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Chapter 1


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Hannah Holmes

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Quick Quizzes
1. The four principles of economic decisionmaking are: (1) people face tradeoffs; (2) the cost of something is what you
give up to get it; (3) rational people think at the margin; and (4) people respond to incentives. People face tradeoffs
because to get one thing that they like, they usually have to give up another thing that they like. The cost of something
is what you give up to get it, not just in terms of monetary costs but all opportunity costs. Rational people think at the
margin by taking an action if and only if the marginal benefits exceed the marginal costs. People respond to incentives
because as they compare benefits to costs, a change in incentives may cause their behaviour to change.
2. The three principles concerning economic interactions are: (1) trade can make everyone better off; (2) markets are
usually a good way to organize economic activity; and (3) governments can sometimes improve market outcomes.
Trade can make everyone better off because it allows countries to specialize in what they do best and to enjoy a wider
variety of goods and services. Markets are usually a good way to organize economic activity because the invisible
hand leads markets to desirable outcomes. Governments can sometimes improve market outcomes because
sometimes markets fail to allocate resources efficiently because of an externality or market power.
3. The three principles that describe how the economy as a whole works are: (1) a country’s standard of living depends
on its ability to produce goods and services; (2) prices rise when the government prints too much money; and (3)
society faces a short-run tradeoff between inflation and unemployment. A country’s standard of living depends on its
ability to produce goods and services, which in turn depends on its productivity, which is a function of the education of
workers and the access workers have to the necessary tools and technology. Prices rise when the government prints
too much money because more money in circulation reduces the value of money, causing inflation. Society faces a
short-run tradeoff between inflation and unemployment that is only temporary and policymakers have some ability to
exploit this relationship using various policy instruments.
Questions for Review
1. Examples of tradeoffs include time tradeoffs (such as studying one subject over another, or studying at all compared to
engaging in social activities) and spending tradeoffs (such as whether to use your last ten dollars on pizza or on a
study guide for that tough economics course).
2. The opportunity cost of seeing a movie includes the monetary cost of admission plus the time cost of going to the
theater and attending the show. The time cost depends on what else you might do with that time; if it's staying home
and watching TV, the time cost may be small, but if it's working an extra three hours at your job, the time cost is the
money you could have earned.
3. The marginal benefit of a glass of water depends on your circumstances. If you've just run a marathon, or you've been
walking in the desert sun for three hours, the marginal benefit is very high. But if you've been drinking a lot of liquids
recently, the marginal benefit is quite low. The point is that even the necessities of life, like water, don't always have
large marginal benefits.
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Chapter 1/Ten Principles of Economics 2
4. Policymakers need to think about incentives so they can understand how people will respond to the policies they put in
place. The text's example of seat belts shows that policy actions can have quite unintended consequences. If
incentives matter a lot, they may lead to a very different type of policy; for example, some economists have suggested
putting knives in steering columns so that people will drive much more carefully! While this suggestion is silly, it
highlights the importance of incentives.
5. Trade among countries isn't a game with some losers and some winners because trade can make everyone better off.
By allowing specialization, trade between people and trade between countries can improve everyone's welfare.
6. The "invisible hand" of the marketplace represents the idea that even though individuals and firms are all acting in their
own self-interest, prices and the marketplace guide them to do what is good for society as a whole.
7. The two main causes of market failure are externalities and market power. An externality is the impact of one person’s
actions on the well-being of a bystander, such as from pollution or the creation of knowledge. Market power refers to
the ability of a single person (or small group of people) to unduly influence market prices, such as in a town with only
one well or only one cable television company. In addition, a market economy also leads to an unequal distribution of
8. Productivity is important because a country's standard of living depends on its ability to produce goods and services.
The greater a country's productivity (the amount of goods and services produced from each hour of a worker's time),
the greater will be its standard of living.
9. Inflation is an increase in the overall level of prices in the economy. Inflation is caused by increases in the quantity of a
nation's money.
10. Inflation and unemployment are negatively related in the short run. Reducing inflation entails costs to society in the
form of higher unemployment in the short run.
Problems and Applications
1. a. A family deciding whether to buy a new car faces a tradeoff between the cost of the car and other things they
might want to buy. For example, buying the car might mean they must give up going on vacation for the next
two years. So the real cost of the car is the family's opportunity cost in terms of what they must give up.
b. For a member of Parliament deciding whether to increase spending on national parks, the tradeoff is
between parks and other spending items or tax cuts. If more money goes into the park system, that may
mean less spending on national defence or on the police force. Or, instead of spending more money on the
park system, taxes could be reduced.
c. When a company president decides whether to open a new factory, the decision is based on whether the
new factory will increase the firm's profits compared to other alternatives. For example, the company could
upgrade existing equipment or expand existing factories. The bottom line is: Which method of expanding
production will increase profit the most?
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