1 4 15 Micro Chapter 1 10 principles of economics What kinds of questions does econ address 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 What is economics all about Scarcity The limited nature of society s resources Economics is the study of how society manages its scarce resources How people decided 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 defenses consumer goods protecting environment and other needs The principles of how people make decisions PRINCIPLE 1 People face tradeoffs All decisions involve tradeoffs Examples 1 Going to a party the night before your midterm leaves less time for studying 1 Having more money to buy stuff requires working longer hours which leaves time for leisure 2 Protecting the environment requires resources that could otherwise be used to produce consumer goods 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 PRINCIPLE 2 The cost of something is what you give up to get it 1 Making decisions requires comparing the costs and benefits of alternative choices 2 The opportunity cost of any items is whatever must be given up to obtain it 3 It is the relevant cost for decision making 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 theater Note the cost of something doesn t not always involve only money 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 PRINCIPLE 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 When gas prices rise consumers buy more hybrid cars and fewer gas guzzling SUVs PRINCIPLE 5 Trade can make everyone better off Rather than being self sufficient people can specialize in producing one good or service and exchange it for other goods Countries also benefit from trades and specialization Get a better price abroad for goods they produce 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 How How Who to produce to produce them much of each to produce gets them 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 act as if led by and Invisible hand to promote general economic well being PRINCIPLE 7 Governments can sometimes improve market outcomes Important role for govt 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 Cause of market failure Externalities when the production or consumption of a good affects bystanders e g pollution negative positive Market power a single buyer or seller has substantial influence on market price e g monopoly Public policy may promote equality The principles of how the economy as a whole works PRINCIPLE 8 A country s standard of living depends on its ability to produce goods and services Huge variation in living standard across countries 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 8 times larger than 100 years ago 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 PRINCIPLE 9 Prices rise when the government prints to 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 government creates money the greater inflation rate Real VS Nominal values Nominal 5000 Real 4000 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 i e higher inflation means lower inflation the Philips curve shows this inverse relationship Other factors can make this tradeoff more or less favorable but the tradeoff is always present Summary The principles of decision making are 1 People face tradeoffs 2 The cost of any action is measured in terms of foregone opportunities 3 Rational people make decisions by comparing marginal costs and marginal benefits 4 People respond to incentives