EC 201 Chapter 1 Ten Principles of Economics The word economy comes from the greek word oikonomos which means one who manages a household The household must allocate its scarce resources among its various members taking into account each member s abilities efforts and desires Scarcity means that society has limited resources and therefore cannot produce all the goods and services people wish to have Economics is the study of how society manages its scarce resources Economists study how people make decisions how much they work what they buy how much they save and how they invest their savings They also study how people interact with one another They also analyze forces and trends that affect the economy as a whole including the growth in average income the fraction of the population that cannot nd work and the rate at which prices are rising Ten Principles of Decision Making 1 People Face Trade Offs Ef ciency means that society is getting the maximum bene t from its scarce resources Ef ciency refers to the size of the economic pie Equality means that those bene ts are distributed uniformly among society s members Equality refers to how the pie will be divided into individual slices 2 The cost of something is what you give up to get it Opportunity Cost of an item is what you give up to get that item 3 Rational People Think at the Margin Rational people systematically and purposefully do the best they can to achieve their objectives given the available opportunities They often make decisions by comparing marginal bene ts and marginal costs Marginal Change a small incremental adjustment to an existing plan of action 4 People Respond to Incentives Incentives Something that induces a person to act such as the prospect of a punishment or reward They are crucial to analyzing how markets work The in uence of prices on the behavior of consumers and producers is crucial for how a market economy allocates scarce resources 5 Trade Can Make Everyone Better Off Trade allows each person to specialize in the activities that he or she does best By trading with others people can buy a greater variety of goods and services at lower costs 6 Markets are Usually a Good Way to Organize Economic Activity In a Market Economy the decisions of a central planner are replaced by the decisions of millions of rms and households Firms decide whom to hire and what to make Households decide which rms to work for and what to buy with their incomes These rms and households interact in the marketplace where prices and self interest guide their decisions In any market buyers look at the price determining how much to demand and sellers look at the price when deciding how much to supply As a result of the decisions that buyers and sellers make market prices re ect both the value of a good to society and the cost to society of making the good Prices adjust to guide these individual buyers and sellers to reach outcomes that in many cases maximize the well being of the society as a whole When the government prevents prices from adjusting naturally to supply and demand it impedes the invisible hand s ability to coordinate the decisions of the households and rms that make up the economy Example Taxes adversely affect the allocation of resources for they distort prices and thus the decisions of households and rms 7 Governments Can Sometimes Improve Market Outcomes The invisible hand of the marketplace can only work if the government enforces the rules and maintains the institutions that are key to the market economy Market economies need institutions to enforce property rights so individuals can own and control scarce resources Two reasons for a government to intervene in the economy and change the allocation of resources that people would choose on their own To promote ef ciency To promote equality Market Failure refers to a situation in which the market on its own fails to produce ef cient allocation of resources Externality is a possible cause of market failure It is the impact of one person s actions on the well being of a bystander ex Pollution Market Power refers to the ability of a single person or group to unduly in uence market prices ex If there is only one seller of a product or item A market economy rewards people according to their ability to produce things that other people are willing to pay for 8 A Country s Standard of Living Depends on its Ability to Produce Goods and Services Almost all variation in living standards is attributed to the differences in counties productivity that is the amount of goods and services produced from each unit of labor input 9 Prices Rise When the Government Prints Too Much Money In ation an increase in the overall level of prices in the economy In almost all cases of large or persistent in ation the culprit is growth in the quantity of money When the government creates large quantities of the nations money the value of the money falls 10 Society Faces a Short Run Trade Off between In ation and Unemployment Most economists describe the effects of monetary injections as follows Increasing the amount of money in the economy stimulates the overall level of spending and thus the demand for goods and services Higher demand may over time cause rms to raise their prices but in the meantime it also encourages them to hire more workers and produce a larger quantity of goods and services More hiring means less unemployment Business Cycle the irregular and largely unpredictable uctuations in economic activity as measured buy the production of goods and services or the number of people employed Policymakers can exploit these trade offs between in ation and unemployment By changing the amount that the government spends the amount it taxes and the amount of money it prints policymakers can in uence the overall demand for goods and services Changes in demand in turn in uence the combination of in ation and unemployment that the economy experiences in the short run