Chapter 1: Ten Principles of Economics

^^Economics^^

• The study of how society manages its scarce resources.

Economy

• Comes from the Greek Word “Oikonomos” meaning one who manages a household.
• A household must allocate its resources amongst its members while considering each person’s abilities, efforts, and desires.
• Similarly, Economics is the field that studies how to best allocate society’s resources.

Scarcity

• The concept that society’s resources are limited.
  • Thus, there are not enough resources to produce all the goods and services people demand.

Economists study:

• How people make decisions;
• How people interact with one another; and
• The forces and trends that affect the economy as a whole

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^^The Ten Principles of Economics^^

How People Make Decisions

Principle 1: People Face Trade-Offs

• “There is no such thing as a free lunch.”
  • In order to get something, we usually have to give up something in return.
• Thus, making decisions requires trading off one goal against another.
  • For instance, when you choose to spend an extra dollar on one good, you have one less dollar to spend on another good.
• One classic trade-off is between guns and butter.
  • The more a society or country spends on national defense (guns), the less resources it has to spend on consumer goods (butter).
• Another trade-off society faces is between efficiency and equality.
  • Efficiency → means that society is getting the maximum benefits from its scarce resources.
  • Equality → means that the benefits from a society’s resources are distributed evenly amongst its members.

Principle 2: The Cost of Something Is What You Give Up to Get It

• Because there are trade-offs in every decision, making decisions requires comparing the costs and benefits of each alternative course of action.
• Opportunity Cost → Whatever is given up in order to obtain an item.
  • For example, if you spend all your time studying, you won’t have the time to work at a job. Thus, the earnings you give up is the opportunity cost of attending school.
• When making any decision, you should be aware of the opportunity costs of each possible action.

Principle 3: Rational People Think at the Margin

• Economists assume that people are rational.
  • Rational People systematically and purposefully do the best they can to achieve their objectives.
• Rational people also know that decisions in life are rarely black and white, but usually involve shades of gray.
  • At dinnertime, you don’t decide whether to fast or eat like a pig. You instead ask yourself questions like, “Should I get an additional spoonful of mashed potatoes?”
• Marginal Change → refers to the small incremental adjustment to an existing plan of action.
• Rational people make decisions by comparing Marginal Benefits and Marginal Costs.
• A rational decision-maker will only act upon an action when the Marginal Benefit exceeds the Marginal Cost.

Principle 4: People Respond to Incentives

• Incentive → Something that influences a person to act.
• Rational people make decisions by comparing costs and benefits; as such, they respond to incentives.
• Incentives are key to analyzing how markets work.
  • For instance, when the price of a good rises, people consume less of that good. In other words, high prices provides an incentive for buyers to consume less.

How People Interact

Principle 5: Trade Can Make Everyone Better Off

• Trade between two or more countries can make each country better off.
• Trade allows countries to specialize in what they do best.
  • This will also allow for a greater variety of goods and services to become available in the market at lower costs.

Principle 6: Markets Are Usually a Good Way to Organize Economic Activity

• Market Economy → An economy where market decisions are made by firms and household.
  • Firms decide who to hire and what to make, while Households decide which firms to work for and what to buy. They they interact in the marketplace.
• Resources in a Market Economy are allocated through the decentralized decisions of firms and households as they interact in markets for goods and services.
• The prices of goods and services, and self-interest guide the decisions of firms and household.
  • There is no one looking out for the economic well-being of society as a whole; aka, decentralized decision-making.
• %%Adam Smith’s Invisible Hand%%
  • States that households and firms that interact in markets are guided by an “invisible hand” that leads them to desirable market outcomes.
  • The Invisible Hand is self-interest. In other words, people will decide based on what will benefit them the most.
  • In a market, demand is determined by the price buyers are willing to buy at, as well as the price sellers are willing to supply at. This decision is influenced by the self-interest of each person.
  • As a result, market prices reflect both the value and cost of the good.
  • Moreover, according to Smith, these prices will adjust to guide buyers and sellers to reach outcomes that will maximize the well-being of society as a whole.

Principle 7: Governments Can Sometimes Improve Market Outcomes

• The Invisible Hand will only be successful in a society where the government enforces the rules and maintains the institutions that are needed in a market economy.
• The government also needs to enforce Property Rights so people can own and control resources. The Invisible Hand relies on the ability of individuals to own Property Rights.
  • Property Rights → The ability of an individual to own and exercise control over resources.
• The government can also intervene in the economy and change the allocation of resources in order to promote efficiency or promote equality.
• Market Failure → Occurs when the market fails to allocate resources efficiently.
  • Market Failures could be caused by Externalities.
  • Externality → The impact of one person’s actions on the well-being of a bystander.
    • An example of an Externality is pollution. When a factory creates pollution when producing goods, it affects the health of those living nearby.
  • Market Failures could also be caused by Market Power.
  • Market Power → The ability of a single or few economic actors to influence market prices.
    • These could include Monopolies or Oligopolies who may take advantage of the market by charging higher prices on their goods or services.
• However, just because the government can improve on market outcomes does not mean it always will.
  • Public Policy is not always effective,. Some may even be designed to only benefit the politically powerful.

How the Economy as a Whole Works

Principle 8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services

• Productivity → The quantity of goods and services produced from each unit of labor input.
• Productivity can explain the disparity in standards of living from country to country.
  • Nations where workers produce a larger quantity of goods and services per hour enjoy a higher standard of living than those in less productive nations.
  • The growth rate of a nation’s productivity also determines the growth rate of average income.
• The relationship between Productivity and Living Standards also has profound implications on policy-making.
  • Government must ask, “How will this policy affect our ability to produce goods and services?”
  • To increase living standards, policy-makers must increase productivity through better education and better tools and technology for the production of goods and services.

Principle 9: Prices Rise When the Government Prints Too Much Money

• Inflation → An increase in the overall price levels in the economy.
  • Inflation is often caused by the growth in quantity of money. When a government creates large quantities of money, the value of the currency falls, raising the prices of goods and services.

Principle 10: Society Faces a Short-Run Trade-off between Inflation and Unemployment

• Increasing the supply of money results in higher prices in the long-run. However, in the short-run, the effects of increasing the supply of money in the economy include:
  • An increase in the overall level of spending, which also increases the demand for goods and services
  • A decrease in unemployment as firms are incentivized to hire more workers to produce a larger quantity of goods and services
• Thus, there is a trade-off between unemployment in the short-run, or inflation in the long-run when a government decides to increase money supply.
• The short-run trade-off plays a key role in the analysis of the Business Cycle.
  • Business Cycle → The fluctuations in economic activity, such as employment and production. This is usually measured by the production of goods and services or the employment rates.

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