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

^^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.