PRINCIPLES OF Economics. Chapter Ten Principles of Economics 1.

PRINCIPLES OF

Economics

Chapter

Ten Principles of Economics

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Ten principles of economics

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How People Make Decisions1: People Face Trade-offs2: The Cost of Something Is What You Give Up to Get It3: Rational People Think at the Margin4: People Respond to IncentivesHow People Interact5: Trade Can Make Everyone Better Off6: Markets Are Usually a Good Way to Organize Economic Activity7: Governments Can Sometimes Improve Market OutcomesHow the Economy as a Whole Works8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services9: Prices Rise When the Government Prints Too Much Money10: Society Faces a Short-Run Trade-off between Inflation and Unemployment

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Ten Principles of Economics

• Economy – “oikonomos” (Greek)– “One who manages a household”

• Economy is composed of households and firms

• Economics is the study of how households and firms make decisions under scarcity– Scarcity – all resources are scarce (finite)

• Decisions about how to use them implies tradeoffs are involved

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The circular flow

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This diagram is a schematic representation of the organization of the economy. Decisions are made by households and firms. Households and firms interact in the markets for goods and services (where households are buyers and firms are sellers) and in the markets for the factors of production (where firms are buyers and households are sellers). The outer set of arrows shows the flow of dollars, and the inner set of arrows shows the corresponding flow of inputs and outputs.

Ten Principles of Economics

• Scarcity - limited nature of society’s resources• Economics

– Study of how society manages its scarce resources

• Economists study:– How people make decisions – How people interact with one another– Analyze forces and trends that affect the

economy as a whole

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How People Make Decisions

Principle 1: People face trade-offs• Making decisions

– Trade off one goal against another– Society

• National defense vs. consumer goods• Clean environment vs. high level of income• Efficiency vs. equality

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How People Make Decisions

Principle 1: People face trade-offs• Efficiency

– Society - maximum benefits from its scarce resources

– Size of the economic pie• Equality

– Benefits - uniformly distributed among society’s members

– How the pie is divided into individual slices

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The production possibilities frontier

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Quantity ofComputersProduced

Quantity ofCarsProduced

0 300 600 700 1,000

3,000

AB

C

D

E

F

1,000

2,2002,000

ProductionPossibilitiesFrontier

The production possibilities frontier shows the combinations of output - in this case, cars and computers - that the economy can possibly produce. The economy can produce any combination on or inside the frontier. Points outside the frontier are not feasible given the economy’s resources.

The Economist as a Scientist

• Efficient levels of production– Economy’s getting all it can

• From the scarce resources available– Points on the production possibilities frontier– Trade-off:

• The only way to get more of one good• Is to get less of the other good

• Inefficient levels of production– Points inside production possibilities frontier

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How People Make Decisions

Principle 2: The cost of something is what you give up to get it

• People face trade-offs– Make decisions

• Compare cost with benefits of alternatives– Opportunity cost

• Whatever must be given up to obtain one item• PPF – Opportunity cost is what you give up as you

produce more of another good

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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

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How People Make Decisions

Principle 4: People respond to incentives• Incentive

– Something that induces a person to act– Higher price

• Buyers - consume less• Sellers - produce more

– Public policy• Change costs or benefits• Change people’s behavior

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Incentives for Firms

• First Law of Supply:• the higher the market price the greater

the quantity supplied by each firm

Incentives - Consumers

• First Law of Demand– The higher the price, the lower is quantity

demanded

Can Economic Incentives Get You Pregnant?

• http://freakonomics.blogs.nytimes.com/2008/01/16/can-economic-incentives-get-you-pregnant/

• Can fertility rates be linked to financial incentives (or disincentives) to have children? Alma Cohen, Rajeev Dehejia, and Dmitri Romanov, “Do Financial Incentives Affect Fertility?” – We find a significant positive effect on fertility, with the mean level of child

subsidies producing a 7.8 percent increase in fertility. – we find that a large, unanticipated reduction in child subsidies that

occurred in 2003 had a substantial negative impact on fertility. – Overall, our results support that fertility responds to financial

incentives and indicate that the child subsidy policies used in many countries can have a significant influence on incremental fertility decisions.

How People Interact

Principle 5: Trade can make everyone better off • Trade

– 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

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How People Interact

Principle 6: Markets are usually a good way to organize economic activity

• Communist countries – central planning– Government officials (central planners)

• Allocate economy’s scarce resources– Decided

» What goods & services were produced» How much was produced» Who produced & consumed these goods & services

• Theory: only the government could organize economic activity to promote economic well-being for the country as a whole

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How People Interact

Principle 6: Markets are usually a good way to organize economic activity

• Market economy - allocates resources– Decentralized decisions of many firms and

households– As they interact in markets for goods and

services – Guided by prices and self interest– Adam Smith’s “invisible hand”

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How People Interact

Principle 7: Governments can sometimes improve market outcomes

• We need government– Enforce the rules – Maintain institutions - key to market economy

• Enforce property rights

• Property rights– Ability of an individual to own and exercise

control over scarce resources

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How People Interact

Principle 7: Governments can sometimes improve market outcomes

• Government intervention– Change allocation of resources– To promote efficiency

• Avoid market failure– To promote equality

• Avoid disparities in economic wellbeing

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How People Interact

• Market failure– Situation in which the market on its own fails

to produce an efficient allocation of resources• Causes for market failure

– Externality• Impact of one person’s actions on the well-being

of a bystander– Market power

• Ability of a single person (or small group) to unduly influence market prices

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How People Interact

• Disparities in economic wellbeing– Market economy

• Rewards people - ability to produce things that other people are willing to pay for

– Government intervention• Public policies

– May diminish inequality– Process far from perfect

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