What are the principles of how people make decisions? What are the principles of how people interact? What are the principles of how the economy as a whole works?
1 How do you spend your pocket money? ECONOMIC DILEMMA 1
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What Economics Is All About Scarcity: the limited nature of society’s resources Economics: the study of how society manages its scarce resources, e.g. how people decide what to buy, how much to work, save, and spend how firms decide how much to produce, how many workers to hire how society decides how to divide its resources between national defense, consumer goods, protecting the environment, and other needs
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The principles of HOW PEOPLE MAKE DECISIONS HOW PEOPLE MAKE DECISIONS Principle #1: People Face Tradeoffs
Going to a party the night before our midterm
leaves less time for studying. Having more money to buy stuff requires working longer hours, which leaves less time for fun. Protecting the environment requires resources that could otherwise be used to produce consumer goods.
All choices involve trade off!
TEN PRINCIPLES OF ECONOMICS 5 HOW PEOPLE MAKE DECISIONS Principle #1: People Face Tradeoffs Society faces an important tradeoff: efficiency vs. equality Efficiency: when society gets the most from its scarce resources Equality: when prosperity is distributed uniformly among society’s members Tradeoff: To achieve greater equality, could redistribute income from wealthy to poor. But this reduces incentive to work and produce, shrinks the size of the economic “pie.” TEN PRINCIPLES OF ECONOMICS 6 TEN PRINCIPLES OF ECONOMICS 7 HOW PEOPLE MAKE DECISIONS Principle #2: The Cost of Something Is What You Give Up to Get It Making decisions requires comparing the costs and benefits of alternative choices. The opportunity cost of any item is whatever must be given up to obtain it. It is the relevant cost for decision making.
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HOW PEOPLE MAKE DECISIONS Principle #2: The Cost of Something Is What You Give Up to Get It Examples: The opportunity cost of… …going to college for a year is not just the tuition, books, and fees, but also the foregone wages. …seeing a movie is not just the price of the ticket, but the value of the time you spend in the theater.
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HOW PEOPLE MAKE DECISIONS Principle #3: Rational People Think at the Margin
Rational people systematically and purposefully do the best they can to achieve their objectives. make decisions by evaluating costs and benefits of marginal changes – incremental adjustments to an existing plan.
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HOW PEOPLE MAKE DECISIONS Principle #3: Rational People Think at the Margin Examples: When a student considers whether to go to college for an additional year, he compares the fees & foregone wages to the extra income he could earn with the extra year of education. When a manager considers whether to increase output, she compares the cost of the needed labor and materials to the extra revenue.
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HOW PEOPLE MAKE DECISIONS Principle #4: People Respond to Incentives Incentive: something that induces a person to act, i.e. the reward or punishment. Rational people respond to incentives: When gas prices increase, people tend to car pool or use public transportation. When cigarette taxes increase, teen smoking falls. Can you think of policies to encourage people to move outside the city?
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The principles of HOW PEOPLE INTERACT HOW PEOPLE INTERACT Principle #5: Trade Can Make Everyone Better Off Not every country can be self sufficient. Rather than being self-sufficient, people can specialize in producing one good or service and exchange it for other goods. Countries also benefit from trade & specialization: Get a better price abroad for goods they produce Buy other goods more cheaply from abroad than could be produced at home TEN PRINCIPLES OF ECONOMICS 14 HOW PEOPLE INTERACT Principle #6: Markets Are Usually A Good Way to Organize Economic Activity
Market: a group of buyers and sellers
(need not be in a single location) “Organize economic activity” means determining what goods to produce how to produce them how much of each to produce who gets them
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HOW PEOPLE INTERACT Principle #6: Markets Are Usually A Good Way to Organize Economic Activity
A market economy allocates resources through
the decentralized decisions of many households and firms as they interact in markets. Famous insight by Adam Smith in The Wealth of Nations (1776): Each of these households and firms acts as if “led by an invisible hand” to promote general economic well-being.
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HOW PEOPLE INTERACT Principle #6: Markets Are Usually A Good Way to Organize Economic Activity The invisible hand works through the price system: The interaction of buyers and sellers determines prices. Each price reflects the good’s value to buyers and the cost of producing the good. Prices guide self-interested households and firms to make decisions that, in many cases, maximize society’s economic well-being.
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HOW PEOPLE INTERACT Principle #7: Governments Can Sometimes Improve Market Outcomes
An important role of the gov. is to enforce property
rights (through the police, courts) What are property rights? -The ability to own, control and use scarce resources. -Firms and people will not produce or work unless they are sure that their output is protected by law TEN PRINCIPLES OF ECONOMICS 18 HOW PEOPLE INTERACT Principle #7: Governments Can Sometimes Improve Market Outcomes Market failure: when the market on its own fails to allocate society’s resources efficiently Causes: Externalities, when the production or consumption of a good affects bystanders (e.g. pollution) Market power, a single buyer or seller has substantial influence on market price (e.g. monopoly) In such cases, public policy may promote efficiency. TEN PRINCIPLES OF ECONOMICS 19 HOW PEOPLE INTERACT Principle #7: Governments Can Sometimes Improve Market Outcomes
Govt may alter market outcome to promote equity
How can the government promote equity?
If the market’s distribution of economic well-being
is not desirable, tax or welfare policies can change how the economic “pie” is divided. TEN PRINCIPLES OF ECONOMICS 20 The principles of HOW THE ECONOMY AS A WHOLE WORKS HOW THE ECONOMY AS A WHOLE WORKS Principle #8: A country’s standard of living depends on its ability to produce goods & services.
Huge variation in living standards across
countries and over time: Average income in rich countries is more than ten times average income in poor countries. The U.S. standard of living today is about eight times larger than 100 years ago.
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HOW THE ECONOMY AS A WHOLE WORKS Principle #8: A country’s standard of living depends on its ability to produce goods & services. The most important determinant of living standards: productivity, the amount of goods and services produced per unit of labor. Productivity depends on the equipment, skills, and technology available to workers. Other factors (e.g., labor unions, competition from abroad) have far less impact on living standards. TEN PRINCIPLES OF ECONOMICS 23 HOW THE ECONOMY AS A WHOLE WORKS Principle #9: Prices rise when the government prints too much money.
Inflation: increases in the general level of prices.
In the long run, inflation is almost always caused by excessive growth in the quantity of money, which causes the value of money to fall. The faster the govt creates money, the greater the inflation rate.
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HOW THE ECONOMY AS A WHOLE WORKS Principle #10: Society faces a short-run tradeoff between inflation and unemployment In the short-run (1 – 2 years), many economic policies push inflation and unemployment in opposite directions. Other factors can make this tradeoff more or less favorable, but the tradeoff is always present.
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CHAPTER SUMMARY
The principles of decision making are:
People face tradeoffs. The cost of any action is measured in terms of foregone opportunities. Rational people make decisions by comparing marginal costs and marginal benefits. People respond to incentives.
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The principles of interactions among people are:
Trade can be mutually beneficial. Markets are usually a good way of coordinating trade. Govt can potentially improve market outcomes if there is a market failure or if the market outcome is inequitable.
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The principles of the economy as a whole are:
Productivity is the ultimate source of living standards. Money growth is the ultimate source of inflation. Society faces a short-run tradeoff between inflation and unemployment.
