Principles of Economics

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Vocabulary Section

• Economics (oikonomos [”one who manages a household”]): The study of how society manages its scarce resources

• Scarcity: The limited nature of society’s resources

• Opportunity Cost: Whatever must be given up to obtain some item; the actual cost of an action + the loss of the next best alternative

• Resources: Composed of land, labor [# of workers]. capital (machines). human capital (ingenuity), time

• Margin: Additional amount, not total

• Rational People: People who systematically and purposefully do the best they can to achieve their objectives

• Marginal Change: A small incremental adjustment to a plan of action

• Incentive: Something that induces a person to act

• Market Economy: An economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services

• Property Rights: The ability of an individual to own and exercise control over scarce resources

• Market Failure: A situation in which a market left on its own fails to allocate resources efficiently </aside>

Economics is all about choices and is a system composed of 3 different actors

1. Firms: Have to make production decisions (what/how much to produce?, continue operating?, profit?, loss?_

2. Consumers: Consumption Decisions (Play?, Work?, Labor-Leisure decisions)

3. Governments: Regulations (Taxes, Quotas, and Price Control)

Notes: How Are Decisions Made?

• Individual Decision-making

  • People face trade-offs among alternative goals

  • The cost of any action is measured in terms of forgone opportunities

  • Rational people make decisions by comparing marginal costs and marginal benefits

  • People change their behavior in response to the incentives they face

• Interactions Among People

  • Trade and interdependence can be mutually beneficial

  • Markets are usually a good way of coordinating economic activity among people

  • The government can potentially improve market outcomes by remedying a market failure or by promiting greater economic equality

• The Economy as A Whole

  • Productivity is the ultimate source of improving living standards

  • Growth in the quantity of money is the ultimate source of inflation

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

12 Principles/Observations of Economics: That guide choices made by consumers, producers, and governments

1. Choices are necessary because resources are scarce

   1. People face trade-offs because resources are scarce

      1. Why would a consumer need to choose between labor and leisure if resources were not scarce?

      2. There is no such thing as free lunch - We must give up something for something else that we like

         1. Examples: How students spend time, how families spend income, how governments spend taxes, environmental regulations vs firm owners

2. The true cost of something is its opportunity cost - Not just the monetary cost

   1. Making decisions requires individuals to consider the benefits and costs of some action

   2. How many hours you work? How many hours are you not working?

   3. What are the costs of going to college?

      1. We should not count room and board (unless they are more expensive elsewhere)

      2. We should count the student’s time, since they could be working

3. “How much” is a decision at a margin.

   1. Rational people think at the margin

      1. Economists generally assume that people are rational

      2. Many decisions in life involve incremental decisions (marginal change): Should I remain in school this semester? Should i take another course this semester? Should I study another hour for tomorrow’s exam?

      3. A rational decision maker takes an action if and only if the marginal benefit is at least as large as the marginal cost

4. People respond to incentive, exploiting opportunities to make themselves better off.

   1. Because rational people make decisions by weighing costs and benefits, their decision may change in response to incentives

5. There are gains from trade

   1. Trade can make everyone better off

      1. Trade is not like a sports contest, where one side gains and the other side loses

      2. Countries benefit from trading with one another as well

      3. In The Wealth of Nations (1776), Adam Smith wrote about the benefits of specialization

6. Markets move toward equilibrium

   1. Many countries that once had centrally planned economies had abandoned this system and are trying to develop market economies. Centrally planned economies failed because they did not allow the market to work

   2. Market prices reflect both the value of a product to consumers and the cost of the resources used to produce it

   3. Adam Smith and the Invisible Hand

      1. Adam Smith (1776) suggested that although individuals are motivated by self-interest, an invisible hand guides this self-interest into promoting society’s economic well-being. Smith’s insights are at the center of modern economics and will be analyzed more fully in the chapters to come

7. Resources should be used efficiently to achieve society’s goals

   1. When an economy is efficient, it is producing the maximum gains from trade possible, given the resources available

   2. There are trade-offs between using resources efficiently and attaining equity in the distribution of goods

8. Markets usually lead to efficiency

   1. The incentives built into a market economy ensure that resources are usually put to good use, that all opportunities to make everyone better off have been exploited

   2. The economy as a whole benefits if each individual specializes in a task and trades with others

9. When markets don’t achieve efficiency, government intervention can improve society’s welfare

   1. Governments can sometimes improve market outcomes

      1. The invisible hand will only work if the government enforces property rights

      2. There are two broad reasons for the government to interfere with economy: the promotion of efficiency and equality

      3. Government policy can improve efficiency when there is market failure

      4. Note that the principle states that the government can improve markets outcomes. This is not saying that the government always does improve market outcomes

10. One person’s spending is another person’s income

11. Overall spending sometimes gets out of line with the economy’s productivity capacity

12. Government policies can change spending

    1. The government can change its own spending

    2. The government can vary how much it comes from the public in taxes

    3. The government can control the quantity of money in circulation