daily life

Productivity

(1) the amount/quantity of goods and services produced from each unit of labor input

Living Standards

(1) the level of material comfort and economic well-being of a person or society, usually measured by income, consumption, access to goods and services

(2) how much people can afford and the material comforts they have in daily life

What does high standard of living say about productivity?

(1) more productive

(2) workers can produce a large quantity of goods and services per hour

What does low standard of living say about productivity?

(1) less productive

(2) workers can produce lesser quantity of goods and services per hour

Inflation

(1) an increase in the overall level of prices in the economy

(2) reduced purchasing power of money because money becomes less scarce

Reasonable Inflation

(1) because high inflation imposes various costs on society, keeping inflation at a reasonable rate is a goal of economic policy makers around the world

(2) key word is cost, the value of things must be greater than the value of how we extracted them

Unreasonable Inflation

(1) high inflation, when the purchasing power of money becomes really low

Fundamental Cause of Inflation

(1) growth in the quantity of money

Why does growth in the quantity of money cause inflation?

(1) when a government creates large quantities of the nation's money, the value of the money falls (money becomes less scarce)

Short-Run Trade-Off Between Inflation and Unemployment

(1) Government ‒ More Money, More Spending

• government gives out money, money supply increases, people spend more, raising overall demand for goods and services

(2) Firms ‒ More Spending, More Demand & Hiring

• higher spending increases demand, prompting firms to produce more and hire more workers in the short run

(3) Microeconomics - More Hiring, Lower Unemployment

• as firms hire more workers to meet demand, unemployment falls

Business Cycle

(1) the irregular and largely unpredictable fluctuations in economic activity, as measured by the production of goods and services or the number of people employed

(2) fluctuations in economic activity, such as employment and production

Instruments of Economic Policy

(1) policymakers can exploit the short-run trade-off between inflation and unemployment using various policy instruments

(2) by changing the amount that the government spends (spending), the amount it taxes, or the amount of money it prints (money printing), policymakers can influence the overall demand for goods and services

(3) changes in demand, in turn, influence the combination of inflation and unemployment that the economy experiences in the short run

4 Factors of Production

(1) Land

(2) Labor

(3) Capital

(4) Entrepreneurship