Chapter 1: Ten Principles of Economics 06/27/2013
Scarcity: The limited nature of societies resources
Economics: The study of how society manages its scarce resources
Economists study how people make decisions and how they interact
with other people to buy or sell goods
How People Make Decisions
Here, we look at the 4 basic principles of decision making
Principle #1: People Face Tradeoffs
To get one thing we like, we must give up on another. The more time you
spend on studying economics, the less time you spend on studying
psychology, or using that time for leisure purposes.
Efficiency: The property of society getting the most it can from its scarce
Equity: The property of distributing economic prosperity fairly among the
members of society
Efficiency refers to the size of a pie, and equity refers to how the
pie is shared. The two have negative correlation. If you want more
equity, the size of the pie becomes smaller. Example: A government may promote a welfare state by redistributing
money from the rich to the poor, but this will lower the incentive for people
to work hard, thus, GDP will go down.
Principle #2: The Cost of Something Is What You Give Up To Get It
Because people make trade offs, they must consider the costs and benefits
when making those decisions.
Example: Going to university does not just cost you tuition fees, dorm room,
etc, but it also costs you time, which can be used to make a few bucks. In
the long run, you end up with (hopefully) a well paid job and more
Opportunity cost: Whatever must be given up to obtain some
The fact that we are in university suggests that we think the benefits
outweigh the costs.
Sellers often mention opportunity cost to buyers who are trying to decide
between two purchases. Sellers will encourage the cheaper purchase, while
mentioning the sum of money (the difference between the two) that can be
potentially saved for additional purchases. This ensures that the seller gets
money in his pocket.
Principle #3: Rational People Think at the Margin
Rational people: People who systematically and purposefully do the best
they can to achieve their objectives
People will buy available goods which give them the highest levels
of satisfaction Marginal changes: Small incremental adjustments to plan of action
When there’s a test coming up, you can either chose not to study at
all, or choose to study 24 hours a day. Making decisions, as we see
here, are not black and white. You may chose to, instead, spend an
extra 2 to 3 hours of studying a day, giving up on T.V time.
Marginal cost: How much you must pay for an extra number of that good
Marginal benefit: How much satisfaction you will get through buying that
extra number of good
A rational decision maker will take action if and only if the marginal benefit
of the action exceeds the marginal cost.
Principle #4: People Respond to Incentives
Incentive: Something that induces a person to act. Because rational people
make decisions by comparing costs and benefits, they respond to incentives.
Example: A tax on gasoline will encourage people to drive less
Example: A law stating that you must drive with a seat belt on
suggests to people that they can drive more recklessly, because
their lives are now under some protection. Thus, although this law
prevents more deaths, it induces more accidents.
How People Interact
3 principles will be talked about here Principle #5: Trade Can Make Everyone Better Off
People often think that competition is a bad thing, and that it’s best to
isolate oneself from that hectic battle; this is false. If you isolate yourself,
it’ll be harder for you to create goods you don’t specialize in. Take a look at
If I am specialized at producing A and you are specialized at producing B, I
will trade some A for your B, so that we are both better off.
Principle #6: Markets Are Usually a Good Way to Organize Economic
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: “Invisible hand”
In a central economy, the government takes over. However, the system
usually is too much for politicians to handle.
Market economies promote the general economic well-being, but does not
promote well-being equally to all individuals.
Principle #7: Governments Can Sometimes Improve Market
The government is needed to institute rules that govern the laws of a market
economy, such as property rights.
Property rights: The ability of an individual to own and exercise
control over scarce resources Policies are also needed to either enlarge the pie or to share it equally
Market failure: A situation in which a market left own its own fails to
allocate resources efficiently. One possible reason why a market would fail is
externality. Another is market power.
Externality: The impact of one person’s actions on the well-being
of a bystander. Pollution is an externality.
Market power: The ability of a single economic actor (or a small
group of actors) to have a substantial influence on market prices.
This happens when there is no competition.
The purpose of government policies is to try to prevent these market failures
from happening. Of course, it doesn’t always happen.
The invisible hand does not guarantee equality of wealth; it only ensures
economic well-being. It’s the government that redistributes the wealth. Of
course, it doesn’t always happen.
How the economy as a whole works
Now, we look at how the economy as a whole works ._.
Principle #8: A Country’s Standard of Living Depends on Its Ability
to Produce Goods and Services
Income determines the quality of life. Here is the primary reason why there
are such large differences in living standards: Productivity: The quantity of goods and services produced from each hour
of a worker’s time
In rich countries, more is produced in the same amount of time.
This means the population must be well educated, have the
essential tools needed, and must have access to the best available
Some people say competition and minimal-wage laws are what increases the
standard of living, but productivity is often the way to go.
Principle #9: Prices Rise When the Government Prints Too Much
Inflation: An increase in the overall level of prices in the economy
High inflation proposes trouble and costs to society. Thus, governments
intervene to keep inflation as low as possible; or to sustain it.
When the government prints large amounts of money, money loses its
economic value, thus, prices of goods rise.
Principle #10: Society Faces a Short-run Tradeoff between Inflation
1. Increasing the amount of money will lead to people wanting to spend
more of it.
2. Because there is increased demand, firms will want to rise its prices to
maximize profit, while increasing the quantity of goods and services.
3. Increasing productivity means hiring more workers. Thus, the
unemployment rate falls. Business cycle: Fluctuations in economic activity such as employment and
The government controls these fluctuations with monetary and fiscal
policies; changing the amount a government spends, tax rates, or how much
money is being printed. Chapter 2: Thinking Like an Economist 06/27/2013
The Economist As Scientist
Yes, economics is actually a science, even though economists don’t use
microscopes or test tubes.
The Scientific Method: Observation Theory, and More Observation
Like all scientists, economists develop hypotheses based on theories.
However, evidence can only be found in the real world, and not inside a lab;
this makes it an extremely difficult science to study.
However, over time, through trial and error, one gathers enough information
to know how to act when there is an economic crisis.
The Role of Assumptions
Assumptions simplify the complex world and make it easier to understand.
Assumptions which are made will not apply to every single individual, but
the majority of a population.
Economists use different assumptions to answer different questions
Like a plastic figurine of the human body used by biology teachers,
economists use models (in the form of diagrams or equations) to help us
Details of a model are often omitted, because they are irrelevant to the main
picture. This also improves our understanding of what we want to learn; no
muss and fuss. Chapter 2: Thinking Like an Economist