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ECO1104 Detailed notes from chapters 1-3

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University of Ottawa
J Ianweizhen

Chapter 1 Ten Principles of Economics Why are decisions made- To find what is best or you within your limited resources How People Make Decisions The first four principles discuss how individuals make decisions because the behaviour an economy reflects the behaviour of the individuals who make up the economy. Principle #1: People face trade-off All decisions involve trade-off ex. Going to a party the night before an exam leaves less time for studying. Society faces an important trade-off- efficiency vs. equality Efficiency: society gets the most from its scarce resources, i.e. the size of the economic pie Equity: when prosperity is distributed uniformly among society members, i.e. how the economic pie is divided The principle of Trade-off is that you cannot gain one thing without losing something else. Principle #2: The Cost of Something is What Young Give Up to get it  All decision requires comparing the costs and benefits of alternative costs  All decisions require opportunity costs. Ex. The cost of going to university and pay tuition costs, books but also the cost of forgone wages  When making decisions, one must look at direct cost and opportunity costs Principle #3: Rational People Think at the Margin Rational People  Systematically and purposefully do their best they can to achieve their objectives  Evaluate the cost and benefits of marginal changes- incremental adjustments to an existing plan. Ex. Fixing a whole car or just an important part of the car Principle #4: People Respond to Incentives  Rational people respond to incentives. Ex. When gas prices rise consumers buy more hybrid cars and fewer gas guzzling SUVs  Rational people will choose the option that will give you the greatest benefit  Rational people try their best to achieve their objectives Doesn’t have to be economical or monetary incentives but can be spiritual, emotional incentives How People Interact The next three principles concern how people interact with one another because many of our decision affect not only ourselves but other people as well. Principle #5: Trade Can Make Everyone Better Off  Rather than being self-sufficient it is more efficient for each person to specialize in producing a good or service, then trading it w/ other people for the things they produce.  Countries also benefit from trade & specialization: o Get better prices abroad for goods they produce o Buy other goods cheaply from abroad than could be produced at home o Gives a country’s consumers access to a greater variety of goods. Ex fresh year-round products  Trade between two country can make each country better off Principle #6: Markets are usually a Good Way to Organise Economic Activity Market: a group of buyers and sellers (need not be in a single location) Commodity market- goods Geographic market- ex. Ontario market  “Organise economic activity” means determining o what goods to produce o how to produce them o how much of each to produce o who gets them  a markets economy is decentralized- no government committee that makes the decisions about what goods  a market economy is led by an invisible hand to which promotes the general economic well- being o the interaction of buyers and sellers determine prices o each price reflects the good’s value to buyers and the cost of producing the good o price guide self-interest households and firms to make decisions that, in many cases maximize society’s economic well-being Principle #7: Government can Sometimes Improve Market Outcomes  Important role of gov’t: enforce property rights  People are less inclined to work, produce, invest or purchase if large risk of their property being stolen  Two broad reasons for government to intervene in the economy: to promote efficiency and to promote equity Market failure: when market fails to allocate society’s resources efficiently Causes:  Externalities: when the production or consumption of a good affects bystanders (e.g. pollution)  Market Power: a single buyer or seller has substantial influence on market price (e.g. monopoly) How the Economy as a Whole Works The last three principles concern the workings of the economy as a whole. How individuals make decisions and people interact with one another together make up the “economy”. Principle #8: A Country’s Standard of Living Depends on its Ability to Produce Goods and Services  Standard of living depends on productivity- the amount of goods and serviced being produced from each hour of a worker’s time.  Productivity depends on equipment, skills and technology available to the workers.  In the study of economics other factors (e.g. labour unions, completion from abroad) have less impact on the standard of living GDD -aggregate market value w/in a certain country w/in a certain economic period of time -Economics mostly only deals w/ potential GDP Principle #9: Prices Rise when the Government Prints too much Money Causes Inflation - increase in the general level of price (economic phenomenon) - caused by excessive growth in the quantity of money which causes the value of money to fall - a healthy economy must have an efficient system to monitor the circulation of money - faster money circulates w/in the economy lowers the demand for money - too much money in the market causes inflation b/c the value of money decreases - oversupply = rise in prices QE - quantitive easing: government policy that adds money into the economy in order to increase the circulation Principle #10: Society Faces a Short-Run Trade-off between Inflation and Unemployment  Inflation means money supple > money demand  Inflation provides incentives to producers because their fixed costs would reduce  Leads to increase in production which leads to increase in employees  If inflation rate > 10% = hyperinflation- everybody loses  2% inflation rate is acceptable by developed countries- may affect ability to produce and actual purchasing power Chapter 2 Thinking like an Economist The Economist as Scientist  Economist play two roles: 1. Scientist: try to explain the world 2. Policy advisors: try to improve it  In the first, economist employs the scientific method, the dispassionate development and testing of theories about how the world works Assumptions & Models  Assumptions simplify the complex world, make it easier to understand  Ex. To study international trade assume that there are only two countries and two goods – unrealistic, but simple to learn and gives insights about the real world  Model: a highly simplified representation of a more complicated reality. Economist use models to study economic issues Our First Model: The Circular-Flow Diagram  The Circular-Flow Diagram: a visual model of the economy, shows how dollars flow through markets among households and firms  Two types of “actors” within the economy o Households: they own the factors of production and consume all the goods and services that the firms produce o Firms: produce goods and services using inputs, eg. Labour, land (natural resources), and capital (buildings and machines)  Two markets: o The market for goods and services: in this market households are buyers and firms are sellers. In particular households buy the output of goods and services that firms produce o The market for “factors of production”: in the market, households are the sellers and firms are the buyers. In this market households provide the input that the firms use to produce goods and services Factors of Production  Factors of production: the resources the economy uses to produce goods & services, including o Labour o Land o Capital (buildings & machines used in production)  The red arrow represents flows of goods & services (including the factors of production in the lower half of the diagram – the households sell the use of labour, land and capital to the firms in the markets for these factors of production. The firms then use these factors to produce goods and services, which are later sold to households in the market for goods and services. The FoP flow from households to firms, and goods and services flow from firms to households  The green arrow represents the flows of income/payments. – the household spend money to buy goods and services from the firms. The firms use some of the revenue from these sales to pay for the FoP, eg wages for their workers. What’s left is the profit of the firm owners, who are also members of households. Spending on goods and services flows from households to firm, and income of wages, rent and profit flows from firms to household  The government financial system, and foreign sector was omitted to keep the graph simple Our Second Model: The Production Possibilities Frontier  The Production Possibilities Frontier (PPF): a graph that shows the combination of two goods the economy can possibly produce given the available resources and the available technology  Ex o Tw goods: computer and wheat o One resource: labour (measured in hours) o Economy has 50,000 labour hours per month available for production o Producing one computer requires 100 hours labour o Producing one ton of wheat requires 10 hours of labour The PPF: What we know so Far  Points on the PPPF (like A – E) o Possible o Efficient: all resources are fully utilised  Points under the PPF (like F) o Possible o Not efficient: some resources underutilised ( e.g. workers unemployed, factories idle)  Points above the PPF ( alike G) o Not possible –resources aren’t available The PPF and Opportunity Cost  Recall: the opportunity cost of an item is what must be given up to obtain that item  Moving along a PPF involved shifting resources (e.g. labour from the production of one good to the other)  Society faces trade-off: getting more of one goods requires sacrificing some of the other – first principle of economics  The slope of the PPF tells the opportunity cost of one good in terms of the other  Slope = rise/run o The amount the line rises/decreases when you move to the right one unity o In the example above the opportunity costs of a computer is 10 tons of wheat o Opportunity cost in this case means how many tons of wheat is need to increase the production of computers o The steeper the slope the greater the opportunity costs o This slope is reversed if trying to find the opportunity cost of one ton a wheat instead of rise/run it would be run/rise Economic Growth and the PPF  In order as to improve a country’s standard of living, one must first improve the ability to produce.  W/ additional resources or an improvement in technology, the economy can produce more computers, more what, or an combination in between  The PPF shows the trade-off between output or different goods at a given time o When the PPF shift outward- economic growth - GDP Increases The Shape of the PPF  The PPF could be a straight line or bow shaped  Depends on what happens to the opportunity costs as the economy shift its resources from one industry to the other o If opp. cost remains constant, PPF is a straight line o If opp. cost of a good rises as the economy produces more goods, PPF is bow-shaped Why the PPF Might be Bow-Shaped As the economy shift its resources from beer to mountain bikes:  PPF become steeper  Opportunity cost of mountain bikes increases  People who are less experienced cause the PPF to be bow-shaped because they have lower than average production output and do not have much impact in the industry that they are in  The people that could have been used to produce mountain bikes are been used to produce beer and have less experience in the production of beer, therefore they won’t contribute to the total production output as the more experienced workers o It is the same with mountain bikes production  Solution: Trade-off; let workers who are experienced w/ producing beer shift to produce beer and let workers who are experienced in producing mountain bikes shift to produce mountain bikes  At point A, most workers are producing beer even those that are better suited to building bikes o So do not have to give up much bee to get more bikes  At point B, most workers are producing bikes. The few left in beer are the best beer brewers o Producing more bikes would
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