Dr Sarna 2011 1 Ten Principles of Economics Macro Econ Exam 1 Study Guide Economy comes from Greek phrase one who manages a household Society must allocate people to various jobs and allocate the amount of goods and services that it produces like a house must allocate how to employ its few people living in it to the various jobs around the home Scarcity Society has limited resources and cannot produce all the goods and services that people want Economics The study of how society manages its scarce resources Economists study how people make decisions such as how much they work and what they buy They study the relationships btwn people like buyers and sellers And they study trends that affect the economy such as the growth in average income or unemployment rates 10 PRINCIPLES How Individuals Make Decisions 1 People Face Trade Offs To get something we like we give up something we like Example choosing to spend money on one good or service gives up the money you could be spending on another good or service How does a family spend their income Efficiency vs Equality Obtaining maximum benefits from scarce resources OR distributing the benefits uniformly among society s members 2 The Cost Of Something Is What You Give Up To Get It Decisions require comparing the cost and benefits of alternative courses of action Example Is the cost of going to college giving up your time that could be spent getting a job worth the value of an education Opportunity Cost What you give up to obtain a certain item 3 Rational People Think at The Margin Doing the best one can to achieve his or her objectives give the available opportunities Example Firms deciding how many workers to hire and how much of their products to manufacture sell to maximize profit Marginal Changes small incremental adjustments to an existing plan of action Rational decision makers take an action only if the marginal benefit of the action exceeds the marginal cost 4 People Respond to Incentives Incentives induce a person to act such as the prospect of a punishment or reward Example a higher market price gives customers an incentive to buy less If policy changes incentives people feel obligated to alter their behavior Example Seatbelt law is an incentive for people to drive faster because they believe that their survival rate in an accident is lower How People Interact 5 Trade Can Make Everyone Better Off Trade between countries is not negative competition Allows for specialization in activities people do best Trading allows people to buy a greater variety of goods and services at lower costs 6 Markets Are Usually A Good way to Organize Economic Activity Market Economies allow for decisions of a central planner to be replaced by the decisions of millions of firms and households No one person watching over the economic well being of society but instead people who are interested in their individual decisions Market prices reflect both the value of a good to society and the cost to society of making 7 Governments Can Sometimes Improve Market Outcomes Government enforces property rights so individuals can own and control scarce that good resources Example a farmer wont grow food if he expects his crops to get stolen or a restaurant wont make food without ensuring that the customer will pay Government also promotes efficiency and promotes equality enlarges the economic pie or Market Failure Situations in which the market on its own fails to produce an efficient changes how the pie is divided allocation of its resources Externality The impact of one person s actions on the well being of a bystander possible cause of a market failure Example pollution Market Power The ability of a single person or small group to influence market prices another possible cause of market failure How The Economy Works As a Whole 8 A Country s Standard of Living Depends on It s Ability to Produce Goods and Services Living standards differ in countries productivity the amount of goods and services produced from each unit of labor input Example in countries where workers can produce a large quantity of goods services per unit of time most people living there enjoy a higher standard of living Growth rate of a nation s productivity determines the growth rate of its average income Effect of Public Policy How will it affect our ability to produce goods and services 9 Prices Rise When the Government Prints Too Much Money Inflation an increase in the overall level of prices in the economy Growth in the quantity of money causes inflation when the government creates large quantities of the nation s money the value of the money falls 10 Society Faces A Short Run Trade Off Between Inflation and Unemployment Short run effects of monetary injections trade between inflation unemployment Increasing in economy stimulates overall level of spending higher demand of goods services Higher demand cause firms to raise their prices higher more workers and produce a larger quantity of goods services More positions available lower unemployment rates Trade off plays key role in Business Cycle irregular and unpredictable fluctuations in economic activity measured by production of goods services or employment rate Effects of Policy Makers Influence demand of goods and services by regulating the amount that the govt spends the amount it taxes and the amount of money it prints 2 Thinking Like an Economist Scientific Method Development and testing of theories Interplay between theories observations Example Inflation Theory hypothesizes that inflation occurs when the government prints an excess of money Tested by analyzing the prices and money from different countries Assumptions simplify the complex world and make it easier to understand Example thinking of international trade between 2 countries each with one good versus attempting to learn about the numerous countries and their thousands of goods makes it easier to understand the big picture and main concept Models allow us to see what is truly important by potentially omitting details and excluding every tiny feature of the economy By doing so models simplify reality to improve our understanding of it Circular Flow Diagram Visual model of the economy that exemplifies how dollars flow through markets among households firms SEE MODEL ON PAGE 25 Economy includes 2 decision makers households firms who interact in 2 markets goods services and factors of production Diagram organizes the economic transactions that occur between the two decision
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