Chapter 1 Microeconomics Economics is the study of how people allocate their scarce resources Economics decisions involve trade offs Two important principles 1 Rational people think at the margin 2 People respond to incentives Principle 1 People Face Trade offs There ain t no such thing as a free lunch Efficiency that a society is getting the maximum is getting the maximum benefits from its scarce resources Equality that those benefits are distributed uniformly among society s members Principle 2 The Cost of Something Is What You Give Up to Get It Opportunity Cost what you lose by doing something else what you give up no free lunches Principle 3 Rational People Think at the Margin Rational people systematically and purposefully do the best they can to achieve their objectives Marginal change a small incremental adjustment to an existing plan Marginal cost the cost of the good Marginal benefits Principle 4 People Respond to Incentives Incentive is something such as a prospect of a punishment or reward that induces a person to act Principle 5 Trade Can Make Everyone Better Off Trade allows countries to specialize Principle 6 Markets Are Usually a Good Way to Organize Economic Activity In a market economy the decisions of a central planner are replacing by millions of firms and households Principle 7 Governments Can Sometimes Improve Market Outcomes 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 Externality the impact of one person s actions on the well being of a bystander Market Power which refers to the ability of a single person or firm or a small group to unduly influence market prices 4 Factors and Production Land Labor Capital Entrepreneurship Economics described in one word scarcity money and supply and demand 3 ways Society Allocates resources Tradition Political System Government ruler leader Market System most uses market is a group of buyers and sellers for particular good and services Economist use theories and models to predict cause and effect outcomes Cause why something happens Effect what happens Correlation vs causation Sometimes the effect is the focus If there is an increase in the cost of college tuition cause what will happen in the market for college education effect Sometimes the cause is the focus Does education cause an increase in someone s lifetime income 2 Types of Analysis Positive Analysis attempts to explain what is test something Normative Analysis opinion attempts to explain what should be Normative statements are subjective and cannot be tested Who is involved in the Market System 1 Households Buyers a Maximize their utility or happiness b Demand Goods and services c Supply workers 2 Firms Sellers a Maximize their profits b Sell goods and services c Supply goods hire workers 3 Government Regulators a Defines the rules of the game b Interferes in a market when the relationship between buyers and sellers breaks down c Government does not supply jobs in this setup 4 The Rest of the World a Same relationship as other economies Circular flow diagram a visual model of the economy that shows how dollars flow through markets among households and firms But how does the market decide what and how much should be produced Answer The Production Possibilities Frontier PPF Production Possibilities Frontier a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology Production Possibilities Frontier Setup Economy produces only 2 goods Economy must decide what and how much to produce The frontier the curve represents the most efficient use of a country s resources It can t do better a b Getting most out both resources Shape of PPF is determined by opportunity cost PPF Example 1 No Specialization A group of tourists are stranded on a desert island They can gather food in two ways Gather coconuts Catch fish There is no specialization in this world o People are equally skilled o The same tools are used to gather both resources How to read PFF A Inefficient a The economy can achieve greater output at no extra cost B Feasible and efficient C Not feasible a You are already using your resources most efficiently a The economy cannot achieve this level output with its current resources Straight Line PPFs constant slope Constant Opportunity Cost PPF Example 2 Specialization Now resources people tools etc can be specialized The Law of Increasing Opportunity Cost As more of a good is produced the opportunity cost of producing that good increases Opportunity Cost What you are giving up What you are gaining Resources with lowest opportunity cost are converted first Then those with 2nd lowest opportunity cost Eventually economy is re specializing Straight line vs bowed outward PPF How does society choose where PPF will go Tradition uses the past Political System leader pick a spot Market System wherever more profitable Is the PPF stuck this way forever No 4 things can shift PPF left or right Shift entire curve 1 Changes in resources availability 2 Changes in stock inventory level of capital 3 Technological change 4 Changes in regulation An increase or improvement in factors PPF will shift to right A decrease or worsening in factors PPF will shift left Both are not affected equally The Benefits of Specialization Can t produce the maximum amount of both goods at same time Specialization and trade have the potential to make everyone better off How can you measure Productivity Absolute Advantage another producer opportunity cost than another person Comparative Advantage the ability to produce goods using fewer inputs than the ability to produce a good at a lower Opportunity Cost what you are giving up what are you gaining A Market is most common type of economy Graphs If X and Y both increase then they are directly or positively related If one variable either X or Y increases and the other decreases then they are negatively or inversely related Straight vs Bowed PPF Straight line Production Possibilities Frontier No Specialization Constant opportunity cost o Constant exchange rate between two goods Bowed outward Production Possibilities Frontier Specialization Increasing opportunity cost o Increasing exchange rate between two goods An economy is most productive with specialized resources The Market System Market is a group of