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ECON120 MICRO, Natasha Park Chapter 1: 10 principles of economics Economy word comes from Greek word for one

e who manages a household Scarcity refers to the limited nature of societys resources in comparison to peoples desires/needs - Does not mean shortage, but everything has an alternative use arises from different wants Economics is the study of how society manages/allocates its scarce resources, including: 1. How people made decisions, how much they work, buy, save, and invest. 2. How people interact with one another how buyers/sellers determine the price of goods 3. Economists analyze forces and trends that affect the economy as a whole, including the growth in average income, the unemployment rate, and the rate at which prices are rising. How people make decisions Decision making is at the heart of economics 4 Principles of Individual Decision Making 1. People face trade-offs Nothing is free to get one thing that we like, we must give up another thing that we like All decisions involve trade-offs (opportunity cost): efficiency vs. equity - Efficiency: getting the most out of scarce resources (the size of the pie) - Equity: distributing prosperity fairly among societys members (how pie is distributed) Trade-off: to increase equity, can redistribute income from the well-off to the poor. But this reduces the incentive to work and produce, and shrinks the size of the economic pie. This does not mean that we should not engage in trade-offs, but that we should acknowledge the importance of trade-offs because people are likely to make good decisions only if they understand the options that they have available redistribute in ways that cause least efficiency loss 2. The cost of something is what you give up to get it Due to trade-offs, making decisions requires comparing the costs and benefits of alternative choices. But usually, the cost of action is not as obvious as it may first appear. Opportunity costs are the costs of using resources for a particular purpose, measured by the benefit of not using them in their next best alternative use - An opportunity cost can only arise when we take an action. If we do one thing or buy one thing, we cant do/buy something else at the same time or with the same money - Firm/person should engage in activity A if the benefits of A exceed the opportunity cost of A - Opportunity costs include o Explicit costs (out of pocket expenses) easy to see since they are connected with specific costs which we pay o Implicit costs (foregone earnings): time (hard to measure by price) - Opportunity costs exclude o Sunk costs (unrecoverable costs): a sum paid in the past irrelevant to future decisions. o Costs that must be incurred regardless of which course of action is taken 3. Rational people think at the margin A person is rational if she purposefully does the best she can to achieve her objectives rational people know that decisions are rarely black and white all or nothing involve marginal (edge) changes to an existing plan (incremental adjustments) A rational decision maker takes an action only if the marginal benefits > cost. The marginal benefit of an item can decrease depending on how much you already have if you are full, you dont gain as much for each extra unit of the good. 4. People respond to incentives Incentive: something that induces a person to act (i.e. the prospect of reward or punishment)

ECON120 MICRO, Natasha Park Rational people respond to incentives because they make choices by comparing costs and benefits Ex: in response to higher gas prices, sales of hybrid cars rise When analyzing any policy, we must consider not only the direct effects, but also the indirect effects that work through incentives. Ex: the seat belt law may lead to people driving less carefully as they depend on the seatbelt may lead to more accidents instead of the intended goal of fewer accidents

3 Principles concerning How People Interact 5. Trade can make everyone better off (how people interact) Rather than being self-sufficient, people can specialize in what they do best, and exchange it for other goods trade allows members to enjoy a greater variety of goods and services Countries also benefit from trade and specialization - Get a better price abroad for good they produce - Buy other goods more cheaply from abroad than could be produced at home A market is a group of buyers and sellers Organize economic activity means determining what goods to produce how to produce them, how much of each to produce, and who gets them 6. Markets are usually a good way to organize economic activity (how people interact) Community countries worked on the premise that central planners in the government were the best position to guide economic activity. Only the government could organize economic activity in a way that promoted economic well-being for the whole country. Central planners failed because they tried to run the economy with the invisible hand tied behind their backs government action impedes the invisible hands ability to coordinate the economy Famous insight by Adam Smith in the Wealth of NationsInvisible hand - Households and firms act as if led by an invisible hand to promote general economic well-being. - Prices are the instrument with which the invisible hand directs economic activity. - the interaction of buyers and sellers determines price of goods and services - Each price reflects the goods value to buyers and the cost of producing the good - Prices guide self-interested households and firms (market economy) to make decisions that maximize societys economic well-being - Firms decide whom to hire and what to make, and household decide which firms to work for and what to buy with their incomes. However, sometimes markets fail due to 1. Lack of competition due to monopoly 2. Externalities 3. Lack of information 4. Public goods: goods that are consumed jointly by many people like national defence 7. Governments can sometimes improve market outcomes (how people interact) The invisible hand can work its magic only if the government enforces the rules and maintains the institutions that are key to a market economy hand doesnt ensure food sufficiency, health, etc. Markets only work if property rights are enforced: the ability of an individual to own/exercise control over scarce resources People are less inclined to work, produce, invest, or purchase if there is a large risk of their property being stolen Invisible hand is powerful, yet not omnipotent. There are 2 reasons for the government to intervene in the economy and change the allocation of resources of individual choices: 1. To promote efficiency to enlarge the economic pie 2. To promote equity to change how the pie is divided

ECON120 MICRO, Natasha Park Market failure: when the market fails to allocate societys resources efficiently in such cases, public policy may increase efficiency 1. Externalities: when the production/consumption of a good affects a third party 2. Market power: a single buyer or seller has substantial influence on market price (monopoly)

3 Principles on How the Economy As a Whole Works 8. A countrys standard of living depends on its ability to produce goods and services Huge variation in living standards across countries and over time - Average income in rich countries is more than 0x the average income in poor countries - The US standard of living today is about 8x larger than 100years ago The most important determinant of living standards is productivity: the amount of goods and services produced from each hour of a workers time the growth rate of a nations productivity determines the growth rate of its average income. Productivity depends on the equipment, skills, education, and technology available to workers The relationship between productivity and living standards also has profound implications for public policy. When thinking about how any policy will affect living standards, the key question is how it will affect our productivity. 9. Prices Rise when the Government Prints Too Much Money Inflation: an increase in the overall level of prices in the economy keeping inflation at a low level is a goal of economic policymakers around the world In most cases of large/persistent inflation, the cause is the growth in the quantity of money. When a government creates a lot of the nations money the value falls. 10. Society Faces a Short-Run Trade-off between Inflation and Unemployment Most economists describe the short-run effects of monetary injections as: - 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 firms to raise prices, but it also encourages them in the meantime to increase the quantity of goods and services they produce and to hire more workers to produce these goods and services - More hiring means lower unemployment Over a period of a year or two, many economic policies push inflation and unemployment in opposite directions. Policymakers face this trade-off regardless of whether inflation and unemployment both start at high levels, or low levels or in between. This short-run trade-off plays a key role in the analysis of the business cycle: the irregular and unpredictable fluctuations in economic activity, as measured by the production of goods and services or the number of people employed Policymakers can exploit the short-run trade-off using various policy instruments. By changing the amount that the governments spend, the amount it taxes, and the amount of money it prints, policy makers can influence the combination of inflation and unemployment. Conclusion Economics offers many insights about the behaviour of people, markets, and economies Based on a few ideas that can be applied in many situations