Ten Principles of Economics

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Economy. . .

. . . The word economycomes from a Greek word for “one who manages a household.”

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A household and an economy face many decisions:

υ Who will work? food , clothing, computers, software

υ What goods and how many of them should be produced?

υ What resources should be used in production?

υ At what price should the goods be sold?

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Scarce resources

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SCARCE RESOURCES

ν A household faces many decisions: Who in the household cooks dinner, who washes up who

controls the tv zapper. In short a household allocates its resources among its

members, taking into account each members abilities, efforts and desires

Like a household a society faces many decisions. It needs some people to grow food, some people to build houses, make computers/software, clothing.

In other words society allocates people to various jobs. But in addition to allocating people to do various jobs it must also allocate the OUTPUT of goods and services produced. It must decide who eats cavier and who will eat potatoes. Who will drive BMWs and who will use public transport.

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Society and Scarce Resources:

The management of society’s resources is important because resources are scarce. A society cannot give every individual the highest standard of living he desires no more than a household can give every member everything he wants.

Examples: land, oil, water

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Economics

Economicsis the study of how society manages its scarce resources.The

study of economics is broad but unified by several basic principles.

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MARKET ORIENTATION

Cuba

Hong KongIRL

Sweden

Cuba

USA

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Distribution of Global Wealth

ν TOP 1% OF WORLD POPULATION CONTROL 40% OF WORLD WEALTH

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ν 1,200 global billionaires with total wealth of $4.5 trillion

ν 3 billion adults with net worth of less than $10,000.

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Economists study. . .

υ How people make decisions.

υ How people interact with each other.

υ The forces and trends that affect the economy as a whole.

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Ten Principles of Economics

∂ People face tradeoffs.

• The cost of something is what you give up to get it.

÷ Rational people think at the margin.≠ People respond to incentives.

How People Make Decisions

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1. People face tradeoffs.

“There is no such thing as a free lunch!”

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1. People face tradeoffs.To get one thing, we usually have to give up another thing.

What families do with their income, holidays, retirements, food, clothing etc.

υ Guns v. butterυ Environment v Living Standardsυ Food v. clothingυ Leisure time v. workυ Efficiency v. equity

Making decisions requires trading off one goal against another. Simply because there are trade-offs does not tell us what decision we should take. We should not decide that poor people should not have welfare payments simply because it

distorts economic activity.

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1. People face tradeoffs.

υ Efficiency means society gets the most that it can from its scarce resources.

υ Equity means the benefits of those resources are distributed fairly among the members of society.

Efficiency v. Equity

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

Decisions require comparing costs and benefits of alternatives.

υ Whether to go to college or to work?υ Whether to study or go out on a date?υ Whether to go to class or sleep in?

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2. The cost of something is what you give up to get it.The opportunity cost of an item is what you give up to

obtain that item.

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3. Rational people think at the margin.

Marginal changesare small, incremental adjustments to an existing plan of action.

E.G. Airlines, Restaurants

People make decisions by comparing costs and benefits at the margin.

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Incentivesν People respond to incentives

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Incentives

ν Most of Economics can be summarised in four words:

PEOPLE RESPOND TO INCENTIVES

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4. People respond to incentives.

υ Marginal changes in costs or benefits motivate people to respond.

υ The decision to choose one alternative over another occurs when that alternative’s marginal benefits exceed its marginal costs!

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People Respond To Incentives

ν Seat Belt lawsν Probability of surviving major accident

rises. Therefore, seatbelts saves lives.ν BUT – people’s behaviour changes in

response to the incentives they face.ν Relevant behaviour here is the speed and

care with which people operate their cars.

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People respond to incentives

ν Driving slowly and carefully is costly because it uses the driver’s time and energy

ν When deciding how safely to drive rational people compare the marginal benefit from safer driving to the marginal cost.

ν They drive more safely and carefully when the benefit from increased safety is high.

ν This explains why people drive more safely when roads are icy.

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People Respond To Incentives

ν How does the seat belt law alter peoples incentives

ν Seat belts make accidents less costly for the driver because they reduce the probability of injury or death.

ν Therefore seat belt laws reduce the benefits of slow and careful driving

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People Respond To Incentives

ν People respond to seat belt laws as they would to an improvement in road conditions – by faster and less careful driving.

ν The unintended result of seat belt laws is a larger number of accidents

ν Drivers are more likely to survive an accident but are also more likely to be involved in accidents

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A Tax on petrol encourages people to drive smaller cars and use public transport and live closer to work.

People change their behaviour in response to the incentives they face.

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Ten Principles of Economics

≡ Trade can make everyone better off.

≈ Markets are usually a good way to organize economic activity.

…Governments can sometimes improve economic outcomes.

How People Interact

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Trade can make people better-off – even superheroes

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5. Trade can make everyone better off.

υ People gain from their ability to trade with one another.

υ Competition results in gains from trading.

υ Trade allows people to specialize in what they do best.

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6. Markets are usually a good way to organize economic

activity.

υ In a market economy, households decide what to buy and who to work for.

υ Firms decide who to hire and what to produce.

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6. Markets are usually a good way to organize economic

activity.

Adam Smith made the observation that households

and firms interacting in markets act as if guided by an

“invisible hand.”

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6. Markets are usually a good way to organize economic

activity.

υ Because households and firms look at prices when deciding what to buy and sell, they unknowingly take into account the social costs of their actions.

υ As a result, prices guide decision makers to reach outcomes that tend to maximize the welfare of society as a whole.

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7. Governments can sometimes improve market

outcomes.

When the market fails (breaks down) government can intervene to

promote efficiencyand equity.

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7. Governments can sometimes improve market

outcomes.

Market failure occurs when the market fails to allocate

resources efficiently.

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7. Governments can sometimes improve market

outcomes.

Market failure may be caused by anexternality, which is the impact of one person or firm’s actions on the

well-being of a bystander.

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7. Governments can sometimes improve market

outcomes.

Market failure may also be caused by market power, which is the ability of a single person or firm to unduly

influence market prices.

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Ten Principles of Economics

The standard of living depends on a country’s production.

Prices rise when the government prints too much money.

↵ Society faces a short-run tradeoff between inflation and unemployment.

How the Economy as a Whole Works

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8. The standard of living depends on a country’s

production.

Standard of living may be measured in different ways:

υ By comparing personal incomes.

υ By comparing the total market value of a nation’s production.

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8. The standard of living depends on a country’s

production.

Almost all variations in living standards are explained by

differences in countries’productivities.

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8. The standard of living depends on a country’s

production.

Productivity is the amount of goods and services produced from each

hour of a worker’s time.

Higher productivity ���� Higher standard of living

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9. Prices rise when the government prints too much

money.

Inflation is an increase in the overall level of prices in the economy.

υ One cause of inflation is the growth in the quantity of money.

υ When the government creates large quantities of money, the value of the money falls.

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10. Society faces a short-run tradeoff between inflation and

unemployment.

The Phillips Curve illustrates the tradeoff between inflation and unemployment:

����Inflation ���� ����Unemployment

It’s a short-run tradeoff!

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Summary

υ When individuals make decisions, they face tradeoffs.

υ Rational people make decisions by comparing marginal costs and marginal benefits.

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Summary

υ People can benefit by trading with each other.

υ Markets are usually a good way of coordinating trades.

υ Government can potentially improve market outcomes.

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Summary

υ A country’s productivity determines its living standards.

υ Society faces a short-run tradeoff between inflation and unemployment.