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Chapter 1

Chapter 1

Course Code
ECN 104
Eric Kam

of 5
Principles of Microeconomics
Chapter 1
The management of society’s resources (example: people, land, buildings,
and machinery) is important because resources are scarce. 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 scarce resources. In
most societies, resources are allocated not by a single central planner but
through the combined actions of millions of households and firms.
Economists also study how people interact with one another. They also
analyze forces and trends that affect the economy as a whole, including the
growth in average income, the fraction of the population that cannot find
work, and the rate at which prices are rising.
How People Make Decisions
An economy is just a group of people interacting with one another as they
go about their lives.
Principle # 1: People Face Tradeoffs
To get one thing that we like, we usually have to give up another thing that
we like. Making decisions requires trading off one goal against another.
When people are grouped into societies, they face different kinds of
tradeoffs. The classic tradeoff is between “guns and butter.” The more we
spend on national defense (guns) to protect our shores from foreign
aggressors, the less we can spend on consumer goods (butter) to raise our
standard of living at home.
Also important in modern society is the tradeoff between a clean
environment and a high level of income. Laws that require firms to reduce
pollution raise the cost of producing goods and services. Because of the
higher costs, these firms end up earning smaller profits, paying lower wages,
charging higher prices, or some combination of these three.
Another tradeoff society faces is between efficiency and equity. Efficiency
means that society is getting the most it can from its scarce resources.
Equity means that the benefits of those resources are distributed fairly
among society’s members. In other words, efficiency refers to the size of the
economic pie, and equity refers to how the pie divided. In other words, when
the government tries to cut the economic pie into more equal slices, the pie
gets smaller.
Principle # 2: The Cost of Something is What You Give Up to Get it
Because people face tradeoffs, making decisions requires comparing the
costs and benefits of alternatives courses of action.
The opportunity cost of an item is what you give up to get that item.
When making any decision, such as whether to attend college or university,
decision makers should be aware of the opportunity costs that accompany
each possible action.
Principle # 3: Rational People Think at the Margin
Economists normally assume that people are rational. Rational people
systematically and purposefully do the best they can to achieve their
objectives, given the opportunities they have. Consumers who buy a bundle
of goods and services to achieve the highest possible level of satisfaction,
subject to their incomes and the prices of those goods and services.
Economists use the term marginal changes to describe small incremental
adjustments to an existing plan of action. Keep in mind that “margin means
“edge,” so marginal changes are adjustments around the edges of what you
are doing.
Rational people often make decisions by comparing marginal benefits and
marginal costs. Why is water so cheap, while diamonds are so expensive?
Humans need water to survive, while diamonds are unnecessary; but, for
some reason, people are willing to pay much more for a diamond than for a
cup of water. The reason is that a person’s willingness to pay for any good is
based on the marginal benefit that an extra unit of the good will yield. The
marginal benefit, in turn, depends on how many nits a person already has.
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 (such as the prospect of a punishment or a
reward) that induces a person to act. Because rational people make
decisions by comparing costs and benefits, they respond to incentives.
For example, when the prices of an apple rises, people decide to eat more
pears and few apples because the cost of buying an apple is higher. At the
same time, apple orchards decide to hire more workers and harvest more
apples because the benefit of selling an apple is also higher.
Public policymakers should never gorget about incentives, because many
policies change the costs or benefits that people face and, therefore, alter
How People Interact
Principle # 5: Trade Can Make Everyone Better Off
Trade allows each person to specialize in the activities he or she does best,
whether it is farming, sewing, or home building. By trading with others,
people can buy a greater variety of goods and services at lower cost.
Countries as well as families benefit from the ability to trade with one
another. Trade allows countries to specialize in what they do best and to
enjoy a greater variety of goods and services.
Principle # 6: Markets Are Usually a Good Way to Organize Economic Activity
The theory behind central planning was that only the government could
organize economic activity in a way that promoted economic well-being for
the country as a whole.
Today, most countries that once had centrally planned economies have
abandoned this system and are trying to develop market economies. In a
market economy, the decisions of a central planner are replaced by the
decisions of millions of firms and households.
Firms decide whom to hire and what to make. Households decide which
firms to work for and what to buy with their incomes. These firms and
households interact in the marketplaces, where prices and self-interest guide
their decisions.
Free markets contain many buyers and sellers of numerous goods and
services, and all of them are interested primarily in their own well-being.
In his 1776 book An Inquiry into the Nature and Causes of the Wealth of
Nations, economists 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 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.
There is an important corollary to the skill of the invisible hand in guiding
economic activity: When the government prevents prices from adjusting
naturally to supply and demand, it impedes the invisible hand’s ability to
coordinate the millions of households and firms that make up the economy.
Taxes distort prices and thus the decisions of households and firms.
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. Most important, markets work
only if property rights are enforced. Property rights is the ability of an
individual to own and exercise control over scarce resources.
The invisible hand is powerful, but it is not omnipotent. Although markets
are often a good way to organize economic activity, this rule has some
important exceptions. There are two broad reasons for a government to