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Hannah Holmes

10 Principles of Economics 10/10/2012 5:30:00 PM TERMS: - Economy: Study of how society allocates scarce resources to satisfy people’s unlimited wants - Scarcity: Society has limited resources, therefore cannot produce all goods and services that consumers wish. - Market Economy: allocates resources through a decentralized decisions of the individuals & households, ex. What to buy, who to work for - Command Economy(centrally planned economy): all production/distribution decision made by a central planner (soviet union) - Traditional Economy: economic decisions based on long standing costumes belief, religion and habits a. Applies often to 3 rdworld underdeveloped countries b. These usually have little industry, mostly agricultural, subsistence economy - Mixed Economies: Combination of market & command economy, ex. Crown corporations run by the government - Economic rationality: making decisions that maximize benefits that we receive from our decisions - Perfect Information: we know everything about everything a. Ex. Firms know all prices how other firms react to changes made b. We assume that we have perfect information - Asymmetrical Information: In practice, its hard to have perfect information, as lack of it makes decisions hard to make a. Usually sellers have more info than buyers do - Resource: anything that can be used to produce something else - Factors of production: Inputs of production a. Land b. Labor c. Physical Capital d. Entrepreneurship - Opportunity Cost; Everything you have to give up to get something  Cost of the best alternative - Equilibrium: absolutely no incentive for any economic actions  Supply and demand price are equal.  No individual would be better off doing something different, as there is the highest profit possible. - Market power: a single firm that influences market power  A. HOW PEOPLE MAKE DECISIONS  #1: People Face Trade Offs  You can only do one thing at a time  Going to class, giving up one hour of sleeping  Making decisions require trading off on goal against another  Trade off: guns and butter, efficiency and equity  Efficiency: means the society gets the most out of its scarce resources – refers to the size of the pie  Equity: benefits of those resources are distributed fairly – refers to how the pie is shared o There is always the conflict of balancing the two  #2: The cost of something is what you give up to get it  Opportunity cost: is it worth it?  Going to university; benefit: lifetime opportunities, networking  Costs: 4 years of cash making time and being in debt  #3: Rational people think at the margin  Cost & benefits, comparing the additional costs & benefits  Going to school vs. working  Rational people do the best they can to achieve objectives  Since many decisions are not black and white, but shades of grey  Its not about to eat or not to eat, but to get the extra helping  Marginal changes: small incremental adjustments to existing action plan, cost and benefits motivate for response  Rational people compare marginal benefits with marginal costs  These small incremental adjustments to an existing plan of action o If marginal benefit exceed marginal cost o If producing one more good adds more to the revenues than their costs  #4: People Respond to Incentives  By taking advantage of what people do to change people’s behavior  Ex. Tutorials for grade shifts  Incentives: something to inducing a person to act, response to incentive  Gas prices encourage people to drive less and to take public trans B. HOW PEOPLE INTERACT  #5: Trade can make everyone better off.  If we add up everything that we trade > cost of the trade  Competition is better than isolation  Trade allows each person to specialize in something they’re good at, when provides higher quality services and foot at a lower cost.  #6: Markets tend to increase efficiency  Centrally planned economy fail  If there are equal shares, those who worked hard won’t  Market act as if they are controlled by an “invisible hand” which leads to desirable market outcomes  Prices are the instrument which the invisible hand directs economic activity, reflecting both the value of a good to society and cost of it.  If the gov’t prevents prices from adjusting to S&D, the invisible hand will not work – this is why communism fails  #7: Sometimes the government can eliminate market inefficiencies  we need the government to enforce rules to maintain institution to a market economy  property rights: ability of an individual to own & control scarce resources  government police help enforce our rights over things produced  the invisible hand counts on our ability to enforce our rights o invisible hand is powerful but not omnipotent o also does not ensure that everyone has sufficient resources 1. Promoting efficiency: Invisible hand usually allocates resources efficiently - Market failure: refers to when the market fails to produce efficient allocation caused by externality which is the impact of one person’s actions on a bystander (like pollution) 2. Promoting equity: market economy rewards people according to ability to produce what others will buy. C.HOW THE ECONOMY AS A WHOLE WORKS  #8: A country’s standard of living depends on its productivity  Almost all variations in living standards attributes to differences in productivity amount of G&S produces each hour of a worker’s time  In high productive nations, there is a high standard of living(vice versa)  To boost living standards, policymakers need to raise productivity by ensuring that workers are well educated, and have the tools needed for producing G&S  #9: Prices increase when the government prints too much $$  Ex. Inflation, Zimbabwe went from 5.1% inflation to 14.9 billion% in a year  What causes inflation: growth of the quantity of money.  When the government creates large quantities of the nations’ money, the value falls.  Vice versa when there is a slow production of money.  #10: Short-run trade off with inflation & unemployment  inflation is the long-run effect of high prices, but short term has many effects  increasing the amount of money in the economy increases spending o higher the demand for G&S.  This results in raised prices= more quantity of goods, and there are more workers o With more workers, there is a lower employment  This short run tradeoff plays a key role in the analysis of the business cycle, fluctuations in economic activity, such as employment and production  The one final economy trade off: an increase of inflation with a decrease in unemployment.  This tradeoff plays a role in the analysis of the business cycle, the irregular unpredictable fluctuations is economic activity. Thinking Like An Economist 10/10/2012 5:30:00 PM - 3 ways to express ideas in economics a. words/text/stories b. algebra/equations c. diagrams/graphs - Economics is a social science a. Observations b. Theorize c. Test Theory - Stock Variable: snapshot in a point in time - Flow variable: time elements per year/minute THE ECONOMIST AS SCIENTIST - Study of the economy is approached like any other: devising theories, collecting data, analyzing data to verify/refute theories  The Scientific Method: Observation, Theory, and more Observation - Economists use theory& observations but experiments are challenging  We cant manipulate economies for research  We used natural experiments provided by history The Role of Assumptions - Economists make assumptions to simplify the complex world  Help focus out thinking, we understood international trade better. - Economists use different assumptions to answer different questions  Analysis is how prices respond in the short& long run  In the long term, prices are Flexible Economic Models - Economists use models to learn about the world, usually composed of diagram & equations  Does not include every feature of the economy  Models are built with assumptions Our First Model: Circular-Flow Diagram - Firms: Produce and sell goods and services, Hire and use factors of production - Households: Buy and consume goods and services, Own and sell factors of production - Markets for Goods and Services: Firms sell, Households buy - Markets for Factors of Production: Firms buy, households sell - Factors of Production: Land, Labor, Capital, Entrepreneurship Our Second Model: The Production Possibilities Frontier  Graph that shows combinations of output that the economy can possibly produce given the available resources and technology o It shows the best an economy can do if its uses all its resources efficiently, given the current technology o What the economy can possibly produce given the available factors of productions & technology that firms can use the turn factors into input o If economies were simplified into two productions of goods, it is good for showing the extremes of production - A, B, C and D: productively efficient – to produce these combos all resources are used, given the technology  You could also be on the PPF but producing the wrong combination of goods society doesn’t want o Even though you have productive efficiency, but social inefficiency o This is because efficiency includes productive and social efficiency. - Point H lies outside the PPF – it is unattainable.  There are not enough resources to produce that combo of goods, or the technology is not good enough or possibly both. - Point K lies inside the PPF.  It is possible to produce that combo, but it can produce more of one or the other or both, given the technology and available resources. o Point K is feasible, but not efficient. - This PPF shows one tradeoff that society faces. You can only get more of one good by producing less of another. - As we move down the PPF, the opportunity cost increases  This is because we’re moving people from one sector to another, who are usually better at making stuff in the other - It is also possible that opportunity costs are constant, the PPF will be linear  An economy always gives us the same amount of one goal for another at the same time  E.g you always give up 1 ton of wheat for 10 tons of carrots. - Shifts in PPF: any changes to the amount of available resources, their productivity  It can change position with growth and decline in various sectors  These can make a larger combinat - Microeconomics and Macroeconomics  Microeconomics: Study of Individual firms and households and how their make decisions  Macroeconomics: Study of the economy as a whole, inflation, unemployment THE ECONOMIST AS POLICY ADVISER Positive vs. Normative Analysis - Positive statements: attempt to describe the world as it is – descriptive  Posi
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