Ten Principles of Economics 09 30 2013 Scarcity limited nature of society s resources Economics the study of how society manages its scarce resources Principle 1 People Face Trade offs The more a society spends on national defense to protect its shores from foreign aggressors the less it can spend on consumer goods to raise the standard of living at home o Guns vs butter example Another tradeoff society faces is between efficiency and equality o Efficiency the property of society getting the most it can from its scarce resources o Equality the property of distributing economic prosperity uniformly among the members of society Principle 2 The Cost of Something is What you Give up to Get it Opportunity cost whatever must be given up to obtain some item Principle 3 Rational People Think at the Margin 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 Principle 4 People Respond to Incentives Incentive something that induces a person to act such as the prospect of a punishment or reward Principle 5 Trade Can Make Everyone Better Off Trade between two countries can make each country better off Trade allow countries to specialize in what they do best and enjoy a greater variety of goods and services Principle 6 Markets are Usually a Good Way to Organize Economic Economy A market economy is an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services o Firms decide whom to hire and what to make and households decide which firms to work for and what to buy with their incomes o The firms and households interact in the marketplace where prices and self interest guide their decision Principle 7 Governments Can Sometimes Improve Market Outcomes property rights the ability of an individual to own and exercise market failure a situation in which a market left on its own fails to externality the impact of one person s actions on the well being control over scarce resources allocate resources efficiently of a bystander market power the ability of a single economic actor or small group of actors to have a substantial influence on market prices Principle 8 A Country s Standard of Living Depends on Its Ability to Produce Goods and Services Almost all variation in living standards is attributable to differences in countries productivity the quantity of goods and services produced from each unit of labor input Principle 9 Prices Rise When the Government Prints too Much Money Inflation an increase in the overall level of prices in the economy when the worth of the dollar bill decreases o the growth in the quantity of money is the culprit of inflation Principle 10 Society Faces a Short Run Trade off between Inflation and Unemployment More hiring mean lower unemployment Over a period of a year or two many economic policies push inflation and unemployment in opposite directions Business cycle fluctuations in economic activity such as employment and production the irregular and largely unpredictable fluctuations in economic activity Thinking Like an Economist 09 30 2013 Economists make assumptions for the same reason Assumptions can simplify the complex world and make it easier to understand When studying the effects of international trade we might assume that the world consists of only two countries and that each country produces only two goods Economic Models Economists use models to learn about the world they are most often composed of diagrams and equations First Model The Circular Flow Diagram o Circular flow diagram a visual model of the economy that shows how dollars flow through markets among households and firms Firms produce goods and services using inputs such as labor land and capital and these inputs are called factors of production Households own the factors of production and consume all the goods and services that the firms produce Households and Firms interact in two types of markets o Markets for goods and services households are buyers and firms are sellers households buy the output of goods and services that firms produce o Markets for the factors of production households are sellers are firms are buyers households provide the inputs that firms use to produce goods and services Second Model The Production Possibilities Frontier o A graph that shows the combinations of output that the economy can possibly produce given the available production technology o An outcome is considered efficient if the economy is getting all it can from the scarce resources it has available Microeconomics the study of how households and firms make decisions and how they interact in markets Macroeconomics the study of economy wide phenomena including inflation unemployment and economic growth Positive statements claims that attempt to describe the world as it is Normative statements claims that attempt to prescribe how the world should be about how the world works Economists may disagree about the validity of alternative positive theories Economists may have different values and therefore different normative views about what policy should try to accomplish Independence and Gains from Trade 09 30 2013 Comparative Advantage the riving force of specialization Absolute Advantage the ability to produce a good using fewer inputs than another producer Economists use this terms when comparing the productivity of one person firms or nation to that of another The producer than requires a smaller quantity of inputs to produce a good is said to have an absolute advantage Opportunity Cost and Comparative Advantage Opportunity cost whatever must be given up to obtain some item Comparative Advantage the ability to produce a good at a lower opportunity cost than another producer o The producer who gives up less of other goods to produce Good X has the smaller opportunity cost of producing Good X and is said to have comparative advantage in producing it Comparative Advantage and Trade The gains from specialization and trade are based not on absolute advantage but on comparative advantage When each person specializes in producing the good for which he or she has a comparative advantage total production in the economy rises Trade can benefit everyone in society because it allows people to specialize in activities in which they have a comparative advantage The Price of Trade For both parties to gain from trade the
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