Econ 102 Study Guide
Chapter 1 - Ten Principles of Economics
1 - People Face Tradeoffs
Basically, in order to get something good people must give up something else that is good.
The classic tradeoff at a society level is between Guns and Butter. The more we consume on defence the less we can spend on goods that raise our
standard of living. Another good example is High Income vs. The Environment.
Society faces the tradeoff between Efficiency and Equity
Efficiency - the property of society getting the most it can from scarce resources. Refers to the size of the economic pie.
Equity - the property of distributing economic prosperity fairly among the members of society. Refers to how the economic pie is divided.
Policies such as welfare, and personal income tax reduce efficiency and raise equity because it reduces the reward for working hard, as a result,
people work less and produce fewer goods. When government tries to cut the economic pie into more equal slices, the pie gets smaller.
2 - The Cost of Something Is What you give up to get it
Opportunity Cost - whatever must be given up in order to obtain some item. This includes, money, time, and resources.
3 - Rational People Think At The Margin
Rational People - people who systematically and purposefully do the best they can to achieve their objectives. THey know that decisions in life
are rarely black and white, but usually involve shades of grey.
Marginal Changes - small incremental adjustments to a plan of actions. Adjustments around the edges of what you are doing.
Rational people often make decisions by comparing marginal benefits and marginal costs.
Marginal decision making helps explain some puzzling economic phenomena. Water is cheap but needed and diamonds are expensive but
unnecessary. The differences comes in the marginal benefit that an extra unit of the good will yield.
Marginal benefit depends on how many units a person already has.
A rational decision maker takes an action iff the marginal benefit of the action exceeds the marginal cost. This principal can explain why airlines
are willing to sell a ticked below average cost and why people pay more for diamonds than water.
4 - People Respond to Incentives
Incentive - something - such as the prospect of punishment or a reward - that induces a person to act. Because rational people make
decisions by comparing costs and benefits, they respond to incentives.
When the price of an apple rises, people decide to eat more pears and fewer apples. At the same time apple orchards decide to hire more works
and harvest more apples because the benefit of selling an apple is also higher.
Auto Safety Laws - required seat belts reduced the number of deaths per auto accident but it also increased the number of accidents because it
reduced the marginal benefit of safe driving
5 - Trade Can Make Everyone Better Off
Trade between two countries makes them better off. Example - A family would not be better off it it had to do everything itself, it is competing
with other families but it allows people to specialize in what they do.
6 - Markets are usually a good way to organize economic activity
Central Planning - only the government can organize economic activity in a way that it was beneficial to the whole country.
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.
Adam Smith in An Inquiry into the Nature and Causes of the Wealth of Nations said
Households and firms interacting in markets act as if they are guided by an invisible hand that leads them to desirable market outcomes.
Prices are the instrument with which the invisible hand directs economic activity.
Smiths Insight - prices adjust to guide individual buyers and sellers to reach outcomes that in many cases maximize the welfare of society as
When government gets involved in pricing it impedes the ability of the hand to coordinate the economy - Example - Rent Control.
7 - Governments Can Sometimes Improve Market Outcomes
The magic hand can only work if the government enforces rules and maintains institutions that are ket to a market economy.
Property Rights - the ability of an individual to own and exercise control over scarce resources. A farmer wont grow crops if they expect it to
Another reason the government is needed to intervene in the economy is to promote efficiency and equity. Market failure - a situation in which a market left on its own fails to allocate resources efficiently
Externality - the impact of one persons actions on the well-being of a bystander. In the context of world markets pollution is a good
Market Power- the ability of a single economic actor - or small group - to have substantial influence on market prices. When one group has
the only source of a good they are not subject to rigorous competition with which the invincible hand normally keeps self-interest in check.
The invisible hand does not ensure that people have sufficient, food, clothing and health care. Income tax and welfare policies help balance this.
8 - A Countrys Standard of Living Depends on Its ability to produce goods and services
In Canada, individual income has grown on average by about 2% per year, doubling every 35 years.
Productivity - the quantity of goods and services produced from each hour of a workers time.
There is an important relationship between a countrys standard of living and its productivity - to raise standard of living, policy makers must
boost the productivity by giving workers better education, tools and technology.
9 - Prices Rise when government prints too much money
Inflation - an increase in the overall level of prices in the economy.
Growth in the quantity of money is the main culprit for inflation. As each extra dollar is printed, the relative value of each good remains consistent
to the amount of money in print, where as each dollar looses relative value.
10 - Society Faces a Short-Run Tradeoff between Inflation and Unemployment
Increasing the amount of money in the economy stimulates the overall level of speinding and thus the demand for goods and services.
Higher demand may over time cause firms to raise their prices, but in the meantime, it also encourages them to increase the quantity of
goods and services they produce and to hire more workers to produces those goods and services
More hiring means lower employment
Business Cycle - fluctuations in economic activity, such as employment and production.
Economic Tools used by government - amount government spends, taxes, amount of money that is printed.
Chapter 2 - Thinking Like An Economist
The Scientific Method: Observation, Theory and More Observation
Economists use the scientific method but they face the obstacle that experiments are often difficult. Economists are not allowed to modify monetary
policy just to collect useful data. To make up for this economists pay attention to history in order to prove and observe data for their theories.
The Role of Assumptions
Assumptions allow economists to simplify the problem without substantially affecting the answer - Example: Physics in a vacuum - To study
international trade we may assume that the world consists of only two countries and two goods. Once we understand two countries and two goods
we are in a better place to understand actual international trade.
Used to simplify reality in order to improve our understanding of it.
Circular Flow Diagram
A visual model of the economy that shows how dollars flow through markets among households and firms. The economy is simplified to include only two types of decision makers - Firms and Households. Firms produce goods and services using inputs -
labor, land, capital - called the factors of production. Households own the factors of production and consume all the goods and services that the
The outer arrows show the flow of dollars, the inner arrows show the corresponding flow of inputs and outputs.
There are two markets - the market for goods and the market for the factors of production.
Markets for Factors of Production - households are the sellers, firms are the buyers
Markets for Goods and Services - households are the buyers, firms are the sellers.
Spend $1 at Tim Hortons - $1 moves to the cash register where it becomes revenue for the firm - $1 is then used to buy inputs in the market for
the factors of production for like land and people.
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
Efficient - there is no way to produce more of one good without producing less of the other.
A, B - Efficient
D - Inefficient
C - Not possible with current resources and technology
The PPF shows the opportunity cost of one good as measured in terms of the other good. This means that the OC is equal to the slope the PPF.
The OC of a car in terms of computers is not constant because of the shape of the PPF. The Opportunity cost of a car is highest when the economy
is producing many cars and few computers.
The reason for the bowed shape is that the opportunity cost for cars is highest when the economy is using its resources that arent efficient at
making cars are making cars like skill computer builders. Because skilled computer workers are being used in the auto industry, the cost of making
more cars in terms of computer production is higher. A technological advance in the computer industry enables the economy to produce more computers for any given number of cars.