EC 111 Test One What Economics is All About 08 25 2015 Scarcity the limited nature of society s resources Economics the study of how society manages its scarce resources o How people decide what to buy how much to work save and spend o How much firms decide to produce how many workers to hire o How society decides how to divide its resources between national defense consumer goods protecting the environment and other needs Principle 1 People Face Tradeoffs All decisions involve tradeoffs Examples o Going to a party the night before your midterm leaves less time for studying o Having more money to buy stuff requires working longer hours which leaves less time for leisure Society faces an important tradeoff o Efficiency vs equality Efficiency when society gets the most from its scarce resources Equality when prosperity is distributed uniformly among society s members equity and equality are the same thing for this class o 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 Making decisions requires comparing the costs and benefits of The opportunity cost of any item is whatever must be given up to alternative choices obtain it o It s measured as the highest valued alternative given up o It is the relevant cost for decision making o Examples The opportunity cost of going to college for a year is not just the tuition books and fees but also the foregone wages The opportunity cost of seeing a movie is not just the price of the ticket but the value of the time you spend in the theater Principle 3 Rational people think at the margin Rational People o Do the best they can to achieve their objectives o Make decisions by evaluating costs and benefits of marginal changes incremental adjustments to an existing plan o Example When a student considers whether to go to college for an additional year he compares the fees foregone wages to the extra income he could earn with the extra year of education 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 o When gas prices rise consumers buy more hybrid cars and fewer gas guzzling SUVs o When cigarette taxes increase smoking falls Applying the principles on repairs You are selling your 1996 Mustang You have already spent 1000 At the last minute the transmission dies You can pay 600 to have it repaired or sell the car as is o A blue book value is 6500 if transmission works 5700 if it doesn t Benefit of fixing the transmission 800 6500 5700 Have the transmission fixed 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 trade specialization o Get a better price abroad for goods they produce o Buy other goods more cheaply from abroad than could be produced from home 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 o what goods to produce o how to produce them o how much of each to produce o who gets them A market economy allocates resources through the decisions of many households and firms as they interact in markets The invisible hand works through the price system o The interaction of buyers and sellers determines prices o Each price reflects the good s value to buyers and the ost of producing the good o Prices guide self interested households and firms to make decisions that in many cases maximize society s economic well being Principle 7 Governments can sometimes improve market outcomes Important role for gov t enforce property rights with police courts People are less inclined to work produce invest or purchase if large risk od their property being stolen Market failure when the market fails to allocate society s resources efficiently o Causes Externalities when the production or the consumption of a good affects bystanders ex pollution Market Power a single buyer or seller has substantial influence on market price ex monopoly o In such cases public policy may promote efficiency Gov t may alter market outcome to promote equity If the market s distribution of economic well being is not desirable tax or welfare policies can change how the economic pie is divided Principle 8 A country s standard of living depends on its ability to produce goods services 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 Other factors e g labor unions competition from abroad have far less impact on living standards Principle 9 Prices rise when the government prints too much 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 gov t creates money the greater the inflation rate Principle 10 Society faces a short run tradeoff between inflation and In the short run 1 2 years many economic policies push inflation and unemployment in opposite directions money unemployment o Assumptions Models Assumptions Models 08 25 2015 Assumptions simplify the complex world make it easier to Example To study international trade assume two countries and two goods Unrealistic but simple to learn and gives useful insights about the real world Model a highly simplified representation of a more complicated understand reality Economists use models to study economic issues Our first Model The Circular Flow Diagram The Circular Flow Diagram a visual model of the economy shows how dollars flow through markets among households and firms Two types of actors o Households o Firms Two markets o The market for goods and services o The market for factors of production Factors of Production inputs Factors of Production the resources the economy uses to produce goods services including o Labor o Land raw material natural resources o Capital buildings machines used in production o Entrepreneurship the idea behind the business every business started with an idea Figure 1 The Circular Flow Diagram Households Firms Own the factors