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Chapter 1

What Economics Is All About


Economy : comes from the Greek word “oikonomos”
meaning the “one who manages the Household”
Economics : the study of how society manages its
scarce resources
Scarcity: the limited nature of society’s resources

Economist study: how people make decisions


: how people interact with one another.
: analyze forces and trends that affect
the economy as a whole
TEN PRINCIPLES OF ECONOMICS
How People Make Decisions
1: People Face Trade-offs
2: The Cost of Something Is What You Give Up to Get It
3: Rational People Think at the Margin
4: People Respond to Incentives
How People Interact
5: Trade Can Make Everyone Better Off
6: Markets Are Usually a Good Way to Organize Economic Activity
7: Governments Can Sometimes Improve Market Outcomes
How the Economy as a Whole Works
8: A Country’s Standard of Living Depends on Its Ability to
Produce Goods and Services
9: Prices Rise When the Government Prints Too Much Money
10: Society Faces a Short-Run Trade-off between Inflation and
Unemployment
HOW PEOPLE MAKE DECISIONS
Principle #1: People Face Tradeoffs
“Society faces an important tradeoff:
efficiency vs. equality
Efficiency: the property of the society getting the most it
can from its scarce resources
Equality: the property of distributing economic prosperity
uniformly among society’s members

Example:
•Protecting the environment requires resources
that could otherwise be used to produce
consumer goods
HOW PEOPLE MAKE DECISIONS
Principle #1: People Face Tradeoffs

•“There is no such thing as a free lunch.”

•All decisions involve tradeoffs


Tradeoff: trading one goal against the other

EXMPLES:
•Going to a party the night before the midterm exam leaves
less tine for studying.

•Having more money to buy stuff requires working longer


hours, which leaves less time for leisure.
HOW PEOPLE MAKE DECISIONS
Principle #1: People Face Tradeoffs

•“There is no such thing as a free lunch.”

•All decisions involve tradeoffs


Tradeoff: trading one goal against the other

EXMPLES:
•Going to a party the night before the midterm exam leaves
less tine for studying.

•Having more money to buy stuff requires working longer


hours, which leaves less time for leisure.
HOW PEOPLE MAKE DECISIONS
Principle #2: The Cost of Something Is
What You Give Up to Get It

• Making decisions requires comparing the costs


and benefits of alternative choices.

• The opportunity cost of any item is


whatever must be given up to obtain it.

• The cost of any action is measured in terms of


forgone opportunity. It is the relevant cost for
decision making.
HOW PEOPLE MAKE DECISIONS
Principle #3:
Rational People Think at the Margin

•Rational people
Systematically & purposefully do the best they can to
achieve their objectives

•Marginal changes
Small incremental adjustments to a plan of action

•Rational decision maker – take action only if


Marginal benefits > Marginal costs
HOW PEOPLE MAKE DECISIONS
Principle #4: People Respond to Incentives

•Incentive something that induces a person to act, i.e. the


prospect of a reward or punishment.

•Incentive causes people to alter their behavior.

•Higher price
Buyers - consume less
Sellers - produce more

Example:
• A tax on gasoline, for instance, encourages people to
drive smaller, more fuel-efficient car. It also encourages
people to take public transportation rather than drive.
HOW PEOPLE INTERACT
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.

Specialization -Allows each person/country to specialize in


the activities he/she does best

•People/countries can buy a greater variety of goods and


services at lower cost
HOW PEOPLE INTERACT
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
• what goods to produce
• how to produce them
• how much of each to produce
• who gets them
HOW PEOPLE INTERACT
Principle #6: Markets Are Usually A Good
Way to Organize Economic Activity
• A market economy allocates resources through the
decentralized decisions of many households and firms as
they interact in markets.

• Famous insight by Adam Smith in


The Wealth of Nations (1776):
• Each of these households and firms
acts as if “led by an invisible hand”
to promote general economic well-being.
HOW PEOPLE INTERACT
Principle #6: Markets Are Usually A Good
Way to Organize Economic Activity
HOW PEOPLE INTERACT
Principle #7: Governments Can Sometimes
Improve Market Outcomes
• Important role for government- Enforce the rules (with
police, courts)

Property rights
Ability of an individual to own and exercise control over
scarce resources.

• People are less inclined to work, produce, invest, or


purchase if large risk of their property being stolen.
HOW PEOPLE INTERACT
Principle #7: Governments Can Sometimes
Improve Market Outcomes
•Government intervention

•Change allocation of resources

To promote efficiency
- Avoid market failure (such as externalities and
market power)

To promote equality
- Avoid disparities in economic wellbeing
HOW THE ECONOMY AS A WHOLE WORKS
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.

•The growth rate of a nation’s productivity determines the


growth rate of its average income.
HOW THE ECONOMY AS A WHOLE WORKS
Principle #9: Prices rise when the
government prints too much money
•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 government creates money, the greater the


inflation rate.

Ex.
HOW THE ECONOMY AS A WHOLE WORKS
Principle #9: Prices rise when the
government prints too much money
•Hyperinflation: very high and typically accelerating inflation
HOW THE ECONOMY AS A WHOLE WORKS
Principle #10: Society faces a short-run
tradeoff between inflation and unemployment
• In the short-run (1 – 2 years), many economic policies
push inflation and unemployment in opposite directions.

• Short run effects of monetary injections:


- stimulates spending
- higher demand of goods and services
- Firms –raise prices, hire more workers; produce more
goods and services
- lower unemployment
- the purchasing power of currency is falling.
source: N. Gregory Mankiw
Thank you!

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