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Chapter 1-5

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Department
Economics
Course
ECON 1B03
Professor
Hannah Holmes
Semester
Fall

Description
CHAPTER ONE Economics  Scarcity: society has limited resources (ex. People, land, buildings, machinery) and cannot produce all goods and services people wish to have  Economics: o The study of how society manages its scarce resources o Study of how people made decisions: how much they work, what they buy, how much they save, how they invest their savings o Study how people interact with each other (buyers sellers, quantity, prices) o Analyze forces and trends that affect economy as a whole (ex. Growth rate in average income, fraction of population that cannot find work, rate at which population rising)  Economy: group of people interacting with each other as they go about lives  Entrepreneurship: someone who takes all the other resources to make a product, gets all resources to work together How People Make Decisions Principle #1: People Face Tradeoffs  To get one thing we want, usually have to give up another thing we want  Making decisions requires trading off one goal for another  Economic rationality: we make decisions that maximize the benefits we receive from our decisions (everything we do, we do in our best interests)  Assume when make decisions that we have "perfect information"  Perfect information: we know everything about everything, no mysteries, surprises or uncertainty (ex. firms know all prices, how other firms will react to any changes they make, etc.)  Asymmetrical information: hard to have perfect information (ex. sellers usually have more information about the goods they are selling than the buyers do)  Efficiency: society is getting the most it can from scarce resources  Equity: benefits of scarce resources are distributed fairly among society  Efficiency refers to size of economic pie, equity refers to how pie is divided  Government policies often face tradeoff between these two (ex. Income tax makes financially successful give their earnings to the poor – reduces reward for working hard so people will work less/produce less goods and services) Principle #2: The Cost of Something Is What You Give Up to Get It  Making decisions requires comparing costs and benefits of choices  Cost of one decision may not necessarily be clear/easy to calculate (ex. Go to school and get an education vs. work for a year and make money)  Opportunity cost: what must be given up to obtain some item Principle #3: Rational People Think at the Margin  Rational people: people who systematically and purposely do the best they can to achieve their objectives  Marginal changes: small incremental adjustments to existing plan of action  Rational people make decisions by comparing marginal benefits and marginal costs  Rational person takes action only if the marginal benefit is greater than the marginal cost o Ex. People are willing to pay more for a diamond than water even though water is essential for survival whereas diamonds are not o Person’s willingness depends on marginal benefit o Marginal benefit of water is small because there is a lot of it o Marginal benefit of diamonds is large because they are rare Principle #4: People Respond to Incentives  Incentive: something that induces a person to act (ex. Punishment/reward)  Rational people respond to incentives  Effect of a good’s price on behavior of buyers/sellers in a market is crucial for understanding how economy allocates scarce resources  Policymakers should not forget about incentives because policies can change costs/benefits people face and alter their behavior o Ex. Seatbelts resulted in less deaths per accident, more accidents from careless driving and more pedestrian deaths How People Interact Principle #5: Trade Can Make Everyone Better Off  Trade between two countries does not mean one wins and one loses; can make each country better off  Trade allows each person/country to specialize in activities they do best  Trade allows people to buy greater variety of goods/services at lower cost Principle #6:Markets Are Usually a Good Way to Organize Economic Activity  Communist countries: central planners in government were in best position to guide economic activity  Planners decided what goods/services were produced, how much, who produced/consumed them  Market economies: economy that allocates resources through decentralized decisions of many firms and households as they interact in markets for goods and services  No one looking out for economic well-being of society as a whole  Even though everyone fends for themselves, are all generally successful  “Invisible hand” seems to direct households and firms  Invisible hand directs economic activity with prices: buyers look ate price when determining how much to demand, sellers look at price when deciding how much to supply  Invisible hand cannot coordinate millions of households and firms if government prevents prices from adjusting naturally to supply/demand  Mixed economies: combination of mainly market and command economies Principle #7: Governments Can Sometimes Improve Market Outcomes  Invisible hand can only work if government enforces rules and maintains institutions that are necessary to market economy  Property rights: ability of an individual to own and exercise control over scarce resources (ex. Music company will not produce CDs if all customers download illegally)  Governments need to enforce our rights over things we produce  Two main reasons for government to intervene: 1. Promote efficiency 2. Promote equity  Market failure: market left on its own fails to allocate resources efficiently  Externality (can cause market failure): impact of one person’s actions on well being of bystander (ex. Pollution)  Market power (can cause market failure): ability of single person (or group) to have substantial influence on market prices  Invisible hand does not ensure everyone has sufficient food, decent clothing, adequate health care How The Economy As A Whole Works Principle #8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services  High-income countries have more luxuries than low-income countries (ex. TVs, nutrition, health care)  Productivity: amount of goods and services produced from each hour of a worker’s time  Growth rate of nation’s productivity determines growth rate of it’s average income (higher rate of income means higher living standards)  To raise living standards policymakers must ensure workers are well educated, have tools needed to produce goods/services, have access to best technology Principle #9: Prices Rise When the Government Prints Too Much Money  Inflation: increase in overall level of prices in economy  Policymakers worldwide try to keep inflation at a low level  Main cause of inflation is growth in quantity of money  When government creates a lot of money, value of money falls Principle #10: Society Faces a Short-Run Tradeoff Between Inflation and Unemployment  Short-run effects of increase in money: o Increasing amount of money stimulates overall level of spending and thus the demand for goods and services o Higher demand may cause firms to raise prices but also encourages them to increase quantity of goods/services they produce and hire more workers o More hiring means lower unemployment  Leads to economy-wide tradeoff: short-run tradeoff between inflation and unemployment  Business cycle: fluctuations in economic activity measured by employment or production of goods  Policymakers can control this tradeoff: change amount that government spends, amount it taxes, amount of money it prints CHAPTER TWO The Economist As A Scientist  Economists devise theories, collect data and analyze data to verify/refute theory (use scientific method) The Scientific Method: Observation, Theory, and More Observation  Economists develop theories and use scientific method to prove them  Problem: hard to perform experiments in economics  Cannot manipulate an economy just to generate useful data  Must pay attention to natural experiments throughout history  Economy of past lets us illustrate and evaluate economic theories of present The Role of Assumptions  Assumptions can simplify complex world and make it easier to understand  Once we understand a situation in an imaginary world it makes it easier to understand in the real world  Must use different assumptions to answer different questions o Ex. If studying prices that do not change frequently in a short-term situation, could assume prices do not change much or are fixed o If studying long-term may assume all prices are completely flexible Economic Models  Economists use models such as diagrams and equations to learn about world  Will not include every feature of economy  Models built with assumptions about many details of economy that are irrelevant to studying question at hand Our First Model: The Circular-Flow Diagram  Circular-flow diagram: visual model of the economy that shows how dollars flow through markets among households and firms  Firms produce goods/services using factors of production o Labour o Land (natural resources) o Capital (buildings, machines)  Households and firms interact in: o Markets for goods and services: households are buyers, firms are sellers (households buy output of goods/services produced) o Markets for the factors of production: households are sellers, firms are buyers (households provide inputs firms are using to produce)  Inner loop of circular-flow diagram represents flows of inputs and outputs  Factors of production flow from households  firms  Goods and services flow from firms  households  Outer loop of circular-flow diagram represents corresponding flow of dollars  Spending on goods and services flows from households  firms  Income in form of wages, rent and profit flows from firms  households Our Second Model: The Production Possibilities Frontier  Production possibilities frontier: graph that shows various combinations of output that economy can possibly produce given available factors of production and available production technology  Pretend economy only produces two goods  If all resources used in one industry, only produce that good and not the other one (and vice versa)  Two end points of production possibilities frontier represent extremes  Economy will divide scarce resources between two industries  Economy can produce any point on or inside frontier but not points outside frontier (because only has certain number of resources)  Efficient: outcome where economy is getting all it can from scarce resources available (points on the frontier, not inside)  Inefficient: economy is producing less than it could from available resources (points inside the frontier)  Shows opportunity cost of one good measured in terms of another good (what is tradeoff in one industry to get more from the other industry)  Opportunity cost of a good is highest at end where economy is producing a lot of that good and lowest where economy is producing more of other good Microeconomics and Macroeconomics  Microeconomics: study of how households and firms make decisions and how they interact in specific markets  Macroeconomics: study of economy-wide phenomena (inflation, unemployment, economic growth)  Each subfield may look at factors from the other when analyzing a situation The Economist as a Policy Adviser Positive versus Normative Analysis  Positive statements: claims that attempt to describe world as it is (scientific)  Normative statements: claims that attempt to prescribe how world should be  Positive statements can be evaluated using data  Normative statements cannot only be evaluated on data, must consider views on ethics, religion and political philosophy  Positive views about how world works affect normative views about what policies are desirable Why Economists Disagree  Economists may disagree about validity of alternative positive theories about how world works  Economists may have different values so different normative views about what a policy should try to accomplish  Perfecting the science of economics will not tell us what the right answer is Perception versus Reality  There are some matters that almost all economists agree on (ex. Rent control, trade barriers)  Sometimes policies still exist even though economists do not approve because they have not yet convinced the general public/government CHAPTER THREE A Parable For The Modern Economy Production Possibilities  Farmer/rancher can produce maximum amount of meat in certain amount of time or maximum amount of potatoes in that time (only get one good but a lot of it)  Could also spend half the time on each good and get half as much of both (get both goods but less)  If choose to be self-sufficient each will consume exactly what they produce Specialization and Trade Farmer Rancher Meat Potatoes Meat Potatoes Without Trade: Production and Consumption 4kg 16kg 12kg 24kg With Trade: Production 0kg 32kg 18kg 12kg Trade Gets 5kg Gives 15kg Gives 5kg Gets 15kg Consumption 5kg 17kg 13kg 27kg Gains from Trade: Increase in Consumption +1kg +1kg +1kg +3kg  Both gain from trade  Each specialize in producing what they produce best  Now farmer and rancher can consume more without working more hours Comparative Advantage: The Driving Force of Specialization Absolute Advantage  Absolute advantage: comparing productivity of one person/firm/nation to another for a certain good  Producer that requires smaller quantity of inputs to produce good has an absolute advantage in producing that good Opportunity Cost and Comparative Advantage  Opportunity cost measures tradeoff between two goods each producer faces  Opportunity cost of one good = inverse of the opportunity cost of the other good  Comparative advantage: comparison among producers of a good according to their opportunity cost  Producer who gives up less of other goods to produce good X has smaller opportunity cost of producing good X (has comparative advantage)  Impossible for one person to have comparative advantage in both goods  Since it is inverse: if opportunity cost of one good is high, opportunity cost of other good must be low The Price of Trade  For both parties to gain from trade, the price at which they trade must lie between the two opportunity costs  Does not have to be exactly in the middle  If below both peoples opportunity cost for one good, will want to buy the other good  If above both peoples opportunity cost for one good, will want to sell the other good Applications Of Comparative Advantage Sho
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