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Chapter 1

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Bridget O' Shaughnessy

Unit 1: The Nature and Method of Economics - Objective 1: Ten Key Economic Principles Principle 1: People Face Tradeoffs Since society’s resources (like labour, land, and machinery) are in limited amounts, it is not possible to produce all desired goods and services. This necessitates the study ofeconomics, which is concerned with how society manages scarce resources by using them in the best possible or most efficient manner, implying that we must carefully decide what must be given up in order to achieve what is desired. For example, at an individual level, studying more hours of economics means there are fewer hours available for other activities like studying other subjects, working, or engaging in leisure activities. As another example, at the collective level, national governments are faced with tradeoffs or choices or options for using annual budgetary surpluses by either creating more infrastructure (e.g., colleges, hospitals, highways) or using these funds to bring down the accumulated national debt. In the wake of the current global economic crisis, governments have to choose the optimal combination of infrastructure spending and tax reduction to implement so as to achieve the goal of stimulating their national economies. Principle 2: The Cost of Something is What You Give Up to Get It Due to the fact that resources are scarce, before we decide on using them for one purpose, an evaluation and comparison of the costs and benefits of alternative uses for these resources must be conducted. The concept of opportunity cost is central to the study of economics. The opportunity cost of a particular decision is all the possible alternatives given up to achieve it. The notion of opportunity cost will be applied later in this unit when we discuss the production possibilities frontier model, and the concept of comparative advantage. Principle 3: Rational People Think at the Margin Due to the inevitable tradeoffs faced, all decisions involving the use of scarce resources must be economically sound or rational. Marginal analysis is the tool used by economists for determining whether the considered option is rational. Marginal implies extra, so marginal analysis involves evaluating the extra benefits of a particular option with the extra costs of that option. The decision makes sound economic sense if the extra or marginal benefitsoutweigh the extra or marginal costs. An example: After finishing your undergraduate studies (hopefully in economics), you face the option of either working or furthering your studies at the graduate level. The decision of whether to study further should be made by comparing the marginal costs with the corresponding marginal benefits. Marginal or extra costs to consider would be the sum of all direct school related costs such as tuition and books, as well as the indirect costs or foregone income due to not being able to work at all during this period when you focus only on studying. Marginal benefits to consider would be the incremental or extra earnings attributable to the higher level of education. Suppose the direct cost of schooling over the two year study period is $30,000, and the indirect cost or the income lost by not using your undergraduate education for working during those two years is $120,000. The resulting $150,000 of marginal costs have to be weighed against the extra or marginal benefits of the study program. Upon finishing your higher studies, suppose you earn an extra $15,000 annually. Note that $15,000 is the annual extraearnings over what you would have earned each year with your undergraduate degree alone. Assuming that you intend to work for 30 years, the cumulative marginal benefits would amount to $450,000. Based on the above analysis, the decision to further your education would be rational from the economic standpoint because, after using marginal analysis, the marginal benefits outweigh the marginal costs (in this scenario by a considerable $300,000 over your intended working horizon). Principle 4: People Respond to Incentives Incentives, in both the form of “carrots” (potential rewards) or “the stick” (possible punishment), influence our behaviour. Let us examine an example of each type.  The federal government, in the wake of the economic crisis, implemented the Home Renovation Tax Credit (2009 federal budget) to influence homeowners to spend on home renovation projects and get rewarded by earning tax credits of up to $1350, thereby adding fiscal stimulus to the economy.  The Alberta Environmental Protection and Enhancement Act carries a maximum penalty of $500,000 for being judged guilty of violations. This is an example of how the threat of punishment might influence us by providing an incentive not to engage in behaviour for which penalties are possible. Principle 5: Trade Can Make Everyone Better Off Trade between two countries can make each country better off. Each nation would export its specialized products and import specialized products of other nations. Having trade channels between countries would encourage trading nations to specialize in their respective products, thereby increasing economic efficiency. Because each nation is specializing in or producing what it is best suited for, scarce resources (e.g., labour, land, and machinery) are put to their optimal use, which helps to improve economic efficiency. Chapter 3 of the textbook provides details of how trade can benefit everyone. It first introduces, then applies, the important concept of comparative advantage, which forms the basis for trade and specialization. We will examine comparative advantage in detail later in this unit. Principle 6: Markets are Usually a Good Way to Organize Economic Activity In general, markets perform the role of bringing together buyers and sellers. The market economy allocates scarce resources through decisions made by firms and households as they interact in product markets. A market economy is considered to be a good way to organize economic activity—the interaction between buyers and sellers—because of the important inherent characteristic of the invisible hand of the price mechanism. The price mechanism refers to changing prices of products and resources in a market economy due to the forces of demand and supply. A detailed discussion of how changes in the supply and/or the demand for any product influences its price will be discussed in Chapter 4 of the textbook. For now, we will examine a simple example of how changing prices perform the key function of optimally allocating society’s scarce resources. Suppose the desirability of a certain product rises. In a market economy with adjustable prices, the price paid for this product would increase due to the enhanced demand from consumers. This increased price would signal producers to step up production of this good or service, which ensures that society’s scarce resources are being used up by producers to create those products that are needed by consumers. Scarce resources (e.g., labour, land, and machinery) are therefore put to their most optimal use, thereby increasing economic efficiency. Principle 7: Governments Can Sometimes Improve Market Outcome There are several ways in which the governments can help improve the functioning of a market economy. Principle 6 suggests that the market economy usually ensures that scarce resources are put to their optimal use to create the correct amounts of all the desired products. This is generally true. Sometimes, however, the market
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