Matt OwensPrinciples of MicroeconomicsJanuary 13, 2015Today’s notes consist of a large amount of vocabulary, and covers very basic concepts of Microeconomics.What Economics is All About- Scarcity: The limited nature of society’s resources- Economics: The study of how society manages its scarce resourceso How people decide what to buy, how much to work, save, and spendo How firms decide how much to produce, how many workers to hireo How society decides to divide its resources between national defense, consumer goods, protecting the environment, and other needs Roughly 40% of the United States’ federal budget goes towards national defenseo Economics is not just the study of money or business, however those are pieces of the subjectHow People Make DecisionsPrinciple #1: People Face Tradeoffs- All decisions involve tradeoffso Examples: Going to a party the night before your midterm leaves less time for studying Having more money to buy stuff requires working longer hours, which leaves less time for leisure Protecting the environment requires resources that could otherwise be used to produce consumer goods- Society faces an important tradeoffo Efficiency vs equality- Efficiency: When society gets the most from its scarce sourceo Bang for your buck- Equality: When prosperity is distributed uniformly among society’s memberso We all get an equal share- Tradeoff of efficiency and equality – To achieve greater equality, we could redistribute income from wealthy to poor. But this reduces incentive to work and produce, shrinks the size of the economic “pie”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 ito What is your opportunity cost for coming to this class? Working – The opportunity cost of going to college for a year is not just the tuition, books and fees, but also the foregone wageso The Opportunity cost of seeing a movie is not just the price of the ticket, but the value of the time you spend in the theatero Opportunity Cost is measured as the highest valued alternative given up- It is the relevant cost for decision makingPrinciple #3: Rational People Think at the Margin- Rational peopleo Systematically and purposefully do the best they can to achieve their objectives Rational model – only does that which makes us better According to a COMPLETELY rational model:- Nobody would smoke- Nobody would have unprotected sexo Make decisions by evaluating costs and benefits of marginal changes o Marginal Changes: incremental adjustments to an existing plan- Examples:o When a student considers whether to go to college for an additional year he compares the fees and foregone wages to the extra income he could earn with the extra year of educationo When a manager considers whether to increase output, she compares the cost of the needed labor and materials to the extra revenuePrinciple #4: People Respond to Incentives- Incentive: Something that induces a person to act, i.e. the prospect of a reward or punishment- Rational people respond to incentives- Examples:o Amari Cooper (Star football player for University of Alabama) leaving college football early to go into the NFLo When gas prices rise, consumers buy more hybrid cars and fewer gas guzzling SUVso When cigarette taxes increase, smoking fallso What is the incentive for having a playoff system in college football? (January, 2015) Increase revenue, and increase ratingso You are selling your 1996 Mustang. You have already spent $1000 on repairs. At the last minute, the transmission dies. You can pay $600 to have it repaired, or sell the car “as is.” In each of the following scenarios, should you have the transmission repaired? Blue book value is $6500 if transmission works, $5700 if it doesn’t- Benefit of fixing the transmission is $800, so fix the transmission Blue book value is $6000 if transmission works, $5500 if it doesn’t - You would lose $100 if you fixed the transmission before selling it. So sell it as is. Principle #5: Trade Can Make Everybody Better Off- Rather than being self-sufficient, people can specialize in producing one goodor service and exchange it for other goods- Countries also benefit from trade and specializationo Example: Apple makes products in China for VERY cheap, yet sells them in US for hundreds of dollarso Get a better price abroad for goods they produceo Buy other goods more cheaply from abroad than could be produced at homePrinciple #6: Markets Are Usually a Good Way to OrganizeEconomic Activity- Market: A group of buyers and sellers (need not be in a single location)- “Organize economic activity” means determining:o What goods to produceo How to produce themo How much of each to produceo Who gets them- A Market Economy allocates resources through the decisions of many households and firms as they interact in markets- The invisible hand works through the price system:o Adam Smith – The Bible of Economicso The interaction of buyers and sellers determines priceso Each price reflects the good’s value to buyers and the cost of producing the goodo Prices guide self-interested households and firms to make decisions that, in many cases, maximize society’s economic well-beingPrinciple #7: Governments Can Sometimes Improve MarketOutcomes- Important role for government: enforce property rights (with police, courts)- People are less inclined to work, produce, invest, or purchase if large risk of their property being stolen- Market Failure: When the market fails to allocate society’s resources efficiently- Causes:o Externalities: When the production or consumption of a good affects bystanders (e.g. pollution)o Market Power: A single buyer or seller has substantial influence on market price (e.g. monopoly)- In such cases, public policy may promote efficiency- Example: Government restricted AT&T and T-Mobile from merging because they would control over 60% of that market, and therefore have a monopoly in the cellular field. - Government may alter market outcome to promote equity (equality)- If the market’s distribution of economic well-being is not desirable, tax or welfare policies can change how the economic “pie” is dividedPrinciple #8: A Country’s Standard of Living Depends on its Abilityto Produce Goods and Services- The most important determinant of living standards: