ECO100 Textbook Notes.docx

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University of Toronto St. George
James Pesando

ECO100 Test 1 Textbook Notes Chapter 1: Ten Principles of Economics Key Terms • Business Cycle – fluctuations in economic activity, e.g. employment and production • Economics – the study of how society manages its scarce resources • Efficiency – the property of society getting the most it can from its scarce resources • Equity – the property of distributing economic prosperity fairly among the members of society • Externality – the impact of one person’s actions on the well-being of a bystander • Incentive – something that induces a person to act • Inflation – an increase in the overall level of prices in the economy • Marginal Changes – small incremental adjustments to a plan of action • 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 • Market Failure – a situation in which a market left on its own fails to allocate resources efficiently • Market Power – the ability of a single economic actor (or small group of actors) to have a substantial influence on market prices • Opportunity Cost – whatever must be given up to obtain some item • Productivity – the quantity of goods and services produced from each hour of a worker’s time • Property Rights— the ability of an individual to own and exercise control over scarce resources • Rational People – people who systematically and purposefully do the best they can to achieve their objectives • Scarcity – the limited nature of society’s resources Ten Principles of Economics 1) People face trade-offs • Making decisions requires trading off one goal against another • Classic trade-off is between “guns and butter” (national defence vs. consumer goods) • Society faces trade off of efficiency vs. equity (size of economic pie vs. distribution) 2) The Cost of Something is What You Give Up to Get It • Comparison of costs and benefits of alternative courses of action • Must consider the opportunity cost 3) Rational People Think at the Margin • Marginal changes (small incremental adjustments) to existing plan of action • Decisions made by comparing marginal benefits and marginal costs • Aperson’s willingness to pay for any good is based on marginal benefit that an extra unit will yield • Marginal benefit depends on how many units a person already has • Arational decision maker acts if and only if marginal benefit exceeds marginal cost 4) People Respond to Incentives • Because rational people make decisions by comparing costs and benefits • Direct and unintended effects of altering incentives • Alternation of the cost-benefit calculation 5) Trade Can Make Everyone Better Off • Trade allows each person to specialize in the activities he/she does best and enjoy a greater variety of goods and services • Simultaneously competitors and partners 6) Markets Are Usually a Good Way to Organize EconomicActivity • Market economy > central planning • Decisions of a central planner = replaced by decisions of millions of firms and households • Firms and households interact in marketplace; prices and self- interest guide decisions • Free markets comprised of buyers and sellers primarily interested in own well-being • Adam Smith: Households and firms interact in markets as if guided by an “invisible hand” • Market prices reflect both value of a good to society and the cost of making that good • Smith’s insight: Prices adjust to guide these individuals to reach outcomes maximize the welfare of society as a whole • Taxes distort prices, price control causes harm 7) Governments Can Sometimes Improve Market Outcomes • “Invisible Hand” can work magic only if government enforces rules and maintains institutions • Rely on government-provided services and courts to enforce property rights “invisible hand” not omnipotent – 2 reasons for government to intervene in economy and change allocation of resources ­ To promote efficiency ­ To promote equity • Most policies aim to either enlarge economic pie or change division of the economic pie • “Invisible hand” may also fail to ensure equitable distribution of economic prosperity • Although the government CAN improve market outcomes, at times doesn’t mean it WILL 8) ACountry’s Standard of Living Depends on Its Ability to Produce Goods and Services • Large variation in average income reflected in various measures of quality of life • Big changes in living standards over time • Almost all variation in living standards is due to differences in countries’productivity • Growth rate of a nation’s productivity determines growth rate of average income 9) Prices Rise When the Government Prints Too Much Money • Keeping inflation at a low level is a goal of all economic policy- makers • Growth in quantity of money causes inflation because the value of money falls 10)Society Faces a Short-Run Trade-off Between Inflation and Unemployment • Short-run effects of monetary injections: ­ Stimulates overall level of spending, thus demand for goods and services ­ Cause firms to raise prices over time, in meantime encourages increase of quantity of goods and services produced and to hire more workers ­ More hiring = lower unemployment • Over short time periods, many economic policies push inflation and unemployment in opposite directions (issue faced regardless of level starting points) Summary 1) Individual Decision-Making Fundamental Concepts: • People face trade-offs among alternative goals, cost of any action measured in terms of forgone opportunities, rational people make decisions by comparing marginal costs and benefits, people change behaviour in response to incentives 2) InteractionsAmong People Fundamental Concepts: • Trade can be mutually beneficial, markets are usually good way of coordinating trade among people, government can potentially improve market outcomes if there is some market failure or if market outcome is inequitable 3) EconomyAsAWhole Fundamental Concepts: • Productivity is the ultimate source of living standards, money growth is ultimate source of inflation, society faces a short-run trade-off between inflation and unemployment Chapter 2: Thinking LikeAn Economist Key Terms • Circular-Flow Diagram – a visual model of the economy that shows how dollars flow through markets among households and firms • Macroeconomics – the study of economy-wide phenomena, including inflation, unemployment, and economic growth • Microeconomics – the study of how households and firms make decisions and how they interact in markets • Normative Statements – claims that attempt to prescribe how the world should be • Positive Statements – claims that attempt to describe the world as it is • 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 production technology Circular-Flow Diagram Model • Economy is simplified to two types of decision makers – households and firms • Firms produce goods and services using inputs (e.g. land, labour, capital) known as factors of production while households own factors of production and consume goods and services produced The Production Possibilities Frontier Model • Shows the various combinations of output that the economy can possibly produce given the available factors of production and the available production technology that firms can use to turn these factors into output • Two end points represent the extreme possibilities; mostly likely division of time between the two • Resources are scarce, therefore not every conceivable outcome is feasible • An outcome = efficient if economy is getting all it can from available scarce resources (represented by points on [rather than inside] production possibilities frontier) • If source of inefficiency is eliminated, economy can increase its production of both goods • Shows one trade-off that society faces – once efficiency is reached, must produce less of one good to get more of another • Shows opportunity cost of one good as measured in terms of other good • PPF often has this bowed shape; shows trade-off between outputs of different goods at a given time, but can change over time Ex: Positive versus NormativeAnalysis Polly: Minimum-wage laws cause unemployment. Norma: The government should raise the minimum wage. Why Economists Disagree • May disagree about validity of alternative positive theories about how the world works ­ May have different values and therefore different normative views about what policy should try to accomplish Summary • Economists try to address subject with scientist’s objectivity: make appropriate assumptions and build simplified models (e.g. circular-flow diagram and production possibilities frontier) • Field divided into 2 subfields: microeconomics (study decision-making by households + firms and interaction among the two in marketplace) and macroeconomics (study forces and trends that affect the economy as a whole) • Positive statement = an assertion about how the world IS: normative = how the world OUGHT TO BE. Normative statements are acting more as policy advisors than scientists • Economists who advise policy-makers offer conflicting advice either because of differences in scientific judgment or in values.At times economists may be united in advice, but policy-makers may ignore Chapter 3: Interdependence and the Gains From Trade Key Terms • Absolute advantage – the comparison among producers of a good according to their productivity • Comparative advantage – the comparison among producers of a good according to their opportunity cost • Exports – goods and services produced domestically and sold abroad • Imports – goods and services produced abroad and sold domestically • Opportunity cost – whatever must be given up to obtain some item ­ If (e.g. farmer and rancher) choose to be self-sufficient, each consumes exactly what is produced • PPF = consumption possibilities frontier • Specialization and Trade = mutually beneficial Comparative advantage: the driving force of specialization ­ Absolute advantage: producer that requires a smaller quantity of inputs to produce a good ­ Opportunity cost and comparative advantage: as reallocate time between producing goods, move along PPF; opportunity cost measures trade-off ­ Comparative advantage: used when describing opportunity cost of two producers; the one who gives up less of other goods to produce good X has comparative advantage • Although possible for one person to have absolute advantage in producing both goods, impossible to have comparative advantage in both ­ Opportunity cost of one good is inverse of opportunity cost of the other good Comparative advantage and trade: gains from specialization and trade are based on comparative advantage • When each specializes, total production rises increase in size of economic pie ameliorates all • Benefits from trade by obtaining a good at a price lower than their opportunity cost • For both parties to gain from trade, price at which they trade must lie between the two opportunity costs • Moral: Trade can benefit everyone in society because it allows people to specialize in activities in which they have a comparative advantage. Summary • Each person consumes goods and services produced by many others (both domestically and abroad). Interdependence and trade = desirable because allow all to enjoy greater quantity and variety of goods and services • 2 ways to compare ability of 2 people in producing a good: a) Person who produce with smaller quantity of inputs = absolute advantage b) Person with smaller opportunity cost = comparative advantage. • Gains from trade based on comparative, not absolute, advantage • Trade makes everyone better off because allows people to specialize in activities of comparative advantage • Principle of comparative advantage applies to countries as well; economists use this principle to advocate free trade Chapter 4: The Market Forces of Supply and Demand Key Terms • Competitive market – a market in which there are many buyers and many sellers so that each has a negligible impact on market price • Complements – 2 goods for which increase in price of one decrease in demand for other • Demand curve – a graph of the relationship between the price of a good and the quantity demanded • Demand schedule – a table that shows the relationship between the price of a good and the quantity demanded • Equilibrium – a situation in which price has reached level where quantity supplied = demanded • Equilibrium price – price that balances quantity supplied and quantity demanded • Equilibrium quantity – quantity supplied and quantity demanded at equilibrium price • Inferior good – a good for which, other things equal, an increase in income a decrease in demand • Law of demand – the claim that, other things equal, the quantity demanded of a good falls when the price of the good rises • Law of supply – the claim that, other things equal, quantity supplied of a good rises when price of the good rises • Law of supply and demand – claim that the price of any good adjusts to bring the quantity supplied and quantity demanded for that good into balance • Market – a group of buyers and sellers of a particular good or service • Normal good – a good for which, other things equal, an increase in income an increase in demand • Quantity demanded – the amount of a good that buyers are willing and able to purchase • Quantity supplied – amount of a good that sellers are willing and able to sell • Shortage – a situation in which quantity demanded > quantity supplied • Substitutes – two goods for which an increase in the price of one increase in demand for other • Supply curve – a graph of the relationship between price of a good and quantity supplied • Supply schedule – table that shows relationship between price of a good and quantity supplied • Surplus – a situation in which quantity supplied > quantity demanded Markets • Take many forms: can be highly organized (e.g. many agricultural commodities, buyers and sellers meet at specific time/place and auctioneer helps set prices and arrange sales) • Usually less organized (e.g. buyers/sellers of ice cream in a town) Competition • Each buyer aware there are several sellers to choose from; each seller aware his product is similar to that offered by other sellers • Thus price and quantity are determined by all sellers and buyers as they interact in the marketplace • To reach highest form of competition (perfectly competitive) must have 2 characteristics: 1) The goods offered for sale are all exactly the same 2) The buyers and sellers are so numerous that no individual has any influence over market price ­ In these markets, buyers and sellers must accept price market determines = price takers ­ At market price, buyers can buy all they want, sellers can sell all they want monopoly: markets with only one seller who is then able to set the price Demand • Price of the good = central determinant of quantity demanded • Quantity demanded is negatively related to price • Market demand vs. individual demand ­ Sum of all individual demands for a particular good or service ­ Sum individual demand curves horizontally to obtain market demand curve • Shifts in the demand curve: ­ Any change that increases quantity demanded at every price shifts curve to the right, called an increase in demand ­ Any change that reduces quantity demanded at every price shifts the demand curve to left, called a decrease in demand Variables that can shift demand curve: • Income ­ If demand for a good falls when income falls = normal good ­ If demand for a good rises when income falls = inferior good • Prices of Related Goods ­ When a fall in price of one good reduces demand for another, the 2 = substitutes ­ When fall in price of one good raises demand for other = complements • Tastes ­ Historical and psychological forces beyond realm of economics • Expectations ­ About future may affect demand for a good or service today • Number of Buyers Summary • Demand curve shows what happens to quantity demanded of a good when its price varies, holding constant all other variables that influence buyers • When one variable changes, demand curve shifts • Price on vertical axis, thus change represents movement along demand curve (others not on either axis, thus shifts demand curve (see pg. 75 for chart) Supply • Quantity supplied = amount that sellers are willing/able to sell • Many determinants, but price is key • Quantity supplied is positively related to the price of the good • Supply curve slopes upward because, other things equal, higher price = greater quantity supplied • Market supply vs. individual supply ­ Sum of the supplies of all sellers ­ Sum individual supply curves horizontally to obtain market supply curve • Shifts in supply curve: ­ Any change that raises quantity supplied at every price shifts the supply curve to the right, called an increase in supply ­ Any change that reduces the quantity supplied at every price shifts curve to left, called a decrease in supply Variables that can shift supply curve: • Input prices ­ When price of one or more inputs rise, producing good is less profitable, firms supply less ­ If input prices rise substantiall
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