I. Introduction
What is economics
What is the fundamental economic problem?
II. How People
Make Decisions
Principle #1: People Face Trade-offs
What do I mean by “There ain’t no such thing as a free lunch.”?
Provide your own tradeoff examples.
A special example of a trade-off is the trade-off between
efficiency and equality.
What is efficiency
What is equity
Principle #2:
The Cost of Something Is What You Give Up to Get It
Making
decisions requires individuals to consider the benefits and costs of some
action.
What are the
opportunity costs of going to college?
Principle #3:
Rational People Think at the Margin
Definition of marginal
changes: small incremental adjustments to a plan of action.
D. Principle #4:
People Respond to Incentives
Definition of
incentive: something that induces
a person to act.
III. How People Interact
Principle #5:
Trade Can Make Everyone Better Off
Trade is not
like a sports contest, where one side gains and the other side loses.
Principle #6: Markets Are Usually a
Many countries that
once had centrally planned economies have abandoned this system and are trying
to develop market economies.
Definition of
market economy: an economy that
allocates resources through the decentralized decisions of many firms and
households as they interact in markets for goods and services.
Market prices
reflect both the value of a product to consumers and the cost of the resources
used to produce it.
Adam Smith’s
1776 work suggested that although individuals are motivated by self-interest, an
invisible hand guides this self-interest into promoting society’s economic
well-being.
Smith’s
conclusions will be analyzed more fully in the chapters to come.
Principle #7: Governments Can Sometimes Improve Market Outcomes
The invisible hand will only work if price adjust properly.
Examples of Market
Failure
Definition of
externality: the impact of one
person’s actions on the well-being of a bystander.
Definition of
market power: the ability of a
single economic actor (or small group of actors) to have a substantial influence
on market prices.
Even though it is not a market failure the government can improve equity.
IV. How the Economy as
a Whole Works
Principle #8: A
Country’s Standard of Living Depends on Its Ability to Produce Goods and
Services
The explanation
for differences in living standards lies in differences in productivity.
Definition of
productivity: the quantity of
goods and services produced from each unit of labor input.
High
productivity implies a high standard of living.
Principle #9: Prices Rise When the Government Prints Too Much
Money
Definition of
inflation: an increase in the
overall level of prices in the economy.
When the
government creates a large amount of money, the value of money falls, leading to
price increases.
Examples:
Principle #10:
Society Faces a Short-Run Trade-off between Inflation and Unemployment
The Economist as Scientist
Economists
Follow the Scientific Method.
Observations
help us to develop theory.
Data can be
collected and analyzed to evaluate theories.
Using data to
evaluate theories is more difficult in economics than in physical science
because economists are unable to generate their own data and must make do with
whatever data are available.
Thus,
economists pay close attention to the natural experiments offered by history.
Assumptions
Make the World Easier to Understand.
Example: to
understand international trade, it may be helpful to start out assuming that
there are only two countries in the world producing only two goods. Once we
understand how trade would work between these two countries, we can extend our
analysis to a greater number of countries and goods.
Economists
often use assumptions that are somewhat unrealistic but will have small effects
on the actual outcome of the answer.
The Circular Flow Diagram
Definition of
circular-flow diagram: a visual
model of the economy that shows how dollars flow through markets among
households and firms.
This diagram
is a very simple model of the economy. Note that it ignores the roles of
government and international trade.
There are two
decision makers in the model: households and firms.
There are two
markets: the market for goods and services and the market of factors of
production.
Firms
are sellers in the market for goods and services and buyers in the market for
factors of production.
Households
are buyers in the market for goods and services and sellers in the market for
factors of production.
The Production Possibilities Frontier
Production
possibilities frontier: a graph that shows the combinations of output that
the economy can possibly produce given the available factors of production and
the available production technology.
Because
resources are scarce, not every combination of computers and cars is possible.
Production at a point outside of the curve (such as C) is not possible given the
economy’s current level of resources and technology.
Production is
efficient at points on the curve (such as A and B). This implies that the
economy is getting all it can from the scarce resources it has available. There
is no way to produce more of one good without producing less of another.
Production at
a point inside the curve (such as D) is possible, but inefficient.
The production
possibilities frontier reveals Principle #1: People face tradeoffs.
Principle #2
is also shown on the production possibilities frontier: The cost of something is
what you give up to get it (opportunity cost).
The production possibilities frontier can shift if resource
availability or technology changes. Economic growth can be illustrated by an
outward shift of the production possibilities frontier.
Microeconomics and
Macroeconomics
Economics is
studied on various levels.
microeconomics:
the study of how households and firms make decisions and how they interact in
markets.
macroeconomics:
the study of economy-wide phenomena, including inflation, unemployment, and
economic growth.
Positive Versus
Normative Analysis
positive statements:
claims that attempt to describe the world as it is.
normative statements:
claims that attempt to prescribe how the world should be.