ECON 203 Exam 1 Study Guide Chapter 1 Introduction Scarcity society has limited resources and can t produce all goods and services people wish to have Economics the study of how society manages its scarce resources Allocated through combined actions of households and firms Economists study how people make decisions How much they work what they buy They also study how people interact with one another How buyers and sellers of a good determine price and quantity of a good sold How People Make Decisions 1 People Face Trade offs a Example how does a student allocate her time for psychology and economics i All her time on economics all on psych or divide ii For every hour spent on one subject she loses an hour on the other iii For every hour studying she loses an hour for napping b Within societies people face different trade offs c More spent on defense less spent on good to improve standard of living d Clean environment or higher income i Reduce pollution means raising the cost of production ii Higher costs means smaller profits and lower wages e Efficiency v Equality i Efficiency maximum benefits for scarce resources ii Equality benefits are distributed uniformly iii Conflict 1 Welfare seeks to equalize distribution 2 With the income tax the financially successful contribute more 3 More equality means less efficiency a With a lower reward people produce less 2 The Cost of Something is What You Give Up to Get It a Example decision to go to college i Benefits better job opportunities enrichment ii Costs tuition books room part of the cost but not all of it 1 Even if you aren t in college you need room and food 2 Cost of college is the extent of how much more expensive 3 Calculation ignores the cost of time time in class means less time working to earn money b Opportunity Cost what you give up to get an item i College athletes often drop out because they can earn millions professionally 1 Opportunity cost stay in college potentially give up millions of dollars 3 Rational People Think at the Margin a People who think systematically and purposefully do the best they can to achieve objectives b Decisions involve shades of grey i Extra roll or not at dinner extra hour studying or sleeping c Marginal change small change to a plan of action d Rational people make decision by comparing marginal costs and marginal benefits e Example 200 seat plane costs 100 000 to fly regardless of how many people fly i 10 seats are left and standby passengers will pay 300 a ticket 1 Take the offer the marginal costs is the cost of drinks and peanuts a As long as the passenger pays more than the marginal cost f A person s willingness to pay for a good is based on the marginal benefit of an extra unit and depends on how many units a person already ha i Water has a low marginal benefit because it is cheap and plentiful ii Diamonds being rare have a high marginal benefit because the benefit of another diamond would be rather high g A rational person will only take action if the marginal benefit exceeds marginal cost 4 People Respond to Incentives a Incentive something that induces a person to act b Example the price of an apple rises so people eat fewer but since the price is higher orchards will hire more labor to harvest more c Also applies to policymaking i Example tax on gas will encourage people to drive fuel efficient cars carpool ii Seatbelt laws 1 When a person wears one they are more likely to survive an accident 2 Similar drive slowly when the benefit of increased safety is higher than the cost of time energy 3 So people respond to seat belts like improved roads by driving faster and less carefully a Seat belts reduce benefits of careful driving iii Policymakers must consider direct and indirect effects through incentives How People Interact 5 Trade Can Make Everyone Better Off a Example when a family member looks for a job he or she competes against members of other families i If your family is isolated you would have to grow your own food make your own clothes etc 1 Trade allows each person to specialize in their best activities a When you trade with others there is a greater variety of goods and services at a lower cost b Same concept applies to different countries 6 Markets Are Usually a Good Way to Organize Economic Activity a Market economy allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services ii Firms choose who to hire what to produce iii Households who to work for what to buy b Contains buyers and sellers focused on their own well being not on society itself c Adam Smith 1776 book invisible hand iv Households and firms interact as if they are led by an invisible hand leading them to desirable outcomes v Price is the instrument that directs economic activity 1 Buyers look at the price when determining how much to demand 2 Sellers look at the price when deciding how much to supply 3 Result prices reflect value of the good to society and the cost to society of making the good vi When the government prevents prices from naturally adjusting it keeps the invisible hand from coordinating decisions within the economy 1 Taxes distort prices which distorts the decisions of buyers and sellers 7 Governments Can Sometimes Improve Market Outcomes a The hand only works if the rules are enforced b Institutions are needed to enforce property rights vii Property rights the ability of an individual to own and exercise control over their scarce resources c Two broad reasons for government involvement promote efficiency and equality d Market failure the market alone fails to produce efficient allocation of resources viii Externality impact of one person s actions on well being of bystander ix Market power ability of a single economic actor to have a substantial influence on market prices e In regards to equality x Example the best basketball player earns more than the best chess player a People will pay to watch basketball b The hand doesn t ensure everyone is well off c Public policy achieve equal distribution of well being i Not perfect some of it rewards politically powerful How the Economy Works as a Whole 8 A Country s Standard of Living Depend on Its Ability to Produce Goods and Services a Living standards across the world are varied i Variation in income means a variation in life quality b Living standards have hugely change over time c Explained by productivity i Quantity of goods and services produced from each unit of