ECON 2000 : Econ Test 1 Notes
Econ Test 1
Chapter 1
• Scarcity means that society has limited resources and therefore cannot
produce all the goods and services people wish to have
• Economics is the study of how society manages its scare resources
• In most societies, resources are allocated not by an all-powerful dictator but
through the combined actions of millions of households and firms
• Economists study how people interact with one another
• Economists analyze forces and trends that affect the economy as a whole,
including the growth in average income, the fraction of population that
cannot find work, and the rate at which prices are rising
Principle 1: People face trade-offs
• An economy is just a group of people dealing with one another as they go
about their lives
• Making decisions requires trading off one goal against another
• When people are grouped in societies, they face different kinds of trade-offs.
Ex: “guns and butter”
• Also important in modern society is the trade-off between a clean
environment and a high level of income
• Another trade-off society faces is between efficiency and equality
o Efficiency means that society is getting the maximum benefits from
its scarce resources
o Equality means that those benefits are distributed uniformly among
society’s members
• When government policies are designed, these two goals often conflict
• When the government tries to cut the economic pie into equal slices, the pie
gets smaller
Principle 2: The cost of something is what you give up to get it
• Because people face trade-offs, making decisions requires comparing the
costs and benefits of alternative courses of action
• The opportunity cost of an item is what you give up to get that item
• When making any decision, decision makers should be aware of the
opportunity costs that accompany each possible action
Principle 3: Rational people think at the margin
• Ration people systematically and purposefully do the best they can to
achieve their objectives, given the available opportunities
• Rational people know that decisions in life are rarely black and white but
usually involve shades of gray
• Economists use the term marginal change to describe a small incremental
adjustment to an existing plan of action
• Rational people often make decisions by comparing marginal benefits and
marginal costs
• Why is water so cheap, while diamonds are so expensive? People are willing
to pay more for a diamond than a cup of water even though it is not
necessary. The reason is that a person’s willingness to pay for a good is based
on the marginal benefit that an extra unit of the good would yield. The
marginal benefit, in turn, depends on how many units a person already has.
Water is essential, but the marginal benefit of an extra cup is small because
water is plentiful. By contrast, no one needs diamonds to survive, but
because diamonds are so rare, people consider tem marginal benefit of an
extra diamond to be large
• A rational decision maker takes an action if and only if the marginal benefit of
the action exceeds the marginal cost
Principle 4: People respond to incentives
• An incentive is something that induces a person to act, such as the prospect
of a punishment or a reward
• Because rational people make decisions by comparing costs and benefits,
they respond to incentives
• Incentives are crucial to analyzing how markets work
• A higher price in a market provides an incentive for buyers to consume less
and an incentive for sellers to produce more
• The influence of prices on the behavior of consumers and producers is
crucial for how a market economy allocates scare resources
• Public policymakers should never forget about incentives: Many policies
change the costs or benefits that people face, and therefore, alter their
behavior
Principle 5: Trade can make everyone better off
• Trade between two countries can make each country better off
• Trade allows each person to specialize in the activities he or she does best.
By trading with others, people can buy a greater variety of goods and
services at lower cost
Principle 6: Markets are usually a good way to organize economic activity
• Most countries that once had centrally planned economies, whose theories
were that only the government could organize economic activity in a way
that promoted economic well-being for the country as a whole, have
abandoned the system and are instead developing market economies
• In a market economy, the decisions of a central planner are replaced by the
decisions of millions of firms and households.
• These firms and households interact in the marketplace, where prices and
self-interest guide their decisions.
• In a market economy, no one is looking out for the economic well being of
society as a whole. Yet despite decentralized decision making and self-
interested decision makers, market economies have proven remarkably
successful in organizing economic activity to promote overall economic well
being
• In An Inquiry into the Nature and Causes of the Wealth of Nations, economist
Adam Smith made the most famous observation in all of economics:
Households and firms interacting in markets act as if they are guided by an
“invisible hand” that leads them to desirable market outcomes.
• In any market, buyers look at the price when determining how much to
demand, and sellers look at the price when deciding how much to supply
• As a result of the decisions that buyers and sellers make, market prices
reflect both the value of a good to society and the cost to society of making
the good
• Smith’s great insight was that prices adjust to guide these individual buyers
and sellers to reach outcomes that, in many cases, maximize the well-being of
society as a whole
• Smith’s insight has an important corollary: When the government prevents
prices from adjusting naturally to supply and demand, it impedes the
invisible hand’s ability to coordinate the decisions of the households and
firms that make up the economy
• This explains why taxes adversely affect the allocation if resources, for they
distort prices and thus the decisions of households and firms. It also explains
the great harm caused by policies that directly control prices, such as rent
control. And it explains the failure of communism.
Principle 7: Governments can sometimes improve market outcomes
• One reason we need government is that the invisible hand can work its magic
only if the government enforces the rules and maintains the institutions that
are key to a market economy
• Market economies need institutions to enforce property rights so
individuals can own and control scare resources
• Property rights is the ability of an individual to won and exercise control
over scare resources
• The invisible hand is powerful, but it is not omnipotent
• There are two broad reasons for a government to intervene in the economy
and change the allocation of resources that people would choose on their
own: to promote efficiency or to promote equality.
• Economists use the term market failure to refer to a situation in which the
market on its own fails to produce an efficient allocation of resources
• One possible cause of market failure is an externality, which is the impact of
one person’s actions on the well being of a bystander. Ex: pollution
• Another possible cause of market failure is market power, which refers to
the ability of a single person (or small group) to unduly influence market
prices
• In the presence of externalities or market power, well-designed public policy
can enhance economic efficiency
• Even when the invisible hand is yielding efficient outcomes, it can
nonetheless leave sizable disparities in economic wellbeing
• A market economy rewards people according to their ability to produce
things that other people are willing to pay for
• The invisible hand does not ensue that everyone has sufficient food, decent
clothing, and adequate healthcare. This inequality may call for government
intervention
