Econ 2000 1 Study Guide For Exam 1 The Ten Key Elements of Economics Section This section accompanies pages 5 39 in your Common Sense Economics textbook Economics is the science of how individuals make choices under scarcity Scarcity is the concept that there is not enough of a good freely available from nature so that people can have as much as they would like This is an objective term very different from poverty 1 Scarcity is not the same thing as poverty 2 Scarcity necessitates rationing A Rationing allocating scarce goods to those who want them B In market economy price is used to ration goods 3 Scarcity leads to competitive behavior A According to economist competition is good There are three types of resources An input used to produce an economic good A Human resources human capital skills of a person intelligence not what you see or touch B Physical resources physical capital pens chairs C Natural resources gold natural gas Twelve key elements of economic thinking 1 Incentives matter A People respond to changing incentives in a predictable way example money game B What is rational for one person is not rational for everyone C D Utility The subjective benefit or satisfaction a person expects from a choice Individuals are rational they try to get the most from their limited resources or course of action 2 No such thing as a free lunch because resources are scarce tradeoffs must be made A Opportunity Cost The highest valued alternative that must be sacrificed when choosing an option 3 Decisions are made at the margin A Marginal describes the effect of a change in the current situation change or B Example ponderosa buffet all you can eat side bar 7 steak and all you can eat additional side bar 9 C Example Drive or fly MB is steak MC is 2 o Law of Diminishing Marginal Utility as consumption increases the marginal utility derived from additional consumption will eventually decline Ex Banana eating contest 1 Ex Fav song o the Diamond water paradox don t confuse the total value with marginal value the rarity is worth more why actors get paid more than nurses o Marginal thinking may also be why a stepwise criminal justice punishment system might be more effective than a capital punishment system Speeding ticket different prices different speeds make it the worse punishment for any speed then its 0 100 instead of gradual o Cost benefit analysis when making a decision one system compares the marginal benefits and costs D People will rationally choose not to become fully informed when making decisions o To be economically efficient o Perfection may not always be what you need o May be too costly to run perfection o Why people will choose to not be fully informed when making a decision 4 Voluntary trade promotes economic progress A Know how trade creates value by putting goods into the hands of those who want them the most Voluntary vs coerced Coercion someone will make you worse off if you don t comply Because the value of a good or service is subjective voluntary trade moves goods from people who value them more Trade makes larger output and consumption levels possible because it allows us to specialize in what we do best B Trade makes larger output and consumption levels possible through specialization The Law of Comparative Advantage Law of comparative advantage individuals economies and nations should produce that which they can make at a lower opportunity cost and trade for everything else Should LeBron James clean his own house Who should mow the lawn C Voluntary trade makes it possible to produce things at a lower cost through mass production techniques Voluntary exchange makes it possible for firms to achieve lower per unit costs by adopting mass production methods Average total cost cost quantity 5 Transaction costs are an obstacle to trade Transaction costs are the time effort and other resources needed to search out and complete an exchange Middleman reduce transaction costs Ex penny delivers Walmart 2 6 Prices bring the choices of buyers and sellers into balance know how a market equilibrium is created supply and demand section Sellers prefer to sell things for higher prices Buyers prefer to buy things for lower prices Market prices bring these two conflicting forces into balance 7 Profits direct businesses toward activities that increase wealth A Understand the definitions of profits and losses and their economic role in creating a prosperous society Profit an excess of sales revenue relative to the opportunity cost of production a profit occurs only when the value of the good produced is greater than the value of all the resources used for it production revenue cost profit loss a deficit of sales revenue relative to the opportunity cost of production losses are penalties imposed on those who produce goods that are valued less than all of the resourced required for their production 8 People Earn Income by Helping Others A Entrepreneurs who create things make everybody better off by expanding the pie rather than taking a slice of it The process by which some people become rich will make everybody richer 9 Production not just jobs provides the source of high living standards Know that destruction and jobs that don t produce useful goods and services do not add to economic growth 1 Hole digging decree have people dig holes have other people fill them 2 Window breaking bill breaking window replacing window Window breaking fallacy Lets boost the economy Agricultural Adjustment Act 1993 govmt paid farmers to destroy crops to make them scarce and drive the price up ruled this unconstitutional Car allowance rebate system 2009 pay car manufacturers to destroy used cars in order to raise the economy failed 10 Economic progress comes primarily through trade investment better ways of doing things and sound economic institutions A B Investment makes us richer but costs in terms of current consumption Improvements in technology spur economic progress Student can do more with a computer printer and internet than paper pencil and books Creative Destruction The replacement of old products and production methods by innovative new ones that consumers judge to be superior 3 C Improvements in economic organization can promote growth comes from a legal system that promotes private property rights competition personal and economic freedom 11 The invisible hand and the role of prices A The invisible hand the tendency for people while pursuing their own interests to promote the economic well